ML Investment Highlights:
· Initiating coverage of Rhythms NetConnections
(RTHM) with an intermediate term Accumulate
and a long term Buy rating. RTHM is a 3 rd
generation, or data, CLEC that offers broadband
local access services, local and national data
networking and value-added applications utilizing
digital subscriber line (DSL) technology.
· Our 12-18 month price objective is $87 or
26% upside. We valued RTHM using an
addressable market valuation measure –
YE'99 DSL POPs or D-POPs -- vs. its peer
data CLEC, Covad.
· We forecast strong top-line growth with revenues
of $11.5M in ‘99 growing by 435% to $50M by ‘00,
and finally reaching $1.9B by ‘08. We further
estimate EBITDA losses will hit $83M in ‘99, with
breakeven targeted for 2H03. EBITDA margins
should reach 29% by '08.
· In our view, the attractive economics of RTHM's
DSL-based business plan require low initial capital
costs and yield fast cash flow breakeven points with
less than 2% of the access lines served out of the
central offices RTHM offers service.
· RTHM has a highly-regarded entrepreneurial
management team with many years of experience
running data oriented telecom companies.
· The company's key strategic relationships with
MCIWorldcom, Microsoft and Cisco highlight
RTHM's position as a leading player in the market
for local broadband connectivity to business
customers.
· We believe RTHM is a significantly attractive
consolidation target given its co-location
spaces, interconnection agreements, deployed
DSL equipment, metropolitan switching
centers, backbone network and embedded
customer base.
We are initiating coverage on Rhythms NetConnections
(RTHM) with a near-term Accumulate and a long term
Buy rating. Our 12-18 month price objective is $87 or
26% upside based on an addressable market valuation
measure – DSL POPs or D-POPs.
Company Overview: Founded in ‘97 and headquartered in
Denver, CO, RTHM is a 3 rd generation, or data, CLEC
offering high speed, broadband local access services to
businesses customers over a new technology called digital
subscriber line or DSL. RTHM offers its services over the
same copper wires that incumbent local exchange carriers
(ILECs) offer plain old telephone service (POTS) by
leasing the copper plant from the ILEC as an unbundled
network element as provided for by the ‘96 Telecom Act.
Focus on High Value-Added Revenue Sources: RTHM
derives its revenues from 3 main sources: 1) local
broadband connectivity from remote workers and
telecommuters to both the internet and their corporate local
area networks (LANs); 2) value-added bandwidth-enabled
services like PBX-extension which extends the
digital functionality of the office phone to a remote
location (i.e., a teleworker's home) allowing such features
as 4-digit dialing, call forwarding, etc. utilizing the DSL
infrastructure; and, 3) backbone services which provide
high speed data connections between customer locations
both within a city and around the country.
The Rhythms Network: The RTHM network consists of
DSL Access Multiplexers (DSLAMs) that are located in
ILEC central offices (COs) which, in turn, are connected to
Metropolitan Service Centers (MSCs) through DS3 (45
Mbps) private lines. RTHM generally constructs 1 MSC,
which contains application servers and switching
equipment, and deploys 30-60 CO co-locations per market
and interconnects the MSCs through a nationwide
backbone network leased from MCIWorldcom. RTHM
customers connect to the RTHM DSLAM serving their
region in the nearest CO over a DSL modem which is
connected to their PC through a Network Interface Card.
The DSLAM equipment is installed in co-location space
secured in ILEC COs as allowed by the '96 Telecom Act,
while the MSCs are separate building facilities. RTHM's
ISP partners and corporate customers connect their
services directly into the ATM switches and IP routers
housed in the MSC which allows customers both locally
and around the country to access these services entirely
over RTHM-owned private network facilities.
The company provides always-on connectivity from its
customers' locations into the RTHM network through
either symmetric DSL service, in which the upstream and
downstream speeds are identical, or asymetric DSL
service, in which they are not. RTHM offers 7 speeds of
symmetric service: 128K, 256K, 384K, 512K, 768K 1.0M
and 1.5M at list prices ranging from $115/month at the low
end to $325 at the high end. Asymetric service runs up to
7.1 Mbps down/1.0 Mbps up and costs about $700. The
fastest speed that any given customer can receive is
primarily a function of the distance separating the
customer's location from the serving central office.
