Market Tremors Don't Shake Strong Secular Telecom Trends-Part 1
Global Crossing Ltd(GBLX)#*
Rating: 1S
19980908
Salomon Smith Barney ~ April 17, 2000
--SUMMARY:----Telecommunications Services
*Despite current market conditions, we reiterate that secular trends in the
telecom industry remains strong.
*Well-run companies in all categories should create a ton of value for
shareholders and we would be taking advantage of current stock prices to
buy the best names in each segment of the telecom industry.
*We have run a rigorous backwards engineering of our emerging telco
DCF models which illustrates that current stock prices reflect absurdly
high risk premium levels (close to October 1998 levels, business plans are
now much better formulated and funded.)
*Note includes liquidity tables for CLECs and bandwidth providers as well
as reverse-engineered DCF tables solving for implied terminal revenues.
--OPINION:------------------------------------------------------------------
We are taking a stand today and reiterating our Buy ratings on our
emerging telecom plays similar to our "call" on October 9, 1998 during
the last NASDAQ meltdown. In fact, we continue to be bullish on our
entire sector and in particular on our emerging players. We have taken a
rigorous mathematical approach to valuation, as we did in October 1998
and we believe that our emerging names are significantly undervalued. In
addition, we believe that the outlook for the CLECs and broadband players
is better today than it was in October 1998.
The fact that NASDAQ is having a "bad hair" week does not change the
secular trends in this industry. Namely, we believe capital formation is
leading to new competitive entities that will take market share in
traditional revenue streams while participating, in a very leveraged way,
in the growth of new revenue streams, driven by new bandwidth
applications. Thus, the fact that NASDAQ is getting rocked does not
change our view of the world or the stocks that we like. In fact it
allows you to buy high-quality names 40%-50% lower than where they were
selling 3-4 weeks ago.
Despite the market meltdown, the emerging telcos continue to achieve
operational progress, have a strong liquidity position (see Table
1)--most of our names have raised significant amounts of capital in the
past year and half of them have added new types of capital sources such
as bank loans and private equity players--and, finally, emerging telcos
have business plans which are far better formulated than they were in
October 1998. Despite these compelling developments, the current CLEC
prices are reflecting almost the same equity risk premium and cost of
equity that they did in October 1998.
When we backwards engineer our DCF valuations (to solve for the discount
rate while keeping the terminal multiple, terminal revenues, and terminal
EBITDA flat), current stock prices imply a cost of equity of about 28%
and an implied equity risk premium of nearly 25% (as shown in Table 1).
Keep in mind that an equity risk premium of 25% is almost 3x the
"textbook" historical equity risk premium of 8.4%--which some argue is
too high. On October 9, 1998, the CLEC stock prices were implying a cost
of equity of 34% and an equity risk premium of 31%.
TABLE 1 -- IMPLIED RISK PREMIUM AND COST OF EQUITY IMPLIED IN CURRENT
CLEC PRICES
Ticker Current Implied Cost Implied Implied
Price Discount of Cost of Risk
Rate Debt Equity Premium
ABIZ (1S) $28.81 23.9% 12.0% 33.6% 37.7%
ATTC (1M) 44.63 16.4% 8.4% 23.0% 32.7%
FCOM (1S) 34.50 22.7% 12.3% 31.3% 30.0%
ICGX (1S) 24.00 20.5% 12.5% 27.0% 20.9%
ICIX (1S) 30.88 20.7% 11.3% 28.5% 23.7%
MCLD (1S) 54.63 17.7% 10.6% 23.6% 22.9%
MPWR (1S) 47.81 22.8% 13.8% 30.3% 25.4%
NXLK (1S) 86.88 15.4% 11.6% 18.5% 14.6%
RCNC (1S) 40.44 19.0% 12.3% 24.6% 24.1%
TGNT (1S) 38.25 23.5% 13.9% 31.3% 25.5%
CLEC (1S) 25.44 22.8% 14.5% 29.6% 23.8%
WCII (1S) 31.55 21.6% 13.5% 28.2% 24.3%
AVERAGE 20.8% 12.2% 27.5% 24.9%
Source: Salomon Smith Barney.
