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NOVEMBER 27, 2000
Don't Hang UpXO Communications plots an ambitious strategy as upstart
rivals fall
By Jacqueline DohertyIf you think the dot.coms have been a disaster, take a look at the carnage in
the telecommunications sector. Since Congress opened up the local telephone
market with the Telecommunications Act of 1996, scores of small companies
have entered the fray. Four years later, these startups, dubbed competitive
local exchange carriers, or CLECs, are fighting for their lives. According to
Merrill Lynch, the average CLEC stock is down more than 83% from its high
this year. And the first fatalities have already arrived: GST
Telecommunications filed for bankruptcy protection in May and ICG
Communications followed suit earlier this month. More will surely follow.
"We track a list of 25 companies, and in my opinion there are probably less
than four that will survive," says Daniel Akerson, chief executive of XO
Communications. One of those companies, he insists, will be XO. "We think
we are the survivor of the emerging broadband telecom players."
The obvious next question is, what the heck is XO Communications?
Formerly known as Nextlink Communications, the Reston, Virginia-based
firm was founded in 1994 by telecom mogul Craig McCaw to offer local and
long-distance services to businesses. And like McCaw Cellular before it, XO
boasts some of the strongest management and most ambitious buildout plans
in the industry. Indeed, XO is in the midst of laying a brand new fiber and
wireless telecommunications network, which Akerson claims will have more
capacity than competitors' and will offer the most advanced voice and data
products, while boasting the best margins in the business. "We will be able to
stand toe-to-toe with what are recognized as the players today" like AT&T,
WorldCom and the Baby Bells, boasts Akerson. "We can compete with
anybody, from the very small to the very large."
Like MCI, where Akerson previously served as chief financial officer and
ultimately president, XO also wants to turn the telecommunications industry
on its head. In Akerson's vision of the future, telecom traffic will be carried
over data lines, and charges will resemble an Internet bill, with one flat rate
per month. Levies for time and distance will disappear. And while rival firms
have seen financing dry up for their ambitious plans, XO has a secret weapon:
Craig McCaw. Over the years, McCaw, who owns a 20% equity stake and
has 51% of the voting control, has borrowed and repaid billions of dollars in
junk-bond debt. First came McCaw Cellular, which borrowed over $4 billion
in the 1980s and early 1990s and was later sold to AT&T. Next came
Nextel, which McCaw took control of in 1996. And while he's not involved
in day-to-day operations, McCaw, who sits on XO's board, gives the
company a huge amount of credibility. Now, with XO he's tapped the
markets again, selling $6.44 billion in debt and preferred stock to help fund its
growth. And while other small telcom players are probably shut out of
junk-bond markets for the foreseeable future, XO could likely still sell bonds,
albeit at a lofty 18% rate. And in today's markets, access to financing can
mean the difference between life and death.
XO also benefits from a seasoned
management team sprinkled with folks that
have worked with McCaw or Akerson in the
past. Akerson, whose tenure at MCI lasted
from 1982 to 1993, spent three years as chief
executive of Nextel before coming to XO last
year. His time at MCI, however, during
which the upstart firm successfully took on
AT&T, is perhaps the most relevant to his
current charge. "MCI beat AT&T because
we had better marketing and we had the best
back office systems in the industry," he says.
True to form, XO began its first national
advertising campaign this fall and has been
pumping money into its back-office systems.
If XO gets it right, its opportunity is huge. Daniel Ernst, an analyst at Legg
Mason Wood Walker, estimates that the business-communications market
generates $180 billion in revenues and grows about 8%-9% per year. The
data segment of that market expands by around 30% annually, a rate that will
slow over time but is still quite attractive. Right now, CLECs have about 5%
of the local business lines. Believers hope the evolution of the local markets
follows the same path as that of the long-distance market. Before the 1984
breakup of AT&T, Ma Bell held nearly 100% of the long-distance market.
Today, its share is a mere 50%.
And just as the stock market soured on cellular stocks a decade ago, when
the junk-bond market went dry, so too have CLECs been all but given up for
dead. XO's shares haven't been spared. They've fallen from a peak of 66 in
March to a recent 16. And XO's market value has shrunk to about $5.9
billion from $24.1 billion. "XO below $30 is very attractive. We think it's
worth $35 a share," says Dean Kartsonas, a portfolio manager of the
Federated Communications Technology fund. Kartsonas recently lowered his
XO target price to adjust for the higher cost of capital that XO now faces.
But he likes the fact that the company continues to hit its financial targets.
