about 6 months ago I posted on this thread a CSFB analysis of ESPI that included comparisons to WCII. Don't have the link handy, but here's a 6 week old CSFB report:
Summary
Recent Operating Problems and Management Changes Cause for
Concern. Over the past several months ESPI has been reeling
as a company and stock. Internal operating problems have
overflowed into the stock market (appropriately) and made this
one of the worse performing CLECs in the group. The problems
include: higher SG&A costs than originally anticipated as the
company attempts to migrate more customers on-net; expensing
OSS back-office efforts which the company originally believed
it could capitalize; costs associated with Year 2000 (Y2K)
efforts; and lower revenues than projected as a result in a
decline in reciprocal compensation revenues. Management is
trying to address these problems by gaining a tighter grip on
fiscal controls. In order to boost margins, ESPI announced
that it would phase out local switched resale. In addition,
the company is looking for a partner to share the cost of
developing an OSS system. And, management changes are geared
to stabilizing the situation and getting the company on the
right path. While it is too early to speculate how quickly
success can be achieved, we think the stock currently
discounts all these negatives, and therefore it's too late to
be bailing out. Thus, we're retaining our Buy rating for now,
and plan on monitoring the situation closely over the coming
weeks and months.
New Initiatives Announced to Reduce Expenses and Improve
Overall Performance
Phasing Out of Local Switched Resale. On December 14, ESPI
announced that it would begin the phase out of local switched
resale from its product portfolio as part of its effort to
improve margins. While the company will provide local resale
to multi-location clients whose telecom needs can only be met
through a combination of on-net and off-net facilities, ESPI
will take steps to eliminate the balance of local switched
resale customer base. The company will achieve the phase out
by adjusting resale pricing, accelerating the deployment of
switching equipment in order to migrate more traffic on-net,
and through the cancellation of orders. According to the
company, approximately 5% of third quarter revenues were from
TSR. Management would like to see this proportion go down
sharply. As most CLECs are discovering (and AT&T discovered a
year ago) TSR is simply not an economic way to enter the local
business.
Operational Support System (OSS) Update. In addition, the
company announced that it was in the process of seeking a
partner to share the cost of developing an OSS system.
According to the company it could purchase an existing system
from another CLEC or software developer, develop an OSS system
with a partner, or purchase software and have the vendor
customize it to meet ESPI's needs. According to CEO Anthony
Pompliano, ESPI is in no great "rush" to automate their
current system as they can manually provision approximately
10,000-15,000 lines per month quite easily. This comment
suggests two things. One, the rate of provisioning is not
likely to rise too much in the short term as the old manual
systems are retained. And, two, that the company recognizes
that provisioning systems are critical to successful
operations and good ones are too expensive for a small company
to develop and support itself. Thus, joint development with
other CLECs is a wise move, and is a point of view we've heard
other CLECs express. We wouldn't be surprised to see a
collection of CLECs announce such an initiative in the first
half of 1999. This would be a very positive development, and
we think crucial for the survival of those CLECs experiencing
operating problems.
Management Changes
On November 23, ESPI announced that Jack E. Reich, president,
CEO and director, resigned and that Anthony J. Pompliano would
reassume his prior role as chief executive officer. We
suspect that the Board of Directors, reflecting investor
concerns, was not pleased by the surprise third quarter EBITDA
shortfall and due to the fact that the EBITDA inflection point
has now been pushed out twice. As such, Mr. Pompliano
initiated a review of the existing operating and overhead cost
structure of the company. Mr. Pompliano joined ESPI in 1993.
He was one of the founders of Metropolitan Fiber Systems of
Chicago (predecessor of MFS Communications). Given the
complexity of the CLEC business, operating problems have
become pretty common in the CLEC sector, which is being
reflected in the floundering stock prices of the group.
Separately, on December 15, the company announced that Ron
Spears, chief operating officer, would be given the additional
responsibilities of president. Mr. Spears joined ESPI in
February of this year. Prior to joining ESPI, Mr. Spears
served as corporate vice president-telecommunications for
Citizens Utilities since 1995. Prior to his tenure at
Citizens, Mr. Spears served as chairman and CEO of Videocort
Inc. for two years and President of MCI Communications'
Midwest operating division for six years.
In addition, ESPI announced that Douglas Hudson was named
president of ESPI's ACSI Network Technologies Inc. unit. Mr.
Hudson joined ESPI in May of 1994 and most recently served as
Executive Vice President of National Distribution and
Strategic Development. Prior to joining ESPI, Mr. Hudson was
with Metropolitan Fiber Systems, Inc., where he was Vice
President and General Manager, MidAtlantic Region.
Where Do We Stand?