We view the current implied cost of equity and implied equity risk
premiums as absurdly high, and consequently we believe that the stocks
are absurdly cheap, especially in view of the fact that the CLECs as a
group are far more developed today than they were in October 1998.
Considering that the implied high levels are close to where they were in
October 1998, we would argue that the implied premiums are more out of
whack today than they were in October 1998; on a business adjusted basis,
the stocks are cheaper now then they were in October 1998.
In our October 1998 report "CLEC Stocks Way Oversold", we pointed out
five reasons the CLECs were oversold, which still apply today:
1) liquidity is there for the next 18 months (today many of our names
have prefunded business plans)
2) the long-term value proposition is unchanged
3) the current business is a good domestic, defensive business
4) asset values to strategic buyers are increasing with each passing day
5) current stock prices reflect a scenario beyond a prudent increase in
the risk profile.
Additionally, we would argue that the CLECs today have five quarters
under their belts in which they have proven that they can in fact take
customers in the marketplace (net line adds for the CLECs we follow in
the first quarter of 2000 should be about 740,000 versus 470,000 in the
fourth quarter of 1998). When one considers that the entire net line
additions in the US business market is likely to be about 3-4 million and
that NEXTLINK alone is accounting for 10% of that number, it does tell
you that the CLECs as a group are clearly taking the lion's share,
60%-70%, of the growth in the business switched local exchange market.
Furthermore, the liquidity outlook for CLECs today is better than it was
in 4Q98, and access to capital today is broader with commercial banks and
private equity being pools of capital which did not exist in October
1998.
TABLE 2 -- CLEC LIQUIDITY ANALYSIS (in millions of dollars)
Cash Credit Total Cash Cash Year Add'l Year When
on Facili- Cash Burn on When Finan- Add'l
Hand ties Avail- Until Hand FCF cing Financing
(a) Avail- able YE00 as of Posi- Needs Needs
Start
able 12/31/00 tive
ALGX $1,195 $500 $1,695 ($528) $1,167 2003 none none
FCOM 454 26 894 (330) 564 2006 1,064 4Q 2001
ABIZ 469 0 469 (423) 47 2004 1,960 2000
ICGX 876 0 876 (847) 29 2004 600 2000
ICIX 441 0 441 (271) 170 2003 none none
MCLD 327 1,000 1,327 (1,256) 71 2003 500 2001
MPWR 518 225 743 (290) 454 2003 none none
NXLK 1,882 621 2,503 (1,570) 933 2005 4,350 2001
RCNC 1,820 2,143 3,962 (1,489) 2,473 2006 3,982 2003
TGNT 795 600 1,395 (703) 692 2004 1,309 2001
CLEC 316 78 394 (293) 101 2001 none none
WCII 1,146 2,740 3,886 (1,353) 2,533 2002 none none
(a) CASH ON HAND IS AS OF 12/31/99 PLUS ALL 1Q 2000 FINANCING ACTIVITIES.
Source: Salomon Smith Barney and Company Reports.
Also, since October 1998, CLEC business models have evolved from both
geographic and services perspectives as companies have expanded into more
markets and added data capabilities--in particular, offering DSL on top
of voice. Furthermore, the regulatory situation is clearly better today
than it was in October 1998. Since then, the Supreme Court has ruled
emphatically that the FCC is in charge of implementing the Telecom Act.
Following the FCC's blessing of mergers, such as SBC-Ameritech or others
in the vein of 271 approval, CLECs have become the beneficiaries of very
favorable rule-making vis-a-vis restrictions on RBOCs. This has been
seen in terms of separate data subsidiaries and the fact that the Bells
have to treat the CLECs transparently with their own subsidiary when it
comes to provisioning, line sharing for DSL and other items. In fact, in
that regard, Rhythms got an agreement out of US WEST that US WEST would
not charge Rhythms for line-sharing for DSL since US WEST does not charge
its own subsidiary.
Furthermore, on top of our view that current risk premiums and cost of
equity rates are clearly absurdly high, we have added a new wrinkle to
our reverse engineering of DCF models. In addition to looking at what
the implied cost of equity and risk premiums are, we have decided to
solve for the year 10 implied revenue level for each of these companies
using the current stock prices as the derived net present value. To do
so, we assume that the discount rates and terminal value multiples that
we use are correct (and we think they are given that the implied free
cash flow growth rates in perpetuity are 8%-10% in most of our models).