That said, most of today's investors don't like risk, and XO has tons of it. The
company is expected to lose $1.4 billion, or $4.15 a share, this year on $726
million in revenues. And the numbers don't look any prettier next year with a
$2.1 billion, or $5.55 a share, loss expected on $1.4 billion in revenues. The
huge losses stem from XO's aggressive spending plans for its network. This
year and 2001 should be the high-water marks for spending. And then XO is
expected to turn cash flow-positive in 2002 and show profits in 2007. That,
of course, assumes that Wall Street's perpetually optimistic analysts are
correct. To get comfortable with XO's stock, an investor has to bet that the
company will have enough cash to finish building its network and that its sales
force will successfully drum up enough business to put over that
communications system. Analysts put together 10-year models of what they
think the company's operations and cash flows will look like. By 2010, XO
could generate $13.2 billion of revenues and earnings of $3.3 billion, or
$7.34 a share, according to Lehman Brothers' estimates.
But reaching profitability will take awhile, in part because XO borrowed huge
amounts to help fund the buildout of its network. The company has $4.37
billion in long-term debt and $2.07 billion in preferred stock. That means
interest and dividend payments of $585 million this year. Since a large slug of
the debt is in the form of zero-coupon bonds, which don't pay cash interest,
the company will have to shell out only $380 million in cash. XO does have
$3.3 billion of cash and available bank credit, but it plans to use those funds
to keep building its network. Indeed, most analysts believe the company still
needs to raise more than $3 billion to complete this project. And that doesn't
include the buildout of its European network. On Tuesday, XO's recently
appointed chief financial officer, Wayne Rehberger, who previously headed
up finance at MCI, will be among the managers announcing the company's
European spending plan. Some analysts believe it will call for a slower rollout
than first expected, as XO conserves cash to cope with the changed market
environment.
Debt levels and liquidity became an issue this year, as the endgame changed
for many CLECs. "One of the key hooks for much of the debt and financing
for the New Economy telcos was predicated on their being able to sell out to
the incumbents, converting a CCC credit into an investment-grade bond,"
wrote Ravi Suria in a recent Lehman Brothers research report. It worked in
1997 when WorldCom purchased Brooks Fiber Properties for 4.4 times
gross plant, property and equipment (PP&E). And it worked again in 1998
when AT&T bought Teleport Communications Group for 7.5 times PP&E.
But now the giants are struggling with their own leverage problems and
slow-growth retail businesses.
The depressed stocks of AT&T or WorldCom no longer provide the
currency to make blockbuster acquisitions. And none of the incumbents has
an appetite for taking on the large debt loads that come with CLECs, leading
naysayers to wonder whether XO and others have the right capital structure.
In fact, some potential buyers may wait, hoping to buy assets on the cheap
after CLECs file for bankruptcy protection. When Time Warner Telecom
purchased assets of bankrupt GST in August, it paid just 0.7 times PP&E.
XO has $2.4 billion in PP&E and $987 million invested in wireless licenses.
Combined, those two remain well below its market cap.
Akerson, however, contends he's not building the business with the intention
of selling. Indeed, he remains confident about XO's future and is no stranger
to tough times in the capital markets. MCI lost 50% of its market value on six
separate occasions over 10 years, he points out. That includes October 19,
1987 -- Black Monday. That day, Akerson released his first set of earnings
as MCI's CFO and the stock lost two-thirds of its market value.
"I've looked into the dark abyss many times in my career. There were times
we did not know if we would make payroll at MCI, and I am not kidding,"
says Akerson. "Nobody gave us a chance. Nobody. And we beat them and
really started a revolution."
He again proved the naysayers wrong at Nextel Communications. "I was at
Nextel when everybody counted us out. Two years ago, we showed $1.5
billion of negative cash flow. This year, they'll show $1.5 billion positive" cash
flow, he declares. "You have to spend to build your network." Now he's
spending to build again. But this time, his focus is on both the local and
long-distance markets. Here's the challenge: Most long-distance traffic is
carried over fiber networks, which can handle the huge quantities of data that
businesses generate. But about 95% of companies connect to that fiber
through local copper lines owned by the Bell companies. Copper can't handle
the same volume of information. So, transporting data has become like
pushing a large volume of water through a fire hose that is connected to a
straw. It just doesn't work. The problem will only worsen if data
communications continues to explode. As the Internet drives demand for data
communications, the need for better transmission, especially at the local level,
will climb, or so the theory goes. "As more bandwidth gets out there, I think
we're going to see all kinds of streaming audio and video changing the way
people buy music, talk to each other and the way they communicate with
each other," says XO President Nate Davis. Davis previously served as
Nextel's executive vice president for technical services and MCI's chief
financial officer. Fifteen years ago, he recalls, MCI installed fiber from New
York to Washington, believing it would last for 10 years. Instead, MCI had
to lay additional fiber three times over 10 years. "We can't just build enough
for what we see coming in the next three years," says Davis. "We're building
enough for the things we can't see. We're building 10-20 times the capacity
we think is needed because we believe there will be new applications we
haven't even thought of."