Rhythms' first commercial market went into service in
April '98 in San Diego. Since then, the company has
expanded with operations now in 10 markets in total,
including San Francisco, San Jose, Oakland, Chicago, LA,
Orange county CA, Boston, Sacramento and New York.
Key Points of the Investment Thesis:
1) Substantial Pent-up Demand for Broadband
Connectivity: We believe there is a huge, pent-up demand
for high-speed data connections by business customers
who are in the approx. 95% of office buildings in the US
not currently served by fiber. RTHM is a key beneficiary
of this unmet demand, utilizing loops “conditioned” for
DSL services provided by the ILECs which affords RTHM
very wide coverage of potential customers in target
markets.
Throughout the telecom sector, we continue to be
positively surprised by the rapidly growing demand for
data services and bandwidth. Driving this strong growth
are a number of key factors including: 1) Internet related
demand – access to the internet, e-commerce, web hosting
etc.; 2) Telecommuting/remote workers who need high
speed access to corporate LANs and databases; and, 3) The
development and growing importance of bandwidth
intensive applications that rely heavily on complex
graphics, audio and soon to be video services.
2) Attractive Economics of a DSL-based Business Plan:
We think RTHM has a very attractive business case with
strong top line growth expected over the life of our 10-year
forecast model. We expect revenues to grow from $530K
in '98 to $11.5M in '99, to $50.4M in '00 and finally
reaching $1.9B by '08, the last year of our model.
Table 1: Breakdown of Costs for New Subscriber Line
Customer Premise Equipment (Modem, NIC card, etc.) $275
Installation Expenses $300
Customer Acquisition Cost (Sales & Marketing) $450
Loop Provisioning from the ILEC $100
Installation Payments from Customer ($350)
Total Access Line cost to Rhythms $775
Source: Company Disclosure & Merrill Lynch Research
We estimate that RTHM's cost for both acquiring a new
co-location site and buying and installing the necessary
equipment is about $160K. The costs for entering a new
market, including outfitting between 30-60 central offices,
a new metro service center and all required networking, we
believe come to about $10M for a large market and less
than $5M for a small-medium size market. In Table 1, we
show how RTHM's costs for adding a new access line
come to about $775 per customer while in Table 2, we
derive that incremental gross profit and EBITDA margins
are 65% and 36% respectively on a recurring basis.
These numbers yield a bottom-line payback period of just
14½ months (the $775 investment from Table 1 divided by
the $54/month cash flow from Table 2) and an annualized
Table 2: Monthly Profitability per Customer
Item Monthly Amount Margin
Revenue per Customer $150 100%
Cost of Goods Sold $52
Gross Profit $98 65%
Billing, Customer Care & Overhead $44
EBITDA per Customer $54 36%
Source: Company Disclosure & Merrill Lynch Research
cash-on-cash return of 75% in just 3 years. We further
estimate that a new market will cross over to positive
EBITDA when only 105 lines have signed up for service
out of each central office co-location.
We target EBITDA breakeven by 2H03 and forecast that
margins will eventually reach 29% by '08. Details of our
model, including key operating statistics such as the
number of central offices deployed and the number of lines
in service are given in the summary model in Table 3.
As of the end of February '99, RTHM had installed
DSLAM equipment in 300 central offices, up from the 200
it had in service at the end of '98. We believe the
company is on pace to deploy a total of 1,000 COs in 32
cities by the end of ‘99 and 1,600 COs in 50 cities by the
end of ‘00. By the end of this year, we forecast that
RTHM should have a little over 12,000 DSL lines in
service, growing to 35,800 lines by the end of ‘00.