The results of our exercize show that current stock prices imply that the
group of US business-oriented CLECs we follow add up to about $48 billion
in total revenue in 2009, which equates to a 17% implied market share of
the domestic business local and long distance market versus the 28% share
that our models suggest. (We assume that today's domestic business local
and long distance market of $120 billion market grows at a 9% CAGR to
$284 billion in 2009.)
TABLE 3 -- US BUSINESS CLECs, IMPLIED MARKET SHARE IN 2009 (dollars in
millions)
Ticker Current 2009 Revenues Differ- 2000-2009 Rev CAGR
Share Current Implied ence Current Implied
Price at SSB by SSB by
4/14/00 Estimate Current Est Current
Price Price
ABIZ $28.81 $6,639.8 $2,240.0 (66.3%) 32.0% 18.4%
ALGX $61.00 $6,411.4 $3,188.5 (50.3%) 35.7% 26.5%
FCOM $34.50 $6,034.2 $1,740.7 (71.2%) 42.2% 25.6%
ICGX $24.00 $6,189.5 $3,890.9 (37.1%) 22.4% 16.8%
ICIX $30.88 $9,069.4 $5,144.7 (43.3%) 22.7% 15.9%
MCLD $54.63 $11,754.5 $9,769.2 (16.9%) 25.1% 22.8%
MPWR $47.81 $2,117.8 $938.4 (55.7%) 35.9% 25.3%
NXLK $86.88 $18,282.7 $15,084.8 (17.5%) 38.5% 35.9%
TGNT $38.25 $5,348.6 $2,112.7 (60.5%) 42.6% 29.9%
CLEC $25.44 $1,187.8 $457.6 (61.5%) 22.5% 11.4%
WCII $31.55 $6,744.2 $3,351.0 (50.3%) 26.1% 17.6%
CLEC sub ttl (a) $79,779.8 $47,918.6 (39.9%) 31.9% 25.7%
Est mkt size (b) $284,083.6 $284,083.6
Implied market share 28.1% 16.9% (39.9%)
Other (c)
ATTC $44.63 C$6,689.9 C$4,265.0 (36.2%) 15.5% 10.4%
GTTLB $13.88 C$3,112.5 C$1,748.6 (43.8%) 49.2% 40.9%
RCNC $40.44 $9,634.7 $6,538.6 (32.1%) 37.6% 32.3%
(a) CAGR figures reflect weighted averages.
(b) Assumes a 2000 business market size of $120B, growing at a CAGR of 9%.
(c) ATTC and GTTLB excluded to reflect U.S. market only;
RCNC excluded because of residential focus.
Sources: company information and Salomon Smith Barney estimates.
BANDWIDTH STOCKS ARE AS OVERSOLD AS CLECs
As far as the bandwidth names are concerned, clearly, companies like
Level 3, Metromedia Fiber Network, Williams, Qwest (without US WEST) and
Global Crossing are also suffering in the downdraft of the NASDAQ
market. As shown in Table 4, the bandwidth names are implying a 31% cost
of equity and an implied risk premium of 24% which again is unjustly high
given that the "textbook" equity risk premium is 8.4% or lower. Unlike
the CLECs, the bandwidth names do not have the same liquidity issues so
we have not provided a separate liquidity table. Suffice to say, though,
the billions of dollars raised and generally positive EBITDA in the
bandwidth space provides sufficient liquidity to fund current business
plans. We have included the implied revenue levels in 2009 that the
current stock prices are reflecting. As shown in Table 5, at current
stock prices the broadband group is implying an absurdly low collective
2.8% market share; even our models implying a very conservative 6% market
share. We believe the global networks that companies such as Level 3 and
Global Crossing are building will allow these companies to gain more than
2.8% market share. To estimate total market size, we take the current
$600 billion global business voice & data market and grow it at 12.5% for
a $2 trillion market in 2009.
