(Extremely long) telecom debt discussion (from TheStreet.com 3/28/01) with Ravi Suria, formerly with Lehman Brothers. (He's the person who shocked a lot of people with his early analysis of Amazon.com's debt structure).
thestreet.com
The TSC Streetside Chat: Ravi Suria
By Brett D. Fromson
Chief Markets Writer
3/28/01 10:41 AM ET
No Wall Street analyst saved professional investors more money in 2000 than
Ravi Suria, the convertible bond strategist who just left Lehman Brothers to
join Stan Druckenmiller at Duquesne Capital Management. Druckenmiller is
one of the top hedge fund managers of the past 20 years.
Suria presciently nailed the unwinding of the telecom services
industry, as well as the stock market disaster known as
Amazon.com (AMZN:Nasdaq - news). People who listened to
him either got out of those stocks or shorted them. While his
work on Amazon.com has gotten more publicity because of the
popularity of the Web site, Suria's analysis of the telecom
services sector may stand as his most important contribution; after all,
Amazon's peak market capitalization was $39 billion, which is dwarfed by the
peak $640 billion market cap of the telecom services industry. (Amazon is
now valued at about $4 billion and the telcos at about $220 billion.)
Suria is a brainy analyst with a penchant for hardheaded, fundamental
research. He actually knows his way around a balance sheet and pays
attention to a company's credit structure.
Unlike other analysts with higher profiles, Suria worries about the downside to
investors -- he can connect the financial dots. For example, seeing credit
spreads for the telecommunications services companies widen dramatically in
the first quarter of 2000, Suria dug into their balance sheets. He found the soft
underbelly of the tech boom -- the vast, debt-financed overcapitalization of
untested companies swimming in uncharted waters. He wrote a devastating
report on the sector in November. By late last year, he was making
by-appointment-only presentations to Lehman's top institutional clients --
including many of the top hedge funds -- about his findings and their
investment implications.
Suria sat down withTSC Chief Markets Writer Brett D. Fromson and updated
his views on the debt binge of the 1990s and the future of telecom service
companies, telecom equipment companies, the overall economy, the IPO
market and, oh, yes, Amazon.
Brett D. Fromson: Ravi, let's start with your take on the telecom services
sector.
Ravi Suria: OK. The biggest problem for the telecommunications industry is
clearly the fact that it is overcapitalized. Now, overcapitalization for an industry
is not necessarily bad if it comes through the equity side.
Brett D. Fromson: Meaning via stock offerings?
Ravi Suria: Yes. Because then you just have a lower return on equity. At
some point, it catches up with you. But your balance sheet is still fine. You can
operate and survive. The problem with excess capitalization when it comes
from the debt side is that if your business model is unable to support the debt,
you go bust.
Brett D. Fromson: Debt imposes different burdens on different companies,
right?
Ravi Suria: Yes. The debt problem in telecom services is split between two
groups of companies. One is the old-line investment-grade company, the Old
Economy telephone companies. They have investment-grade balance sheets.
They are feeling what I call a credit pinch. These are the long-distance carriers
like AT&T (T:NYSE - news) and WorldCom (WCOM:Nasdaq - news), the
RBOCs and the PTTs [quasi-public telecommunications monopolies abroad].
It's amazing how similar the credit stories for a lot of these companies are. You
have companies that survived under regulation for 100 years suddenly
deregulated over the past 10 years, and are now facing competitive pressure
for the first time.
Brett D. Fromson: What caused the credit pinch?
Ravi Suria: Their cost of capital has gone up so substantially over the past 18
months that it truly is spectacular. For example, average debt spreads [the
difference between what they must pay to borrow money in the capital
markets vs. what, say, the U.S. Treasury pays] have risen from 100 basis
points [1%] over Treasuries to about 300 basis points [3%].
Now, a 200-basis-point difference in your borrowing costs doesn't sound like a
lot, but when you're running an industry with operating earnings or cash flow
margins in the 8% to 10% range, two percentage points more is a lot. The
interesting thing is that these companies have never had to do this before. They
have never faced a period when their relative cost of capital has been so high.
Over the past three years, their return on invested capital has moved below
their weighted average cost of capital. Before deregulation, they had always
been able to generate more in returns than it cost them to borrow. In part, that
was because regulators made sure that happened. And because the companies
always underinvested, they did not spend as much as they made. You cannot
survive this long if you spend more than what you make.