We built our model on what we believe are conservative
assumptions on RTHM's CO deployment schedule. If the
pace of CO deployment were to be more rapid than our
forecasts, the company could realize more than the 1,000
COs in service and higher revenues than we are
anticipating on the one hand while experiencing higher
EBITDA losses from accelerated expenses on the other. In
an alternate scenario to our model on page 4, we would not
be surprised if RTHM were to end '99 and '00 with 1,100+
and 1,700+ co-locations respectively while generating
EBITDA losses of $100M in '99 and $180M in '00.
3) Potential to Move Further Up Value Chain… a
Performance Strategy: While the average RTHM
customer access line currently in service is rated to support
3.5 Mbps of data (from company measurements), the
average RTHM customer is currently only purchasing
about 700 Kbps of service, or only 20% of the theoretical
capacity of the copper lines. This available capacity
provides RTHM with a huge opportunity to: a) upsell
current customers to higher priced connectivity services;
and b) to offer new bandwidth intensive applications in the
future. This capability to exploit the high-speed
opportunity is currently unique to RTHM as we understand
that the other data CLECs are only offering service up to
1.5 Mbps.
4) Valuable Partners Highlight Rhythms' Strong
Strategic Positioning: RTHM has formed a number of
key strategic partnerships with many leading telecom and
technology companies. These partnerships highlight
in the telecom industry today – high speed local broadband
connectivity to business customers. Key partners include:
MCIWorldCom: In addition to a $30M investment for an
approximate 7% equity stake, WCOM has committed to
resell a minimum of 100,000 DSL lines over a 5 year
period beginning when RTHM has 1,250 co-locations in
service over 32 markets – an event we expect to happen by
mid '00. That WCOM has explicitly committed to resale
100,000 DSL lines from RTHM differentiates this strategic
relationship from almost every other struck within the DSL
sector. We note that although our forecast model has not
explicitly factored in this arrangement for conservatism
purposes, these 100,000 DSL lines represent
approximately 17% of our estimate of total lines expected
to enter service over the 5 year commitment period (mid
'00 through mid '05).
WCOM has also agreed to make RTHM its preferred
provider of business DSL access services in areas where
RTHM is offering service. In addition, RTHM has the
right of first refusal to match offers made to WCOM by
other DSL providers. Lastly, WCOM will serve as
RTHM's preferred provider of network capacity including
metropolitan area networks, long haul and internet
protocol backbone services.
Microsoft: In addition to a $30M investment for an
approximate 7% equity stake, Microsoft and RTHM have
agreed to work together to develop new value-added
applications that showcase the broadband capabilities of
the RTHMs access network. Revenues from these new
applications represent pure upside to RTHM as we have
not included them in our revenue forecast model.
Qwest: Qwest has invested $15M in RTHM for a stake
worth about 2½% RTHM.
Cisco: RTHM has entered into a 2-way partnership
arrangement with Cisco in which RHTM's services are
actively sold through Cisco's extensive direct sales force.
In addition, Cisco has awarded RTHM a contract to
manage and upgrade its corporate-wide program to provide
remote LAN access to 8,500 teleworkers nationwide.
5) Experienced Management Team: RTHM's is
distinguished by the strength and depth of its
entrepreneurial management team including: Catherine
Hapka, President/CEO – Founder and COO of US
West's !nterprise data networking service division and
Executive Vice President of Markets for US West. Prior to
coming to US West, Ms. Hapka held management
positions with both McKinsey & Co. and General Electric;
Scott Chandler, CFO – Formerly president and CEO of
C-COR Electronics, a manufacturer of broadband
telecommunications equipment. Before that, Mr. Chandler
spent 6 years at USWest in both !nterprise and also as
general manager for Cable and Multimedia Ops.
