SSB (who needs sleep) OCR'd but uncleaned from a rough copy (trust
detail accuracy at your OWN risk/ clarifications provided on rqst):
04/08/99 Rhythms Netconnectic (RTHM ~69.12,1-S,Tgt $90.00) Jack fl. Grubman
--OPINION:
We are initiating coverage on Rhythms NetConnections with a 1S (Buy,
speculative) rating and a $90 price target. Rhythms is a next generation
"data" CLEC that will use digital subscriber line (DSL) technology to
break the local loop bottleneck. By targeting the top 50 US cities,
Rhythms offers high perforrrtance networking solutions via high speed loca~
access enabled with DSL. The company plans to provide voice, data, and
video solutions to small and medium business customers as well as
work-at-home employees of larger enterprises.
The bottom line is that we like the Rhythms story since the company is
operating in one of the fastest growing segments of the telecom industry,
has a capable management team and investors will be investing along side
of MCZ WorldCom, Qwest & Microsoft which are clearly companies which have
a strong proven track record of identifying industry trends well ahead of
competitors.
Our $90 price target is based on a 10-year daf which we describe at the
end of the note. However, we would simply point out that our target is
based upon Rhythm's installing 2.6 million lines over the next 10 years
which represents only 6% of the 44 million total 2008 nSL lines in the
U.S. that pioneering consulting Group is estimating or perhaps 14% of
Rhythms addressable market as measured by Rhythms addressing 60% of nSLz
lines derived as a percent of estimated LAN End-User seats. Near-term,
we expect Rhythms to have 12,000 DSL lines by year-end 1999 and 35,000 by
year-end 2000.
This is a top line business and we believe the greatest shareholder value
will be added by those carriers that can drive revenue and add value
beyond just flSL. The key to driving revenue is having lots of speed
available and a full range of products. Right now, Rhythms offers 16
flavors of nSLi and can offer significantly faster downstream speeds than
Northpoint and Covad. speed and value added services drive revenue and
revenue drives value. We therefore believe that the business plan is
expandable and believe penetration targets are achievable.
The best publicly traded comparable in the market today is covad. Covad
is currently trading at a firm value of *4.~ billion and we believe
rthythms should be valued at a premium, because of its ability to provide
faster D5L speeds and more value added services.
DSL opportunity
we see a tremendous opportunity for companies like Rhythms to break what
we see as substantial bottleneck at the local loop level. A great deal of
bandwidth is being built by companies like Level 3, Qwest and Williams
that are deploying long-haul data networks. without broadband access over
the last mile, tho~agh, a major group of customers cannot yet reach it.
Most small and medium b~sinesses and residential customers have to use
dial-up analog modems or at best ISDN lines to access data networks.
Rhythms will use DSL technology, which is deployed by simply upgrading
the existing copper pairs running into virtually every home and business
in North America, to break this bottleneck. By providing downstream
speeds of up to 7.1 Nbps over existing telephone lines, DSL will bring
broadband services to a mass market and further fuel demand for broadband
capacity. DSL will open access to broadband capacity to a wide range of
customers. Increased broadband access will enable a wide array of
applications that will, in turn, increase demand for bandwidth. We cannot
stress enough that capacity fuels demand in this business. Bandwidth
feeds demand in this business and we believe that the network access that
Rhythms provides will feed demand for bandwidth consuming services.
DSL will accelerate demand for both local and ~ong haul bandwidth and we
believe that high-quality, broadband capacity will be a scarce resource
for the foreseeable future. One needs end-to-end bandwidth to best
deliver data solutions. We believe the paradigm in this industry will
shift from voice provided on a metered basis and data priced on a
dedicated circuit basis to an environment where everything is priced by
the bit (binary digit). rn other words, if a customer wants a virtual
00-48, they can use bandwidth as needed and pay accordingly. In order to
deliver flexible solutions, a carrier has to have end-to-end broadband
capabilities.
Leveraging DSL
We believe Rhythms is well positioned to leverage the DSL opportunity.
It is our view that one of the keys to long term%competitive advantage in
this business is to provide a wide range of value added services through
the DSL connection. Tt will be important to drive as much revenue as
possible through the DSL connection. That is, this is largely a "top
line" business.
Since DSL is an overlay network and all carriers essentially shop at the
same store, so to speak, carriers will hays essentially the same network
cost structure. Also, because 75% of long term economies of scale reached
at the first 150 customers, Rhythms does not need to run at full capacity
to have an attractive cost structure. The moral of the story is that the
best run DSL corripanies will be the ones that can deliver the most
products and services across their DSL pipe to the end customer.
It is also critically important to not become just being a commodity
provider of DSL services. We strongly believe that to be successful, a
carrier must add value on top of DSL service.