Brett D. Fromson: So bankruptcy is not an issue for these companies?
Ravi Suria: Bankruptcy is less of an issue for them. The issue is more that
their stock prices -- the equity portion of their total enterprise value -- is going
to suffer over the next few years until they reach a point at which they can
begin to reduce their debt levels and deleverage.
Brett D. Fromson: When will we see that deleveraging?
Ravi Suria: It could be anywhere from three to five years.
Brett D. Fromson: What does that mean for shareholders in the old-line
telecom service companies?
Ravi Suria: As long as the companies' leverage ratios keep going up, equity
valuations go down. Debt takes a bigger and bigger part of the total enterprise
valuations. Until you see a stabilization of credit ratios that says the debt
coverage ratios for these companies have stopped deteriorating and are getting
better, the stock prices will have trouble.
Brett D. Fromson: Do you see their credit quality continuing to deteriorate
over the next three years?
Ravi Suria: Yes, that's why most of these companies are on credit
watch-negative by the credit rating agencies, which says that their credit is
getting worse. From a cash flow viewpoint, you can ask, "Are debt coverage
ratios going to get better for these companies when, one, their interest costs
are increasing, and, two, cash flow is not growing that fast?" I don't think so.
Cash flow as a multiple of interest costs has been coming down for the past
few years, and it will probably come down for the next two.
Brett D. Fromson: What should investors look for as signs of an
improvement?
Ravi Suria: When that ratio, EBITDA, as a multiple of interest costs stabilizes
and starts moving up. That could take three to five years. Another inflection
point will be when debt/total capitalization starts coming down. Again, I expect
to see that over the next three to five years.
Brett D. Fromson: Are any of these old-line telecom services companies likely
to see an improvement sooner than others?
Ravi Suria: It could happen earlier for the European PTTs. They have debt on
the balance sheet that has to be repaid, and they are not making enough money
to repay the debt. But what they could start doing is to sell assets and sell stock
to redeem the debt. But then you run into problems like the Orange IPO or the
Verizon Wireless IPO, which got pulled. That means the debt coming due
may have to be refinanced with debt -- not equity -- so your leverage ratios
don't go down. You simply refinance with higher-cost debt -- and it will be
higher cost, as higher spreads will offset any interest-rate cuts. So, for
European companies, a lot depends on how they can get the money. What they
need is to sell shares and assets and then take the money they receive and start
paying down the debt.
Brett D. Fromson: How badly have their balance sheets eroded?
Ravi Suria: A lot of European PTTs have been downgraded four credit
notches in the past 12 months and are still on credit watch-negative. It
probably takes 10 to 15 years of organic growth for a company that size to
move up the four credit notches they just gave up. That gives you a sense of
the magnitude of the deterioration that has happened to these companies' credit
profiles.
Brett D. Fromson: And these are the blue-chips in the sector?
Ravi Suria: Yes. These are the companies that laid out the worldwide telecom
network over the past 100 years.
"In some ways, the companies that borrowed in the '80s were a lot
more creditworthy than the companies of the '90s."
Brett D. Fromson: Let's talk about the New Economy telecom services
companies that say they'll dominate the next 100 years.
Ravi Suria: Basically, the New Economy telecom companies are those
companies started around the time of the Telecommunications Act of 1996.
These are the companies that were going to be the competitors to the
incumbents. They are characterized by a few things. One, they have weak
balance sheets because they are start-ups. Two, as companies, they have never
been through a down cycle because they were started in a boom. Three, on
average, they don't have revenues or customers, or they have minuscule
revenues and few customers because they always depended on the capital
markets to finance their businesses.
They are facing a credit crunch. They have borrowed so much money over the
past few years. They can't borrow any more. The current debt on the balance
sheets does not allow them to borrow any more, even in an environment where
the Fed is easing rates. Why? Because they have already borrowed too much
money and even the current level of borrowing is not justified by their business
models.
Brett D. Fromson: Explain why they cannot borrow more.
Ravi Suria: The more debt you borrow, the more your cost of borrowing
goes up. Your credit spreads widen because, by definition, the more a
company borrows the riskier the credit is for the lenders. I'll give you an
example. When it was easiest for telecom companies to borrow money in
1998, the average telecom high-yield bond was 8.9% and total debt was about
$70 billion. At the beginning of 2000, the yield was 10.75%. By December
2000, it had reached almost 18%, and total debt was approaching $200 billion.