TABLE 4 -- IMPLIED RISK PREMIUM AND COST OF EQUITY IMPLIED IN CURRENT
PRICES
Ticker Current Implied Cost Implied Implied
Price Discount of Cost of Risk
Rate Debt Equity Premium
GBLX (1S) 28.13 23.6% 12.0% 33.1% 24.7%
LVLT (1S) 73.38 21.6% 11.25% 30.1% 20.7%
MFNX (1S) 49.00 21.8% 12.0% 29.9% 19.2%
Q (1H) 39.50 23.5% 11.0% 33.7% 29.7%
WCG (1S) 36.13 20.6% 12.0% 27.6% 26.3%
AVERAGE 22.2% 11.8% 30.8% 24.0%
Source: Salomon Smith Barney.
TABLE 5 -- BANDWIDTH PROVIDERS, IMPLIED MARKET SHARE IN 2009 (dollars in
millions)
Tkr Current 2009 Revenues Differ- 2000-2009 Rev CAGR
Share Current Implied ence Current Implied
Price at SSB by SSB by
4/14/00 Estimate Current Est Current
Price Price
Bandwidth Providers
GBLX $28.13 $35,943.0 $9,690.9 (73.0%) 20.3% 5.5%
LVLT $73.38 $27,401.4 $13,465.6 (50.9%) 38.2% 28.7%
MFNX $49.00 $6,435.9 $3,082.9 (52.1%) 45.8% 35.5%
Q(d) $40.13 $35,972.5 $22,115.7 (38.5%) 21.5% 15.7%
WCG(e)$36.13 $16,668.6 $8,314.2 (50.1%) 35.5% 26.4%
Bandwidth subttl(a) $122,421.4 $56,669.2 (53.7%) 31.3% 22.1%
Est mkt size $2,000,000.0 $2,000,000.0
Implied market share 6.1% 2.8% (53.7%)
(a) CAGR figures reflect weighted averages.
(d) On a standalone basis (not proforma for the pending USW merger).
(e) Represents WCG's network operations only.
Sources: Company information and Salomon Smith Barney estimates.
Despite current stock prices, we remain as bullish as ever on the demand
for bandwidth vis-a-vis supply. We are great believers in Say's economic
law, which says that expansion of supply creates its own new demand.
This obviously is not true for everything. We suspect you could not
build 10 times as many steel mills and expect to build ten times as many
skyscrapers. However, in the realm of technology, be it computing power,
microprocessors, storage or bandwidth, this economic tenet is
well-grounded.
A fiber network takes light, insulates it in glass--with the idea of
amplifying the signal over distance, regenerating the light from light to
electric current and back into light--and sends colors or wavelengths in
order to expand capacity. A decade ago, distances for amplification and
regeneration were quite short; you could barely do more than shoot white
light across fiber, which is why it used to cost $20,000 per km to carry
a gigabit of capacity. Today, amplification spacing is 40-60 miles. You
can carry light for hundreds of miles before regeneration and one can
shoot up to 100 wavelengths of light. This has resulted in a dramatic
decline in the cost of deploying bandwidth to about several hundred
dollars per kilometer to carry a gigabit of capacity. This dramatic
decline in bandwidth cost frankly makes Moore's law look slow and
unleashes a huge array of enabling applications that drives new demand,
and hence, new revenues.
In fact, if one thinks about the types of things that CISCO or Sycamore
or Juniper are talking about regarding putting optical wavelength in the
back of routers, or what Storage Network or EMC talk about regarding
lifting storage out of silos and putting it on the web real time, or the
ramifications of the content aggregators / net caching companies on the
web, such as Akamai or Inktomi, the demand for bandwidth is going to be
spectacular.
In addition, we would argue that bandwidth exchanges, such as Enron,
Arbinet, Band X, and others bring no new supply to market, but will
create new demand for spot wavelength capacity. In other words, we could
not go to Level 3 or Williams and ask for an OC-192 wavelength for an
hour. However, we could go to Enron who would make a market. Obviously,
there are issues regarding inventory management, delivery and
settlement. Putting those issues aside, the reality is that these
exchanges will stimulate demand for optical carrier products that
otherwise would not be there because certain types of customers would not
have the ability to get high bandwidth capacity for only an hour at a
time from providers such as Level 3 or Williams.
