May 11, 2001, Page One Feature
Rob,
It's not just overcapacity, it's the Mother of all Yard Sales:
Telecom Debt Debacle Could Lead
To Losses of Historic Proportions
By GREGORY ZUCKERMAN and DEBORAH SOLOMON
Staff Reporters of THE WALL STREET JOURNAL
Two years ago, when the Baltimore Ravens agreed to plaster PSINet Inc.'s name on their football stadium in
exchange for $105 million over 20 years, the telecommunications upstart looked like a valuable player.
One of the first to offer high-speed Internet service to corporate America, the Ashburn, Va., company was a
Wall Street hero, with a market capitalization soon to surpass that of American Airlines parent AMR Corp. and
Delta Air Lines combined. But PSINet's game plan didn't work out. Crippled by its $3 billion debt load, the
company warns it may seek federal bankruptcy-court protection, a move one person close to the matter says
may come as soon as next week. That could force the Super Bowl champion Ravens to line up with creditors
seeking court approval for future payments.
1See a chart on 'Telecom Hangups'
2British Telecom Announces Plans to Split in Two to Reduce Debt
3IDT Scavenges for Bargains in Phone-Upstart Wreckage
4Nortel Dissolves Its DSL Division as Part of Ongoing Restructuring
As the epic telecom bust reverberates around the globe, it's getting to be a very long line. Telecom companies,
which gorged on some $650 billion in debt in the past few years, are failing in record numbers for that industry.
It's shaping up to be one of the biggest financial fiascoes ever, with losses to investors expected to approach the
$150 billion government cleanup of the savings-and-loan industry a decade ago.
"I don't know if there's a modern-day precedent for the billions of losses" to investors from the telecom industry,
says Greg Dube, head of global high-yield investments at Alliance Capital.
What's unprecedented -- besides the staggering debt totals -- is how little the assets of the troubled telecom
companies will likely be worth as the restructurings play out. Past bankruptcy waves, such as those that swept the
rail, retail, steel and movie-theater businesses, left bondholders with about 40 cents on the dollar, while bank
lenders usually got most of their money back. But bond investors may not be able to salvage much more than 10
cents on the dollar from the telecom restructurings, with banks also taking a hit, according to analysts. One
reason: The industry's high-tech gear becomes outdated at such a rapid clip.
The Boom Before the Bust
The bust had its origins five years ago, when Congress lifted restrictions on who could sell voice, video and data
services in the local phone markets. Back then, the Internet and wireless services were in their infancies and huge
profits were expected. Hundreds of upstarts rushed to build state-of-the-art networks to carry the expected
surge of demand, and incumbents such as AT&T Corp. and the Baby Bells also awakened to the opportunity,
investing billions in their own wireless and Internet businesses. Investors rushed to supply the cash, and Wall
Street firms have made $7 billion in fees by raising debt and equity for the companies since 1995. But the demand
didn't materialize as quickly as expected, and the Baby Bells proved to be tough competitors for the upstarts.
Today, more than 97% of fiber-optic capacity goes unused.
The debt troubles have spread to every sector of the telecommunications industry. Firms that spent the past few
years digging up streets, highways and ocean floors to build fiber-optic networks, such as Level 3
Communications Inc., are burning through hundreds of millions of dollars each quarter. Local phone companies,
such as Winstar Communications Inc., have filed for bankruptcy protection, while wireless phone companies,
including Nextel Communications Inc., and a slew of high-speed Internet providers have all seen their stock
prices plunge, as heavy debts crimp profits.
And the damage goes far beyond the telecom upstarts. Heavy debts will likely hound blue-chip companies like
British Telecommunications PLC and AT&T for years to come. What's more, the troubles will likely weigh on the
overall growth of the economy for the next several years because the telecom sector has become so big.
How painful will the shake-out be? In the past six months, about 10 telecom providers have filed for bankruptcy.
By the time it's over, dozens more may have to be restructured or seek bankruptcy protection, according to
analysts. The big losers: bond investors, banks, stock investors and venture-capital firms, all of whom are already
seeing their investments tumble in value.
Holders of U.S. and European telecom bank loans currently face more than $30 billion of losses, according to
S&P Portfolio Management Data. Bond investors are sitting on paper losses of about $40 billion of their own,
while stock investors have seen $20 billion in losses from purchases of initial public offerings -- not even counting
the $500 billion in paper losses stemming from the 40% plummet in the sector's market capitalization from the
peak. Venture-capital firms have $20 billion or so in telecom losses and investors in debt securities convertible
into stock have dropped another $5 billion, according to analysts.
As bad as this debt debacle is likely to become, however, it's not likely to spread into a broad financial crisis.