XO also has expanded into Internet services, which Akerson sees as a critical
part of any business telecommunications offering. In June, Nextlink and
Concentric Network completed a $3.6 billion merger and the two changed
their names to XO in September. Concentric gets XO into the business of
Web hosting, e-commerce and other Internet-related data services, which the
company is folding into its other service offerings. So while voice will remain
an important business, XO's future clearly lies in the burgeoning market for
data communications. Last year, for example, about 75% of the company's
revenues came from voice communications. This year, that will shrink to
48%, and next year Akerson thinks it will be closer to 38%, as data revenues
continue to surge.
But just as long-distance phone charges are dropping dramatically, prices of
some data services are also on the decline. Investors need to believe that
declining prices of voice and data communications will be adequately offset by
increasing volumes of data communication, lower transmission costs and new
higher margin services, like Web hosting and virtual private networks.
By the middle of next year, XO will have fiber loops in the 60 U.S. cities that
generate about 80% of all business traffic. XO is also building connections
from individual buildings to its local fiber loop. The connection either occurs
through a costly fiber line, which has more capacity, or through a less
expensive wireless feed, which has less capacity than fiber but much more
than a copper phone line. Unlike most of its competitors, XO will also have a
fiberoptic network connecting the 60 cities by late 2001 to handle
long-distance calls. And it has begun building connections to Canada and to
Europe.
"We're building a long-haul network [in the U.S.] that, when it's up and
operating, can carry all of AT&T, WorldCom and Sprint's traffic and have
capacity to spare," declares Akerson.
XO literally wants to control the call or data transmission from where it
originates to where it terminates. It wants to put the entire phone call or data
feed over its own wires, looking a bit like AT&T's commercial operations
prior to the '84 breakup. If it can achieve that goal, XO won't have to pay
another company to transport its traffic during any leg of the call. That should
give XO some of the best margins in the business because no one else will be
able to do the same thing. Long-distance companies, for example, don't have
the local presence of XO, so they'll have to pay the Bell companies access
fees. And the Bells don't have the long-distance connections or the regulatory
approval in most states, to offer such service.
Not everyone in the industry agrees that building is better than renting,
however. Many of XO's competitors are building only local networks and at a
much slower pace. Some, like WinStar Communications and Teligent, have
opted to use only wireless technology in their platform. This approach, often
referred to as the "smart build," is much less costly. As a result, some
competitors will become profitable sooner than XO (see table). However,
the competition also will be much more dependent on leasing lines and
reselling services from the incumbents, like the Bells, AT&T or WorldCom,
against which they also compete.
Akerson thinks this strategy will end in disaster. It's as simple as two kids
selling apples on a street corner, he says. Johnny gets his apples for free from
a tree in the backyard and sells them for 10 cents each. Meanwhile, Fred
buys apples from Johnny for eight cents each and sells them for nine cents.
When Johnny cuts prices to seven cents, he still makes a profit. But if Fred
cuts his prices to seven cents, he'll be operating at a loss. If he doesn't cut
prices, Fred will lose business to Johnny. Either way, Fred faces a bad
business proposition.
Fred "didn't want to own the strategic assets that create the value," explains
Akerson. "We can compete as vigorously as anybody on price because we
own our own assets." Back in the 1980s, he recalls, there were 6,000
long-distance resellers competing for business. By the early 'Nineties, fewer
than a dozen were left standing. He believes the same fate lies ahead for
companies competing in the local markets that don't own their assets.
One way to evaluate XO's progress is by looking at the cities it entered
earliest. In markets like Memphis and Nashville, where the company launched
service in 1996, XO is generating 68% gross margins and 35% EBITDA
margins, or EBITDA (earnings before interest, taxes, depreciation and
amortization) divided by its revenues. In other words, for every $1 of
revenues, the company generates 35 cents of EBITDA, not including
corporate overhead. Those cities opened in 1997 have gross margins of 70%
and EBITDA margins of 18%, and the class of '98 has 68% gross margins
and is expected to turn EBITDA-positive in the fourth quarter, according to
Jim Friedland, a senior telecom services analyst at Robertson Stephens. "It's
XO's way of demonstrating to the Street that even though the business as a
whole is not EBITDA-positive, the earlier businesses are starting to be
profitable and you can see that over a period of time the entire business is
going to be profitable," Friedland explains. The cities the company launched
earliest show that, given time, XO's model works. And its numbers should
only improve as the company's nationwide network goes online and it can
handle more and more of its business on its own network.