Now, it's back to around 15%. But still, if you had borrowed in 1998 at 8.9%,
it's going to cost you a lot more to borrow today. Any business model started
in 1998 and predicated on getting more debt funding at 8.9% is invalid right
now. Their problem is that they have too much debt.
Brett D. Fromson: Let's talk about some individual names.
Ravi Suria: There is no shortage of examples from those where restructuring
seems imminent, like PSINet (PSIX:Nasdaq - news), Covad (COVD:Nasdaq -
news), RSL Communications (RSLC:Nasdaq - news), Winstar
Communications (WCII:Nasdaq - news) and Teligent (TGNT:Nasdaq -
news), to those where the problems are a few quarters off still, like XO
Communications (XOXO:Nasdaq - news), Williams Communications
(WCG:NYSE - news), Exodus Communications (EXDS:Nasdaq - news) and
Level 3 (LVLT:Nasdaq - news). Their common problem is that they simply
have too much debt. The reason they can't sell out or expand is that their
access to capital has been shut off because they have too much debt.
Brett D. Fromson: I assume you're looking for a rash of bankruptcies among
the New Economy telcos.
Ravi Suria: Yes. Between 2001-04, I expect an unprecedented series of debt
defaults. That basically means the debtholders will take over these companies,
shareholders will not get anything and after the financial restructuring, the
company comes out with little or no debt.
Brett D. Fromson: How common do you think that will be?
Ravi Suria: It's hard to put a number on it. So far this year, you have had
Northpoint, Metrocall (MCLLC:OTC SC - news) and now PSINet on the
brink. But this is just the beginning. I would say that about 80% of the New
Economy telcos will have to restructure.
Brett D. Fromson: How much debt have these new-era telecom services
companies taken on?
Ravi Suria: Between 1996-2000, the high-yield market raised $502 billion, of
which $240 billion was for telecom and media. To put this in perspective,
throughout the 1980s, it raised only $160 billion. A key difference is that the
companies that raised money using junk bonds in the 1980s were industrial
companies with hard assets that generated positive cash flow and had
products. So when you lent them money, you could say, "This company can
generate enough cash flow to repay the debt." You wouldn't give them money
otherwise. So, in some ways, the companies that borrowed in the '80s were a
lot more creditworthy than the companies of the '90s.
"The new guys said, 'We can borrow money from the markets,
build out the networks and then sell to the guys who have the
customers.' "
Brett D. Fromson: Why did the high-yield market give so much money to
these companies to begin with?
Ravi Suria: There are two important reasons. One, by the time of the
Telecommunications Act of 1996, we were in the sixth year of an economic
expansion. All the traditional issuers of high-yield bonds were actually buying
back debt -- the airlines, for example. So investors needed a place to reinvest
the money. The act comes around and essentially creates an industry that
promises the future and needs a lot of capital. But even so, I don't believe the
market would have given these companies all this money if it wasn't for the
endgame.
The endgame for these companies was always to sell out. Nobody was looking
to run a telecom services company 15 years down the line. The money allowed
companies to go out and build networks and go after customers in competition
with the old-line telecom companies, which had networks that were 30 to 40
years old. The argument of the New Economy companies was that the Old
Economy companies had the customers and the revenue base, but they didn't
have the networks. The new guys said, "We can borrow money from the
markets, build out the networks and then sell to the guys who have the
customers."
Brett D. Fromson: I can imagine how appealing that might have seemed to
the junk bond market.
Ravi Suria: For a high-yield manager loaning money at 10% to 11% to these
new companies with CCC credit ratings, the prospect of the new companies
being sold out down the road to AAA-rated old-line companies was as good as
it could get. It looked like a 10-bagger. As long as you believed in the value of
the network, as long as you believed in management's strategy, as long as you
believed that the endgame would work and they could sell out, you gave these
companies money.
Brett D. Fromson: What happened in 2000 to change the game?
Ravi Suria: A couple of things caused the endgame to fall apart, which is why
you are seeing the problems right now. First, look at the companies that were
supposed to be the buyers of the New Economy companies. They had gone on
their own buying and borrowing binge in the wake of the Telecommunications
Act.