Because of changes in the bank-loan and debt markets, this huge amount of telecom borrowing isn't concentrated
in the hands of a few financial institutions, as was the case in the Latin America debt crisis of the early 1980s.
Mutual funds, pension funds and other institutional investors have loaded up on a wide variety of debt, and their
losses on junk bonds issued by telecom companies have been partially offset by gains elsewhere in their
portfolios. Investors will take a hit, but most won't take a devastating hit.
Major banks nowadays don't keep huge pieces of loans on their books but instead break them into pieces among
dozens of other banks and investors. So J.P. Morgan Chase & Co., for instance, which originated some $152
billion in global telecom loans last year, has less than 10% of that on its own books.
Swift and Severe
Still, the industry's shakeout is already shaping up to be unusually swift and severe. Northpoint Communications
Group Inc., founded in 1997, raised $1.2 billion selling stock and bonds to build high-speed lines to sell to
Internet-service providers and corporate customers. A year ago, the San Francisco-based company was valued
at $6 billion. It filed for Chapter 11 bankruptcy-court protection in January, however, after a takeover offer for
the company was withdrawn and Northpoint failed to sign up enough customers to cover its huge debt burden.
When its assets were offered to bidders earlier this year, interested parties were scarce. One problem is that
Northpoint provides essentially the same service as Covad Communications Group Inc. and Rhythms
NetConnections Inc., both of which are struggling financially and could eventually have to sell assets.
In the end, the highest bid came from AT&T, which paid just $135 million for dozens of metal cages containing
racks of high-speed Internet equipment that Northpoint had installed in the central offices of the Baby Bells.
That's just about half the amount Northpoint spent on the gear over the past three years. On their way out the
door, employees are being invited to buy their own computers for hundreds of dollars, according to a Northpoint
executive. Investors who purchased $400 million in bonds will receive almost nothing, while shareholders won't
be getting a penny.
Why is the wave of restructurings likely to result in such puny recoveries, especially as many of the firms sit on
state-of-the-art equipment that's far better than anything on the market just a few years ago? For starters, many
of the struggling telecom companies never became fully formed businesses. PSINet, for example, never integrated
many of the 74 smaller companies it purchased in recent years. Lacking a solid customer base, many of the
upstarts have little hope of becoming profitable in the near future.
"These telecom companies are worth substantially more as ongoing businesses than in liquidation," says Aryeh
Bourkoff, a telecom analyst at UBS Warburg LLC.
Most surviving telecom companies have virtually all the equipment they need, so there are few buyers for
high-tech gear on the auction block. Those who are looking for distressed assets have a wide swath of companies
to choose from and can often get that gear on the cheap.
High-Tech Yard Sale
Indeed, so much used telecom equipment -- such as billing systems, switches and hardware that routes phone
and Internet traffic -- is flooding the market that it's looking like the world's biggest yard sale, with much of it
selling for 20 cents or so on the dollar. Racks and cages, which companies like PSINet use to hold the servers
that power Web sites, sell for about $100, down from about $1,000 six months ago. New equipment still in its
original packaging is even showing up on the used equipment market.
Last month auction site DoveBid.com auctioned off almost all the assets of Pacific Gateway Exchange, a
Burlingame, Calif.-based telecom provider that filed for Chapter 11. Up for grabs were Cisco routers, Nortel
phone switches, Dell servers, fax machines and LaserJet printers, most of which sold for less than 50 cents on the
dollar. One server, which retailed for around $6,000 18 months ago, was auctioned off for about half that.
Another reason there will be big telecom losses: Many investors and lenders who specialize in distressed
companies, and sometimes supply them with additional capital during a restructuring, are steering clear of the
sector. While troubled companies in the past -- such as R. H. Macy & Co. and Federated Department Stores
Inc. in the early 1990s -- had loads of debt but at least had operating profit, most troubled telecom providers
have little in the way of revenues, making them riskier investments for the specialists.
"Manufacturers or retailers had clear values for their assets, [but] if telecoms go bad recoveries can be de
minimus," said Bruce Karsh, a veteran distressed-debt investor at Oaktree Capital Management in Los Angeles.
"Northpoint gives everyone pause, because AT&T's bid was a very rock-bottom price."
But the upstarts need cash as much as ever. Many need money to finish their networks and meet interest
payments until they begin generating profit. With investors and lenders turning a cold shoulder to many telecom
companies, more will go under in the next year unless they can somehow come up with the funds to meet debt
payments. And with stock prices of many telecom companies down, few acquisitions of the debt-laden telecom
providers are likely.
In fact, financial pressures on many telecom providers are only getting worse. Many big companies, including XO
Communications Inc., McLeodUSA Inc. and Level 3 Communications, sold so-called discount notes that haven't
yet required any cash interest payment. As much as $31 billion of these securities have been sold in the last five
years, a third of all junk-bond sales by telecom providers. Over the next three years, a number of these
companies will have to begin making new interest payments totaling $3.9 billion -- putting added pressure on the
companies.