"Our objective is
that, once we
launch in a city,
we will be
cash-flow-positive,
before corporate
overhead, within
30 months.
We've achieved
that goal in every
market we've
launched,"
Akerson says.
In addition to building out networks, XO is attempting to change the way
businesses think about communications. As the technology improves over the
next year or two, voice communication should be able to run over the fibers
previously used exclusively for data. When that happens, the XO folks
believe, voice will be just one more function carried out by a data network
and delivered at a flat fee. "The line between local and long distance line will
be obliterated. It will not be blurred. It will be obliterated," says an
enthusiastic Akerson. "There will be no distinction between local and long
distance." And XO will be able to take advantage of this change because it
will have the wires capable of handling data connecting its customers from
start to finish.
Adds Davis: "Voice will become one more application on your data network.
That's one of the telephone companies' nightmares." The telephone companies
have nothing but revenues to lose if phone calls become just an add-on to
data service. Conversely, XO doesn't have revenues to lose. Instead, it has
only customers to gain by pushing the new paradigm.
XO is already encouraging customers to think along these lines. In
September, it launched XOptions, which allows customers to decide what
their local, long-distance, data and Web-hosting needs are and then choose a
plan that charges one flat rate per month. XOptions eliminates a company's
need to evaluate vendors in as many as four different categories when buying
phone and data services. Now clients can go to one place and purchase the
services for 10%-40% less than they'd find elsewhere, according to the XO
folks. And thanks to XO's strong back-office system, it's all delivered on a
single bill.
Not surprisingly, other telecoms have yet to launch a counterattack. There's
simply too much for them to lose. This appears to be a repeat of the
corporate jujitsu strategy that Akerson employed in the early 'Nineties, when
he was president at MCI. For example, when that company introduced its
highly successful Friends & Family plan in 1991, which offered discounts to
MCI subscribers calling other select MCI subscribers, the company's gain in
new customers more than offset the revenues lost to discounting. AT&T
couldn't respond in kind. With its dominant share of the long-distance market,
Ma Bell simply had too much to lose and very little to gain.
Although XO started life focusing on small businesses, it has begun to target
large, high-profile outfits. Its most notable success has been landing Yahoo as
a client for gigabit Ethernet services. GigE, as the geeks call it, is like a local
area network on steroids. It basically takes your LAN, allows you to extend it
between buildings in a city and pump data over it, at low cost. Companies like
Yahoo will probably use it to connect data centers in different buildings within
a city. XO announced the service and the Yahoo account in September, and
by next July, XO should have GigE rolled out in all of its 60 markets. The
company is already trying to figure out how it can offer GigE nationwide.
So far, no other telecom offers a comparable service. AT&T won't roll out
GigE until early next year. The delay isn't surprising, because when an existing
client switches to the lower-cost GigE service, its telecom provider stands to
lose revenues. For XO, however, GigE means only new business and a way
to reach sophisticated, established players. Ken Hoexter, a managing director
at Merrill Lynch, estimates that GigE could add $50-$100 million to XO's
revenues over the next year. Corporate jujitsu all over again.
XO's next frontier is Europe. In May, the company agreed to purchase local
fiber and empty fiberoptic conduits in London, Frankfurt, Amsterdam and
Brussels and fiber in Paris. The purchase also included an inter-city network
connecting 21 major European cities. The system was bought from Level 3
for $306 million. Separately, the Concentric acquisition included a number of
European data centers.
In Europe, XO will roll out a network that handles data only, but it expects
new technology to allow it to transmit voice over the system within a year or
two. Next year, the company hopes to have $100 million in sales from
Europe, though XO may have to slow spending overseas to conserve cash if
the capital markets remain choppy and illiquid.
Indeed, XO managers are constantly evaluating contingency plans. "A good
manager, a good leader, always has a contingency plan in case things go to
hell in a handbasket," says Akerson, who graduated from the U.S. Naval
Academy before getting a master's degree from the London School of
Economics. Potential backdoors: XO could slow expansion in the U.S.,
stopping its buildout after completing 60 cities. It could also slow international
expansion plans or sell international assets to raise funds. Akerson has steered
through choppy waters before. He was at the helm of Nextel in 1998, when
the currency crisis and Russian default battered the international markets and
froze up the U.S. junk market. Nextel stopped spending until the first quarter
of 1999 and made it through the tough times. Indeed, optimists believe that if
XO survives the current storm, it will emerge bigger and stronger, with fewer
and weaker competitors. But right now, Akerson remains outwardly
confident, helped by the war chest he wisely accumulated over the past year.
"I think XO is about where MCI was in 1980. We're about to realize the full
potential of our asset set, and we're about to spread our wings on a national
scale," he says. If the past is any gauge, investors shouldn' |