This is why it is so valuable to be able to offer a wide range of speed
options and a broad range of products.
Products
Rhythms offers 16 flavors of DSL and provides a wide range of WAN, LAN
and access services. speeds range from 128 Kbps to 7.1 Mbps. This is a
broader range of products than many of its competitors. Most only offer
SDSL type service and limited speed options. Although other carriers can
get there, right now, Rhythms can offer significantly more downstream
capacity than competitors like Northpoint and Covad.
The average Rhythms customer today is receiving 659 kbps of capacity.
Importantly, the average speed available per connection to Rhythms'
customers is 3.5 Mbps. This leaves 2.2 Mbps of unused capacity per
connection. We see this unused capacity as a huge asset for Rhythms. This
capacity will not only allow Rhythms to "up-sell" customers to faster
services, but provides Rhythms with a fat pipe through which to deliver
enhanced products and services down the road. (Covad, for example,
currently of fers a maximum speed of 1.5 Mbps and the average Covad
customer is receiving 384 Kbps of capacity. We estimate that the average
speed available per connection is around 750 Kbps. This leaves 366 rbps
of unused capacity, somewhat less than that of Rhythms.)
Product offerings will include pure Xnternet access and turn-key internet
applications, caching. The company will also offer remote LAN services,
computer backtip, Wax extensions, and dynamic host configuration protocol
(DHCP). Product rollout will occur over the next few years. Rhythms
currently offers computer backup, turn-key internet, mx extensions,
Power Internet, U.S. LAN, and content caching. ThiB year, we'expect the
company to begin offering DHCP, Firewall, virtual private network (VPN)
services, and directory services. xP telephony, PSTN gateway, and
streaming media.. In 2000, we expect Rhythms to add multimedia
conferencing, IP fax, expanded c-commerce services, various vertical
applications, software distribution and rental applications.
Rhythms will offer products for internet access and tele-workers.
Rhythms' primary target markets include tele~workers (e.g.,
work-at-home) and small and medium businesses where it is not economical
to run fiber. Provide internet, corporate LAN, corporate wax, local
voice, long distance voice and many other value-added services like data
backup as well as turn-key solutions for ISP'5 and other customers.
Rhythms is targeting larger customers that are looking for performance,
rather than low price.
Initially we expect the company to acquire a majority of its customers
through indirect channels, but we expect Rhythms' business to evolve to
a greater and greater portion of sales coming from direct sales.
We expect that very high growth will come from tele-worker segment. This
segment is one of the most attractive for Rhythms, but will take some
time to develop. rnternet service is price focused and less profitable.
This is the piece of the business that will likely become a commodity
first.
DSL Technology
DEL provides broadband capacity over the last mile by upgrading the
existing copper pair that runs into a customer's business or hone. DEL
significantly expands the amount of frequency used over the standard
twisted pair and therefore the capacity of the twisted pair. DEL is
essentially a "brute-force" technique, and the farther the user is from
the power supply, the greater the loss of power and the greater the speed
degradation.
Plain old telephone service (POTS) operates in the 30-3,400 Hz range
which corresponds to the perceptible range of the human ear. This is only
about 2% of the available spectrum on a typical copper phone line. DEL
uses a much broader range of frequencies. (DSL replaces the technology
that produces traditional phone service.)
Because DSL uses the existing infrastructure which runs into virtually
every home and business in North America and is fast and relatively
inexpensive to deploy, we believe DEL will ultimately break the local
loop bottleneck for a large group of customers.
The beauty of DEL is that it can be deployed quickly and cheaply, because
it uses existing infrastructure and is an overlay network. The service is
"always on", so unlike conventional dial-up service, the customer never
bangs up. In fact, if a customer does hang up, Rhythms will be notified
and will call the customer to see if there has been a problem! This
"always on" characteristic also enables a wide range of new products such
as automatic data backups.
Rhythms deploys DEL solutions at speeds up to 7.1 Mbps, which is 120
times faster than a standard 56 Kbps dial-up modem. We estimate that more
than 70% of the homes and businesses in Rhythms target markets can be
reached with high speed DSL services. With IDSL, a slower speed (128
Ktps) version1 we believe Rhythms will be able to reach virtually all of
the potential customers within its target market. We also believe that
the number of nodes that can be reached with higher speed versions of DSL
will increase as the technology improves.
Deployment
There are several steps to Rhythms entering a new market. First, Rhythms
secures an interconnection agreement with the ILEC and collocaten at the
ILEC Co. Rhythms currently has six interconnections agreements with
ILEC's, and is certified to provide DSL service in 22 states.