Our price target on the stock of $18, assumes a successful
turnaround over the next couple of years. It is derived by
using a 16% discount rate, along with a terminal year multiple
of 9 times. One might argue that the current operating
problems require a higher discount rate than that applied to
other, more successful CLECs, however for now, we think a 16%
discount rate adequately reflects the risk. It should be
noted that while we have retained our Buy on the stock, this
is not a "table pounding" Buy, it is more a function of the
fact that the stock has gotten so cheap, that we believe it
could bounce significantly upon any positive news such as a
major vendor financing arrangement or an agreement to partner
with another CLEC in the development of a robust OSS system.
Fourth Quarter and 1999 Outlook
ESPI's outlook for the fourth quarter and 1999 is obviously
clouded by recent operating problems. However, we have
revised our model to reflect these problems and to incorporate
trends evident in the third quarter. Here are the key items
from the third quarter and recent initiatives that have
impacted our fourth quarter and 1999 estimates:
Higher SG&A costs associated with ESPI's effort to migrate
more new customers on-net (which) require more manual labor
than anticipated.
Expensing of OSS backoffice efforts which the company
originally believed it could capitalize.
Costs associated with Y2K efforts.
Gradual reduction in revenues due to the phasing out of local
switched resale.
Reduction in 1999 revenues by as much as 10% to account for
the reduction in fees collected from the RBOCs.
According to the company, the EBITDA loss for the fourth
quarter will be in the mid to upper teens and its guidance on
EBITDA breakeven has been pushed back two quarters to mid-
2000. We've adjusted our models to reflect the lower revenue
growth. Our outlook is not quite as good as management is
indicating, since it has been our experience that companies
rarely overcome financial surprises in a single quarter.
Thus, the ramp up we're anticipating is less robust than
management.
As a result of the higher than expected operating costs
reported in the third quarter, we are lowering fourth quarter
earnings estimates to a loss of $1.26 from a loss of $0.85.
Our year end 1998 and 1999 earnings estimates are being
lowered to a loss of $4.28 (from a loss of $3.75) and a loss
of $4.70 (from a loss of $3.28), respectively. The fact that
management did not have its arms around these costs until the
end of the quarter is surprising. It raises questions
regarding internal financial controls, which has been a
nagging problem for many CLECs.
Model Changes
As a result of the increase in expenses and projected revenue
decline at ESPI, we have revised our model accordingly. We
have raised SG&A in the fourth quarter to $32.9 million (or
68% of total revenues) from $26.4 million (or 50% of total
revenues) to reflect higher spending associated with ESPI's
plan to migrate more customers on-net. We have also raised
network expenses by $3.3 million to reflect higher network
costs. In addition, we have reduced our fourth quarter
revenue target to $48.3 million from our previous estimate of
$53.4 million to reflect an anticipated decrease in reciprocal
compensation revenues and the gradual reduction in local
switched resale revenues. As a result of these changes, we
expect a fourth quarter EBITDA loss of approximately $18.3
million versus our previous estimate of a loss of $5.1
million.
Looking forward to 1999, we have increased SG&A to $144.8
million or 59% of revenues from 41% of total revenues. In
addition, we are cutting our 1999 revenue target to $247.5
million from our previous estimate of $304.7 million to
reflect the expected reduction in reciprocal compensation and
the reduction in TSR revenues. As a result, our revised 1999
EBITDA estimate is a loss of $50.2 million versus our previous
estimate of $9.4 million (positive). Our 2000 revenue and
EBITDA estimates have been revised to $380.8 million and $5.0
million from $492.1 million and $51.3 million, respectively.
As a result of our changes to the model, our revised terminal
year (2008) EBITDA margin is reduced to 29.2% versus our
previous estimate of 32.8%.
Outlook
Although the company continues to aggressively build out its
network and increase its market penetration, we remain
concerned that management did not have the internal financial
controls in place to provide an earlier warning of the
unanticipated costs regarding customer migration to on-net
platforms, OSS backoffice costs, and Y2K costs. As such, we
have revised our model to reflect the increased expenses and
projected revenue decline. The problems that ESPI,
Intermedia, ICG, and other CLECs faced this year underscore
the inherent difficulty of the CLEC business and reinforce our
belief that only those CLECs with top management teams in
place will succeed, while others will have to find partners to
maximize shareholder value. During a recent conference call
(December 16), Mr. Pompliano stated that there are no plans at
this time to sell the company and that it is not "receptive"
to any negotiations with the stock trading in the single digit
price range. Undoubtedly, this will further pressure ESPI
shares. We maintain our Buy rating on ESPI shares for long
term investors and expect shares to lag the CLEC group until
management regains the confidence of the investment community. |
