Bear-ons Fiber take (notice how data is not any part of this useless article):
September 6, 1999
Barron's Features
Pacific Overtures
Can undersea cable live up to Wall Street's expectations?
By BILL ALPERT
Calling your mom just gets cheaper by the day, whether she's in Dubuque or
Dublin. Wonderful, right? Not if you're in the long-distance phone business.
While AT&T fights its consumer calling war against Sprint and MCI
WorldCom on the ground, a submarine battle has sunk the price of
transoceanic calls and the undersea cables that carry them. Cable pricing has
plunged 90% in the past 18 months, capsizing business plans and stock prices
of firms such as Global Crossing, which had to ante up more shares of its
stock last week to ensure its $10 billion purchase of Frontier Corp.
The pricing plunge has also squeezed Pacific Gateway Exchange, the
Burlingame, California, bellwether of the international long-distance business.
Unlike Global Crossing, Pacific Gateway has real profits, from its wholesaling
of international phone service. But competition has eroded its margins, and its
Nasdaq-traded shares have sunk from $50 to $20, even though some Wall
Street analysts say its interests in undersea cables are worth up to $50 a share.
But evidence from Pacific Gateway's recent sale of some of those cables
discloses a big problem: Between April and July, Pacific Gateway's sale price
for its transatlantic capacity seems to have slipped sharply.
Worse yet, new accounting rules that took effect in July will make it almost
impossible for firms like Pacific Gateway, as well as biggies like Global
Crossing, IXC Communications and Williams Communications Group, to
continue booking big revenues and profits from fiber sales.
Howard A. Neckowitz founded Pacific Gateway in 1991 to wholesale
overseas connections to U.S. phone firms. As one of the most efficient
international wholesalers, Pacific Gateway boosted sales to $466 million in
1998, with earnings of $20 million, or 97 cents per share. The company bought
into consortiums that should complete fiber links across the Atlantic and Pacific
oceans by 2001. After spending about $260 million, Pacific Gateway will get
about 500 subsea circuits known as STM-1 lines -- each capable of carrying
155 megabits of traffic per second. That's a lot. An STM-1 equals about 100
of the corporate connections known as T1 lines.
Owning fiber should trim Pacific Gateway's costs -- and not a moment too
soon. Since September 1998, competitive pressure in the international
long-distance market has squeezed gross margins from 16.2% to a June '99
level of 13%. Wholesale service for U.S.-based phone firms still accounted for
79% of June '99 revenues, and operating profits in that business segment dove
87% to just above breakeven. The firm has guided Wall Street to expect a
drop in year-over-year earnings, with the consensus now at 81 cents a share
for 1999, according to First Call. (Although Neckowitz scheduled and
rescheduled a phone interview with Barron's last week, he never came
through.)
As the wholesale calling business has suffered, Wall Street has turned its gaze
to Pacific Gateway's ownership of undersea fiber. For $156 million in direct
costs, plus another $100 million in land-based hookups, the company will own
almost 300 STM-1 links beneath the Atlantic and the Pacific. That represents
an all-inclusive cost of about $500,000 per Atlantic link and $900,000 per
Pacific link. Assuming that Pacific Gateway could resell those STM-1 circuits
for a couple of million bucks each, analysts like Jack Grubman at Salomon
Smith Barney have insisted that Pacific Gateway's cable assets were worth
$35-$50 per share.
But the same deep-sea pressure that's crushed calling prices has crushed the
resale price of cables. Underwater bandwidth is exploding, as a result of
capacity-boosting technology and proliferating cable ventures. However, the
much-expected explosion in broadband demand is not within earshot.
Itzhak Fisher, CEO of the
international carrier RSL
Communications, admits to
happy surprise at sliding
transmission-capacity prices.
When he and cosmetics heir
Ronald S. Lauder started RSL
five years ago, the annual lease
of a T1 line to London cost
$250,000. Last year, that sum
could buy one.
Jefferies & Co. analyst Gregory
P. Miller correctly called the
plunge in cable prices. He writes that a transatlantic STM-1 line's cost has
slipped from $12 million in early '98 to about $1 million today.
Cable resales announced this year by Pacific Gateway suggest that the slippage
continues. In April, the firm announced the sale of 17 STM-1 lines to Williams
Communications for $30 million, about $1.8 million each. Last month, Pacific
Gateway disclosed the sale of another 5% of its Atlantic fiber -- which would
be about 25 STM-1 lines -- for $35 million, suggesting that prices have fallen
below $1.4 million per line, or 22% in three months. Pacific Ocean prices have
been stronger, but the Southern Cross cable system just dropped its
Australia-to-U.S. STM-1 price from $37.8 million to $12.9 million, and its
Hawaii-U.S. mainland price from $6.2 million to $1.4 million.
Pacific Gateway told Wall Street to expect $1.30-$1.50 per-share profits next
year, just from announced cable sales. However, only part of those sales were
for cash. The spring deal with Williams, for instance, is actually a swap of
Pacific Gateway undersea circuits for land-based circuits that Williams owns.
And Pacific Gateway's June '99 10Q suggests that most of the $35 million in
summer fiber sales were also swaps.
To book profits on those non-monetary exchanges is akin to an Internet firm's
booking profits on the exchange of banner ads with another Website. Other
fiber owners haven't done that. Austin, Texas-based IXC Communications
reported $47 million in revenues from fiber exchanges in the three years ended
1998, but booked no profits on them, after assuming that those revenues
equaled the cost of the fiber it had traded away. In an exchange of several
hundred million dollars worth of transmission capacity with Williams, the
wireless telecom firm Winstar Communications won't recognize all the
revenues for 25 years.
Historically, much of the industry accounted for such deals as sales -- explains
Williams Communications' financial chief, Scott Schubert -- even though legal
title to the fiber didn't change hands. But July was the effective date of the
Financial Accounting Standards Board's new interpretation of such deals,
requiring title transfer for revenue to be booked in one shot. Past results needn't
be restated, but without title transfer, the FASB and the SEC now say that
revenues and profits from fiber sales must be reported piecemeal over the life of
a deal, like a lease.
Plenty of other firms have been recognizing fiber sales revenues all at once.
Among them: PSINet, Qwest Communications, and Europe's Carrier 1
International and Viatel. Going forward, Pacific Gateway will have a tough
time supplementing its other sales and earnings with fiber deals. This might have
been a factor in what the company's 10Q calls the "lapse" of a letter of intent by
investment firms to raise $200 million for Pacific Gateway.
Pricing and accounting issues loom even larger for Global Crossing. The firm
has historically recognized all the revenues from a 25-year fiber deal when the
fiber lit up for service.
Global Crossing reported gross margins of 56% on its $183 million in
transatlantic capacity sales for the June '99 quarter. But it calculated those
profits by forecasting the "total expected capacity revenues over the life of the
system." Those forecast revenues, says Global Crossing in footnotes to its
10-K, are based on a third-party consultant's market forecast, "updated on an
annual basis." A consultant's market study also establishes the balance sheet
value for Global Crossing's segments under construction -- some $842 million
worth as of June.
With STM-1 prices dropping through the ocean floor, any 25-year forecast
seems tenuous in computing earnings. If prices can fall 22% in a quarter, how
credible is a forecast that's updated "on an annual basis"?
Barron's asked Global Crossing what price per STM-1 the market study
assumed. "The information that you are seeking is considered proprietary
information," a spokesperson curtly replied.
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