Collocation can range from securing a private cage with full access, to
shared space with limited access, to a tandem site next to the CO. There
is a bit of a land grab at the CO, no the first one there will get the
prime real estate. (This will generally be to Rhythms' advantage,
because Rhythms is fairly early to the game.) Tandem sites, for example,
can increase the occurrence of a type of interference known as near end
cross talk (NEXT). Rhythms then installs a DEL Access Multiplexer (DELAM)
at the CO. A DELAM can accommodate up to about 1,200 lines, depending on
the flavor of DEL chosen, before heat becomes a problem. Rhythms leases
ns-3 capacity which connects to its Metro Service Centers (or Metro
LAN'S). These centers then provide wide Area Network (WAN) services.
These Metro LAN's are then connected to form a "National LAN."
Rhythms resells unbundled loops and owns their DELAW's and other central
office equipment. an important point of distinction between Rhythms and
other carriers is that Rhythms uses DELAM equipment from three different
vendors (Copper Mountain, Paradyne and Cisco) which increases the range
of speeds and products the company can offer. Rhythms also has metro
centers with ATM/IP equipment.
Once the DSLAM is in place, the company begins acquiring customers. An
advantage of DSL technology is that it is largely success based. The
DBLAM card and customer premises equipment are not installed until the
customer is acquired. (Rhythms currently dutsources the customer
installation process.)
Rhythms Network Architecture
Rhythms will connect its DELAM's to create regional LAN'S. within each
of these, Rhythms will have a metro service center that will provide
value added features and applications. These regional LAN's will in turn
be connected to form a "LAN." This network will also be
connected to the public internet, the public service telephone network
(PETN), and Rhythms' national operation center. xt is important to not
that DEL service bypasses the Itisa voice switch. In doing so, Rhythms in
effect makes the local loop into a private line. Rhythms plans to attach
a wide range of features and functionality to its basic network.
Partnerships
Rhythms will use strategic alliances to accelerate its business plan and
the company has indeed formed a number of important strategic
partnerships. MCI Woridacra has invested *30 million in Rhythms for a 7.5%
stake. Rhythms will be MCI worldCom~a preferred provider of DSL service
and has committed to purchasing 100,000 DEL lines over five years.
Microsoft has also invested $30 million in Rhythms for a 7.5% stake.
On April 7, 1999, Rhythms announced an alliance with Qwest. Qwest will
make a $15 million investment in Rhythms. The terms of this transaction
are very similar to those given MCI Worldcom. Cisco Systems is another
strategic partner as well as customer which will pursue joint product
development with RTHM. Zn addition, and Cisco's sales reps are
c~pensated to sell Rhythms products. Qwest has committed to 35,000
lines over five years. Also, the Owest/Microfloft relationship will be
leveraged with the Rhythms/Microsoft relationship for web hosting.
The point is that MCI Worldcom and Qwest want to push their electronics
as far into the network as possible. Rhythms will enable this.
Other partners/customers include Verio and Ingram Micro.
Network Status
As of the end of February 1999, Rhythms had 300 Co's build or
operational and had 1,100 more under construction. The company plans to
be in over 1,500 by the end of 2000. Rhythms was operating in 10 markets
by the end at 1998, These include San Diego, San Francisco, Los Angeles,
New York, San Jose, Boston, and Sacramento. fly the end of 1999, the
campany expects to be in 33 markets and in the top 50 U.S. by the end of
2000. This corresponds to 28% of U.S. rauj's at the end of igga, 45% at
the end of 1999 and 60% at the end of 2000. Also as of the end of
rebruary 1999, the company had 850 lines in service, and an additional
9,000 under contract.
Economics of Rhythms DSL
The economics of DSL are very compelling. Capital cost is low. We
estimate that it casts Rhythms just over $10 million in initial capital
to enter a large market (roughly 60 central office locations) and roughly
$5 million to enter a small market (25 central office locations). Much of
this can be financed through leases. Based on this assumption, we believe
EDITDA break-even occurs at roughly 105 lines per Co in large markets and
194 lines per CO in small markets. A typical CO has roughly 25.000 lines.
This means break-even occurs at less than 1% of the available lines in a
given Co. This is less than 2% of the addressable business market.
Rhythms' net cost to acquire a customer is roughly $1,100. This includes
roughly $300 for customer premises equipment (CPE), $300 for installation
at the customer premises, $100-200 in one time charges to the ILEC, and
$350 in marketing costs. Zn some cases, this is offset by an activation
charge, but we believe activation charges will be increasingly difficult
to collect. Rhythms has a highly variable cost structure once the line is
installed. The primary component of cost is the lease of the unbundled lo
cal loop which generally costs between $11 and $22 per month. On top of
this there are billing and customer service charges as well as central
office related charges.
Given the attractive cost structure of the DSL business, we believe
Rhythms has a substantial pricing opportunity relative to ILEC bread and
butter products like T-l and even ranri. By some estimates Rhythms cost is
roughly 65% less than the price being charged by the ILEC'S.