First, the big guys started consolidating. So, among the long-distance carriers
and the Baby Bells, you came down from about 13 companies to seven. So, the
number of potential buyers sharply contracted. And second, they borrowed
more money to do this. Between 1997-2000, EBITDA in the big telecom
companies grew by 65%, but interest costs grew by 85% and debt grew by
140%. The leveraging up by the old-line companies limited their ability to take
on the debt that comes with acquiring a New Economy company. So the
business plans of 1996 that envisioned the old-line companies with pristine
balance sheets swooping in to buy the new guys fell apart with each passing
year. Then, in 2000, credit spreads really exploded for the big guys. Their
credit quality started falling off a cliff, and their borrowing costs started going
way up.
Brett D. Fromson: What spooked the market?
Ravi Suria: What really spooked the bond market was the amount of money
the companies were expected to spend on 3G over the next five to seven years.
Brett D. Fromson: By "3G," you mean the next-generation wireless networks,
right?
Ravi Suria: Yes. Wireless is the next big thing, but it must be financed off the
same balance sheet that is supposed to finance the current wire-line networks.
And the companies don't have the cash flow to do both. When people started
to realize this, things started falling apart for the whole industry.
Brett D. Fromson: How much do you expect 3G to cost?
Ravi Suria: I look at 3G as a new project for the global industry. I don't
believe it happens via individual companies. At the end of the day, you'll
probably have four to six global companies offering end-to-end solutions via
3G wireless. We conservatively expect that to cost $300 billion; $150 billion is
in buying the spectrums at auction, and the remaining $150 million is in
build-out costs.
Brett D. Fromson: $300 billion is a lot of money.
Ravi Suria: Yes. If you assume that the $300 billion is financed 50% by debt
and 50% by equity. Say $150 billion at 8% for the debt. That's $12 billion a
year in interest costs. The entire industry is not supposed to generate revenues
of $12 billion from 3G for four years and incremental cash flow for seven
years.
So, what spooked the bond market is the fact that the old wire-line businesses
that are in decline will have to sustain the interest payments on 3G for the next
seven years. The repayment of the debt and ultimately the value flowing to
equity holders is much further off.
Brett D. Fromson: Are there any historical comparisons?
Ravi Suria: I compare 3G to prior massive capital expenditures in history like
the building of the Interstate Highway System or the electricity grid or the
nuclear reactors. All these projects required a lot of spending initially, but the
reason the industries survived over the next 30 to 40 years was that they were
regulated, and thus cash flows to repay the initial investments were guaranteed.
This time you're borrowing to spend the money and letting loose a bunch of
companies in a highly competitive free market under disinflationary pricing and
telling them to make enough money to repay the original investment. This is an
experiment that has never been tried before. It's hard to see a happy ending to
this experiment under the current spending scenario.
Brett D. Fromson: When did it become apparent that the old-line companies
were in no shape to take over the new-era guys?
Ravi Suria: In April 2000, with the British auctions, when companies spent
$35 billion just buying spectrum. Six weeks later they spent about $45 billion in
Germany. Suddenly all these costs became a reality, and the bond market fell
apart. That was when debt spreads exploded across the board. It became
apparent that the ability of the potential Old Economy buyers to take over the
debt of the new companies had substantially deteriorated in the past three
years. You can see the debt problems of WorldCom and AT&T.
At the same time, the New Economy companies had messed up their balance
sheets a lot more than had been expected. We did an aggregate balance sheet
for about 150 of the new telecom companies that came public in the past four
years. As of the third quarter of last year, the noninvestment-grade companies
had $189.9 billion of debt, but the book value of the network was only $127
billion.
This is the key reason why the endgame for so many of these new companies
won't work. If the network is worth $127 billion, I should be able to build it
for roughly that amount, maybe a bit more. The Old Economy companies will
never buy the new companies if their total debt is significantly more than the
value of their plant and equipment, because you can build the network yourself
for close to its book value. Debt for the new-era companies was 60% more
than the value of plant and equipment. We have not seen a single transaction
where a company has been taken over when the debt was more than 100% of
plant and equipment.
"So the business plans of 1996 that envisioned the old-line
companies with pristine balance sheets swooping in to buy the
new guys fell apart with each passing year."
Brett D. Fromson: And your analysis assumes that the value of the plant and
equipment is not overstated.
Ravi Suria: Yes. The potential problem is that the plant and equipment on the
books of the New Economy companies is rapidly deteriorating because of the
short life cycle of the network. They are amortizing the value of these
networks a lot faster than they thought they would because of technological
obsolescence.
Brett D. Fromson: Do you have a problem with the underlying fundamentals
of the telecom service sector?
Ravi Suria: No. I definitely believe that telecom convergence
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