6) Possible Consolidation Target: We believe RTHM is
an attractive consolidation target given the company's
early mover advantage in securing co-location spaces,
deployed DSLAM equipment and interconnection
agreements. Potential buyers would include: 1) Large
long distance companies – WCOM, T and FON looking
to quickly bulk-up local broadband service offerings and to
drive additional long haul data traffic. We believe that the
combination of RTHM's planned national DSL presence
and its ability to offer both multiple voice lines as well as
high-speed data access over its DSL infrastructure make
RTHM an attractive solution for all 3 of the long distance
companies; 2) New fiber-based network companies –
QWST, LVLT, GBLX and WMB looking to offer end-to-end
broadband data solutions could view DSL technology
as the means to extend their long distance data networks
into the local arena as well as an important source of new
data traffic; 3) Large CLECs – NXLK, TGNT and ICIX
looking to expand their local broadband connectivity
options and data expertise; 4) Data CLECs – COVD and
NorthPoint looking to both consolidate the sector and to
quickly expand their geographic and local network reach;
and 5) RBOCs – BEL, BLS, SBC or USW looking to
expand the geographic reach of their regional data service
offerings to business customers.
7) Attractive Valuation: We valued RTHM using an
addressable market valuation measure utilizing our
estimate of YE'99 DSL-POPs (D-POP) or the number of
local access lines served by the ILEC COs where RTHM
will be co-located. Using our YE'99 estimate of 1,000 CO
co-locations and assuming that RTHM's average CO
serves 25,000 lines results in an addressable market of
25M D-POPs. RTHM's best and only valuation
comparable, Covad Communications (COVD, $71 ½, not
rated), currently trades at an estimated level of $515 per
1Q99E D-POP. At this multiple, layering in a
conservative 45-50% haircut to adjust for the approximate
12 month head start on marketing that COVD enjoys vs.
RTHM, we derive a 12 month price objective of $283/D-POP
or $87 per share.
Investment Risks: We see 4 primary risks to the RTHM
business plan. 1) Execution risk involved with scaling the
RTHM solution out to 1600 COs and 50 markets and in
hiring the right technical and salespeople to properly
expand the business. 2) Reliance on 3 rd party sales
channels and installers. RTHM relies on its partners,
WCOM, CSCO and ISPs, to promote the RTHM product
line and any inability of these partners to fill this role could
have an adverse effect on RTHM's revenue stream. 3)
Reliance on 3 rd party for key local network elements.
RTHM relies on ILECs for the supply of co-location space
and for unbundled copper loops for last mile connection to
customers. Any delays in the provisioning of these items
would adversely impact RTHM's network deployment. 4)
Competitive Risk. RTHM will feel competition from
both alternate technologies, such as cable modems, fiber
and fixed wireless, and other DSL providers such as the
RBOCs, FON and other data CLECs.
Table 3: Our Summary Forecast Model – Rhythms NetConnections
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Revenue
Non-Recurring 4,117.4 8,002.5 21,250.0 45,006.3 50,991.3 57,760.0 62,272.5 63,626.3 64,980.0 67,687
Connectivity 6,885.6 37,143.9 93,581.0 237,445.9 423,472.6 597,417.1 751,786.2 881,151.6 980,965.1 1,060,918
BW-enabled Svcs 344.3 2,476.3 8,664.9 27,000.0 57,928.6 94,782.1 136,624.5 196,083.1 259,874.5 327,761.6
Backbone 160.7 2,806.4 12,708.5 42,788.6 101,761.2 176,926.6 255,761.1 338,831.5 411,374.0 462,345.4
Total Revenue 11,508.0 50,429.1 136,204.4 352,240.8 634,153.7 926,885.8 1,206,404 1,479,692. 1,717,193. 1,918,712.
Gross Profit (32,671.9) (60,268.4) (51,679.2) 43,280.3 198,921.2 359,396.4 513,973.9 668,228.2 795,573.0 908,555.2
Gross Margin N.A. N.A. N.A. 12% 31% 39% 43% 45% 46% 47%
EBITDA (82,111.5) (152,653.1) (190,339.3) (151,658.5) (24,935.1) 107,575.6 236,264.6 368,467.7 472,388.9 563,454.2
EBITDA Margin N.A. N.A. N.A. N.A. N.A. 12% 20% 25% 28% 29%
Lines in Service 12,264 35,856 105,438 253,753 402,413 545,918 675,967 783,400 873,087 954,230
Central Offices in Service 1,000 1,600 1,610 1,620 1,630 1,640 1,650 1,660 1,670
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