"We are approaching the period when the chickens come home to roost," according to a recent report about the
notes from Moody's Investors Service.
McLeodUSA, Level 3 and XO Communications all say they'll have enough cash to make interest payments on
the discount notes as they become due.
Meanwhile, even the nation's biggest long-distance company, AT&T, had to slash its dividend and sell assets to
conserve cash and help pay interest expense on heavy debts from years of acquisitions.
Among the worst off of the big players are European telecommunications companies, including Deutsche
Telekom AG, France Telecom SA, the Netherlands' Royal KPN NV and others, which together have spent
more than $100 billion for so-called third-generation licenses to provide wireless data services. But the European
rollout of "3G" won't happen for several years. Moody Investor's Service recently reiterated its negative outlook
on the European telecom industry, saying cash flow from 3G "is very uncertain, both in terms of amounts and
timing." And the companies will have to spend an additional $100 billion or so just to get the wireless networks
operational.
British Telecom, buckling under its $43 billion debt burden, Thursday announced a sweeping plan to spin off its
wireless business, halt dividend payments and raise cash through a giant equity offering.
For the upstarts the outlook is worse: A series of restructurings is likely, either in bankruptcy or outside, with
bond investors and banks assuming the reins of the most competitive telecom companies, shooing the
entrepreneurs who started the companies out the door.
First In Best Off?
The first companies to file bankruptcy may turn out to be the best off. Several telecom providers, including ICG
Communications Inc., are in bankruptcy protection and in the process of shaving debt, cutting expenses and
cleaning up their balance sheets. That may give them a leg up over even bigger rivals that suffer from heavy debt
payments. "The surprise winner will be ICG, even though they were the first and biggest to go down," says Ethan
Garber, an analyst at Lehman Brothers Holdings Inc.
That isn't to say the process hasn't been painful. Bondholders in ICG, which filed for bankruptcy in November,
will probably get little more than shares in the restructured company for their $3 billion in securities. The
company's lenders will also see big losses. Otherwise savvy investors such as John Malone have seen their
reputations tarnished; his Liberty Media, which invested $500 million in ICG, recently sold its stake for an
undisclosed sum to IDT Corp., another telecom provider. And almost half of ICG's 2,600 employees have been
fired.
Still, ICG is expected to emerge from bankruptcy around the beginning of next year with many of the same
customers and a clean balance sheet, enabling the company to undercut prices of rivals struggling to pay interest
expenses on big debts. "Some of our brethren would have a better chance of surviving if they reorganized
quicker," says Randy Curran, ICG's chief executive.
PSINet's Outlook
The outlook may not be so rosy for PSINet. The company took on mountains of debt and went on an acquisition
spree even though big profits were years away. It built up Web-hosting centers in major cities including New
York, Los Angeles and London. Even as some members of the company's board of directors expressed concern
about the debt, PSINet's chief executive, William Schrader, "was more interested in building the infrastructure
than in achieving profitability with what he already had," says Ian P. Sharp, a PSINet board member. With so
much money available, Mr. Schrader wanted to get it before his competitors, according to Mr. Sharp. Mr.
Schrader didn't return calls seeking comment. PSINet declined to comment.
A year ago, when rival telecom companies contacted Mr. Schrader, to see if PSINet was willing to sell itself, Mr.
Schrader demanded a price far above anything they were willing to pay.
"When the stock was at $30 he'd say 'I'm a seller at $75.' When it went to $60, he said 'I'm a seller at $100,' "
said a person close to PSINet.
Mr. Schrader was sure his firm would be a survivor. At PSINet's holiday party in December, he told employees:
"AT&T is going to go down, but PSINet will survive," according to a former PSINet executive who was there.
By September, PSINet's debt load was hurting, sales were off and the company was dealing with big costs just
to keep its business running. Sitting in his Cherry Hill, N.J., office, watching PSINet's bonds begin to lose value in
the summer, Eric Green, head portfolio manager at Penn Capital Management LLP, became concerned. After
making some calls to people in the industry, and hearing what Mr. Schrader was asking for the company, he
began dumping his own PSINet bonds.
Last month, PSINet reported a $3.2 billion loss for its fourth quarter and said it had defaulted on several loans.
The company said it's "likely that the common stock of the company will have no value."
On April 29, in a hastily arranged afternoon conference call, PSINet's board members asked Mr. Schrader to
resign. He offered no resistance.
In the end, the company's debt discouraged potential acquirers, says Mr. Sharp. "You have companies like
PSINet with a large amount of debt," he says. "Nobody in their right mind is going to step up and say 'I'll take
that debt and buy the company.' "
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