Management
As with all CLEC-like companies, including the DSL companies, management
and execution will be critical and we have strong confidence in this
team. Katherine Hapita, president a CEO. was founder and formerly
President & CEO of INTERPRISE, US WEST's data networking business.
Scott chandler, cr0, was formerly President & CEO of c-COR Electronics,
manufacturer of broadband telecom equipment. The rest of Rhythms'
management team also has extensive operating experience.
Competition
There will no doubt be a wide variety of competitors in the DSL space.
These will include the incumbent carriers, other DSL carriers, CLEC'S
and even the cable companies. However, we also believe that Rhythms is
well positioned to succeed even as competition increases. Rhythms is
providing value added services on top of DSL and will use DSL as merely a
pipe to reach the customer. Rhythms also has somewhat of an early mover
advantage. As a result, Rhythms wil~ get better CO collocations sites,
will get preferred partners. preemptive positioning, brand and awareness.
Because they are early, and because they offer more than just DEL, we
believe customer loyalty and switching costs will help to reduce churn.
Risks
Major risks in this business include pricing and competitive pressure and
execution risk. There are relatively few barriers to entry in this
business and we believe prices will fall as existing telecoa operators
expand into DSL type services. That said, we believe Rhythms will be able
to differentiate itself from this competition. Rhythms will be using DSL
as a pipe to deliver value added services to' customers. This will help
the company to avoid price-ba~ed competition. Also, Rhythms is building
near ubiquitous coverage in the markets it enters. Other carriers, such
as the voice Otic's, will likely only install their own DSL equipment in
relatively small portion of the Co's in a given market. These companies
will outsource to companies like Rhythms for the rest. As for execution
of its business plan, Rhythms has a substantial amount of building ahead
of it. We believe that management has the experience and skill set
necessary to proceed on schedule, There is also funding risk and risk
associated with obtaining collocation agreements and securing funding.
All companies have approximately the same network cost structure, so
Rhythms will not have a significant cost advantage over the other
companies in the sector. Pricing will fall and it will be important to
add value beyond DCL. There is the risk that central office space becomes
scarce with the addition of new competitors and Rhythms may run in to the
situation where they will have to place their nsLAws a other equipment in
a shared (virtua~ co-location) space or a remote location tie-in which
may bring quality problems instead of the more desired secure space (in a
separate cage with a lock). This risk may be mote relevant for
competitors who come after Rhythms as space becomes more scarce. Zn
other words, although we do not believe there will be a widespread
shortage of space in central office locations, we believe there will a
first to market advantage to those carriers that secure the most
desirable space.
As with many of our voice clecs, access to capital is also a risk for
Rhythms. Our model implies that the company will need to raise
additional funding of roughly $950 million starting in the year 2000. We
expect most of the funding to come from vendor financing and debt but
there is always the chance of a secondary equity offering.
Valuation
Our $90 price target is derived from a 10-year discounted cash flow (dcf)
analysis. Our terminal year (2008) revenues of 64.7 billion are driven
by an 6% penetration of total market DSL lines as determined by
pioneering Consulting which is looking for 44 million DSL lines in 2008.
Our 2008 ESITDA estimate of Sl.4 billion implies a 30% EBITDA margin
which we believe is conservative given that the ILECs SBITDA margins for
T-l services to business customers LB probably in the 60% range today.
We are assuming a terminal firm value to EBXTDA multiple of l7x which
implies a PIE of 30x in 2008 and a discount rate of 14%. Our *90 price
target implies a firm value of C7 billion which is a premium to covad
which we feel is justified by Rhythms ability to provide faster DCL
speeds and more value added services. covad is also targeting the top 50
u.s. markets, but does not have the extensive~product mix of Rhythms or
the same achievable speeds.
Rhythms currently gets $150 per month on average for service. This
reflects its mix of wholesale and direct sales and its product mix. since
basic DCL service will, in our estimation, largely be a pricing game, we
expect Rhythms' monthly ARPU to fall. Over time, though. we expect price
decreases to be offset by increased sales of value added services and by
a shift towards fewer indirect sales and more direct sales. We also
expect a shift away from price oriented services like internet access and
towards more value-added services target to the tele-worker market.
NET/NET: Rhythms is operating in a very compelling position within the
telecom value chain. There is a capacity bottleneck at the local loop
level and we believe DCL will be an important tool to alleviate this
bottleneck. As with broadband networks, DCL will enable a whole host of
new, bandwidth consuming applications. This is largely a "top line"
business and we believe Rhythms is very well positioned to drive revenue
through its DSL connections by providing fast speeds and multiple
value added products. Rhythms has an excellent management team,
an expandable business plan plus extremely strong partners in MCI
Worldcom, Qwest, Microsoft and Cisco. |
