[Epoch Research Note] 360networks Joins Gloom Parade
By Mark Langner
Managing Director, Senior Analyst
Todd Fernandez, Bert Bangayan
Associate Analyst, Associate
Key Points
360networks (Nasdaq: TSIX, $7.7031) lowered financial expectations for 2001, after posting quarterly results that exceeded expectations on the top line.
The primary culprit underlying the downward revision is the delay of capacity purchases by the company's carrier customers.
We are lowering our 2001 revenue and EBITDA estimates.
Given the reduced visibility into future cash flow and the lack of network-services revenue to buffer reduced capital expenditures, we do not recommend purchase of shares of TSIX in the near-term.
360networks lowered financial expectations for 2001 on its fourth quarter conference call, after posting quarterly results that exceeded expectations on the top line. The primary culprit underlying the company's downward revision of its estimates is softness in the purchase of IRU capacity and dark fiber by the company's carrier customers. Since cash revenues are dependent on these types of sales, the lowered forecasts increase the company's business risks related to funding, access to capital, and extended inventory cycles. Given the reduced visibility into future cash flow and the lack of significant network-services revenue to buffer reduced capital expenditures, we are changing our outlook on the company and do not recommend purchase of shares of TSIX in the near-term.
Why is 360networks Vulnerable?
It is not surprising that carriers are trying to reduce their capital outlays due to the bleak macroeconomic outlook and the difficult operating environment in the telecom and broadband and IP data services sector. Since 360networks is still in the construction phase of its network and is only now beginning to deliver recurring services, the timing of this reduced spending is unfortunate.
Without a steady stream of recurring revenue from network services, the company is highly dependent on one-time IRU-type sales. In lieu of IRU purchases, customers are opting to lease bandwidth as a recurring operating expense rather than a larger, one-time capital cost.
As a result visibility into the business and financial model of the company on a cash basis will be cloudy. Even though the share price of TSIX has plummeted 30% since Monday, the stock is still trading on an enterprise value to 2001 revenue multiple of 11.4x, a premium to Level 3's 6.4x multiple. On a valuation basis, we would avoid the stock until the company can show better evidence of clearing its execution hurdles over the coming months.
The Numbers
360networks posted fourth quarter revenues of $158 million, topping our estimate of $130 million by 21%. Higher than expected COGS (cost of goods sold) and SG&A (sales, general, and administrative) expenses resulted in the company reporting an EPS loss of ($0.20), missing our EPS estimate of ($0.09). Gross margins for the quarter dropped from 43% to 30% on a quarterly sequential basis as a result of higher development costs.
SG&A expenses jumped 90% over the third quarter to $38 million, leading to SG&A margins of 24% versus 17% during the prior quarter. Much of this increase can be attributed to the bolstering of the company sales force, which grew from 80 to 100 quota-carrying sales people. The result was the company reporting EBITDA for the quarter of $10 million, considerably below our estimate of $44 million.
Joining the Warnings Club
The company cautiously lowered the hurdle for its 2001 financial metrics by reducing cash revenue guidance by 22%, from $3.1-$3.3 billion to $2.4-$2.6 billion. Adjusted EBITDA estimates were cut 27% from $2.5-$2.6 billion to $1.8-$1.9 billion. The impact on the company's GAAP (generally accepted accounting principles) statements will be less severe, as much of these results reflect prior capacity sales that are recorded over 15-20 years. We are cutting our 2001 revenue estimates from $677 million to $650 million. Due to the higher than expected COGS and SG&A expenses, we are reducing our 2001 EBITDA estimates from $145 million to $77 million.
Like its customers, 360networks is also reducing its capital expenditure forecasts for 2001. Capital expenditures for the year should be in the range of $3.5-$4.0 billion, down 13% from prior expectations. The $500 million reduction, which comes from success-based capital expenditures, will be spread throughout various components of the company's infrastructure: $250 million on terrestrial equipment, $175 million on submarine equipment, and $75 million on co-location facilities. This will ultimately slow down the development of the company's network, as fewer circuits will be built and activated, meaning potential revenues from these services may be delayed.
The lowered outlook for the company will also have negative effects on business prospects. Aside from lowered near-term cash flow from infrastructure sales, 360networks faces increased execution risk related to liquidity and funding. Our projections still show that the company is fully funded to build out its network, but it will have to do so with tighter resources and less buffer room.
The Bottom Line
The current difficult operating environment is forcing companies in the sector to re-think their capital expenditure decisions, resulting in much more conservative spending over the near term. According to 360networks' press release, "no one in our sector will be insulated from this market reality."
Relative to its more mature peers, 360networks does not posses as strong a buffer as Level 3 (Nasdaq: LVLT, $24.9375) and Global Crossing (NYSE: GX, $16.19), who already generate considerable recurring network services revenues. This is not to say 360networks is in the boat alone. Other infrastructure builders, including Level 3 and Global Crossing, target the same customer segment and are susceptible to the same bumpy market currents and potential aftershocks of this announcement.
On the brighter side, the company is still fully funded to complete its network build (although under increased risk), which will result in one of the world's first global, optical mesh networks. The company is deploying valuable network assets that can be highly monetized once they are fully operational. Furthermore, we are confident that demand for bandwidth remains strong even in this difficult economic environment. Aside from an aggressive cut in interest rates from the Fed, we do not see any fundamental catalysts that could buoy the stock from its short-term trading range. We cannot recommend purchase of TSIX at these levels until further clarity on the spending habits of carriers is achieved.
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