Actually, as one looks at the backlog for providers such as Williams, 80%
of it comes from companies that barely existed over a year ago. The fact
is that new companies are springing up in all areas of technology, where
bandwidth is the enabling tool for them to accomplish whatever product or
service they are attempting to deliver. Users are buying OC-3's and
OC-12's like they used to buy DS-1's and DS-3's. Of course, the other
thing that people need to keep in mind is that less than 1% of households
today have broadband connectivity into the internet. At some point in
time, as much as 30%-40% of households will have broadband connectivity
via either cable modems, DSL, fixed wireless or even satellite. This will
drive enormous demand for backbone capacity.
In 1999, the sustainable demand at peering points on the internet
backbone was roughly 330 gigabits. This is not in bursts like in Stephen
King's novel, but rather sustainable ongoing demand at peering points.
As we speak, after the first quarter that has already risen by a factor
of more than 2, many people think we will exit this year with well over a
terabit of sustainable demand at peering points on the web. Other
studies suggest that peak hourly traffic on telco networks on a global
basis will increase from 125 gigabits to 69 terabits over the next 5
years. This statistic is driven by the fact that for every bit of storage
distribution, or content delivery, or video streaming, there are
somewhere between 10-20 bits of network bandwidth required. If these
types of forecasts are remotely close to being correct, the price for
binary digit or price per optical wavelength can go down as much as you
want to estimate, and there will still be dramatic new revenue creation
driven by new services for network providers.
----------------------------------------------------------------------------
---ADDITIONAL INFORMATION AVAILABLE UPON REQUEST---
Salomon Smith Barney ("SSB"), including its parent, subsidiaries and/or
affiliates ("the Firm"), usually makes a market in the U.S.-traded over
the counter securities recommended in this report and may sell to or buy
from customers, as principal, securities recommended in this report. The
Firm or employees preparing this report may have a position in securities
or options of any company recommended in this report. An employee of the
Firm may be a director of a company recommended in this report. The Firm
may perform or solicit investment banking or other services from any
company recommended in this report.
Securities recommended, offered, or sold by SSB: (i) are not insured by
the Federal Deposit Insurance Corporation; (ii) are not deposits or other
obligations of any insured depository institution (including Citibank);
and (iii) are subject to investment risks, including the possible loss of
the principal amount invested. Although information has been obtained
from and is based upon sources SSB believes to be reliable, we do not
guarantee its accuracy and it may be incomplete or condensed. All
opinions and estimates constitute SSB's judgment as of the date of the
report and are subject to change without notice. This report is for
informational purposes only and is not intended as an offer or
solicitation for the purchase or sale of a security. This report has
been approved for distribution in the United Kingdom by Salomon Brothers
International Limited, which is regulated by the Securities and Futures
Authority. The investments and services contained herein are not
available to private customers in the UK. This report was prepared by
SSB and, if distributed in Japan by Nikko Salomon Smith Barney Limited,
is being so distributed under license. This report is made available in
Australia through Salomon Smith Barney Australia Securities Pty Ltd. (ACN
003 114 832), a Licensed Securities Dealer, and in New Zealand through
Salomon Smith Barney New Zealand Limited, a member firm of the
New Zealand Stock Exchange. This report does not take into account the
investment objectives or financial situation of any particular person.
Investors should obtain advice based on their own individual
circumstances before making an investment decision. The research
opinions herein may differ from those of The Robinson-Humphrey Company,
LLC, a wholly owned subsidiary of SSB. Salomon Smith Barney is a service
mark of Salomon Smith Barney Inc. ) Salomon Smith Barney Inc., 2000.
All rights reserved. Any unauthorized use, duplication or disclosure is
prohibited by law and may result in prosecution.
# Within the past three years, Salomon Smith Barney, including its parent, subsidiaries and/or affiliates, have acted as manager or co-manager of a public offering of this company.
* Salomon Smith Barney Inc., including subsidiaries and/or affiliates, usually make a market in the securities of this company.
Important disclaimers regarding Salomon Smith Barney research
The prices and information for any security shown on this page may differ from the prices and information for that security on other sections of the site.
The research ratings and commentary shown on this site are as of their original publication date. Salomon Smith Barney is under no obligation to update such information to reflect circumstances that may occur after such a date, and such information may differ from previously published ratings and commentary. |
