from Jim Henry:
James H. Henry
Glenn A. Waldorf
Subject: Industry Overview
Industry: Telecommunications-CLECs
BEAR, STEARNS & CO. INC.
Covad Communications Group* (COVD-$70)
MGC Communications, Inc.* (MGCX-$37 1/2)
Rhythms NetConnect (RTHM-$70 7/8)
Making Sense Of The xDSL Broadband Bonanza: COVD, MGCX, RTHM
_________________________________________________________________
*** xDSL Presents An Historic Market Opportunity To Be Pursued By
Multiple Players.
*** Enterprise Value Per Addressable Line Is The Best Measure For
Relative Valuation.
*** We Recommend Covad & MGC Communications Over Rhythms
NetConnections.
_________________________________________________________________
INVESTMENT VIEWPOINT
Making Sense Of The xDSL Broadband Bonanza. The attention
focused on xDSL pureplays and their corresponding business
opportunities has escalated dramatically in the past few weeks
resulting in significant upward swings in valuation for the likes
of Covad Communications, MGC Communications, and Rhythms
NetConnections. The enthusiasm has even spilled over to many of
the more traditional CLECs such as Allegiance Telecom, ICG
Communications, and Intermedia. What's all the fuss about? This
group of companies is uniquely positioned to leverage historic
advances in technology to deliver huge amounts of bandwidth on a
nearly ubiquitous basis. By coupling a pair of digital
subscriber line (xDSL) modems with a digitally conditioned access
line leased from the ILEC, a CLEC can provide business and
residential customers alike with broadband capacity in the range
of 1.5 Mbps to 7.0 Mbps. This xDSL technology has created two
opportunities for the CLECs. First, a data-centric CLEC like
Covad will use xDSL to provide high-speed connections to the
Internet or high-speed remote access to local or wide area
networks (LANs/WANs) largely on a wholesale basis. Second, CLECs
like MGC will use xDSL to dramatically lower their transmission
cost in providing a bundled package of local, long distance, and
high-speed Internet service directly to small and medium-size
business customers which are among the 95% of business
occupancies not served by fiber. With the remarkable growth in
demand for high-speed Internet access and the $105+ billion local
telephone market up for grabs, we believe that investors will be
well served by focusing their attention on this opportunity.
Recent Catalysts For The xDSL CLECs. The enthusiasm for the xDSL-
centric CLECs has been fueled by a number of positive catalysts.
First, the importance of providing high-speed access to
businesses and homes on a national basis has come to the
forefront as a result of the AT&T-TCI merger and the ensuing
deals that AT&T has made with a variety of cable MSOs. Second, a
number of the telecom and technology industry bellwethers have
made strategic investments in the xDSL CLECs in order to solve
their last-mile bandwidth bottleneck issues. Covad received
strategic investments from AT&T, Concentric Network, Intel,
NEXTLINK, and Qwest while Rhythms NetConnections received
strategic investments from MCI WorldCom, Microsoft, and Qwest.
Third, a March 18, 1999 ruling by the FCC improved the "rules of
engagement" under which the CLECs will be able to establish
collocations with in the ILECs' central offices in order to gain
access to unbundled loops. CLECs will be able to establish
collocations in a more timely and cost effective manner, thereby
measurably accelerating their time to market and improving their
cost structures. For example, a CLEC may once have paid a one-
time setup fee in the range of $50,000 to $350,000 to establish
its collocation in order to gain access to an ILEC's copper
lines. Under the FCC's order this price will likely fall to the
$10,000 to $25,000 range. For a CLEC like Covad that plans
1,000+ collocations, this pro-competitive order by the FCC will
improve the viability and cost structure of its business plan.
Fourth, the high-profile IPOs by Covad and Rhythms have called
much attention to the xDSL opportunity and created large-cap,
liquid names in which investors can get significantly involved.
Valuation Considerations In The xDSL Arena. It is inherently
difficult to value companies such as the xDSL CLECs that have
nascent businesses and financial models that offer significantly
greater profitability and return-on-investment characteristics
than any carriers that have come before them. Moreover, the
market for Internet, data, and telecom stocks has demonstrated
beyond a shadow of a doubt that the laws of supply and demand
take precedence over a discounted cash flow (DCF) model in
establishing stock prices on any given day. In that context, we
believe that relative valuation metrics such as enterprise value
per addressable line, or multiples of forward revenue make the
most amount of sense. In fact, we believe that enterprise value
per addressable line - similar to the use of POPs in the early
days of cellular and PCS - is the most compelling metric of all
because it offers a common yardstick by which to measure all
players. As each company shows its ability to penetrate the
market and generate revenue, the Street will gain better insight
on how to more appropriately value the stocks. In Table 1 we
present the relative valuations for Allegiance Telecom, @Home
Network, Covad, MGC Communications, and Rhythms NetConnections.
We believe that these companies are remarkably similar in that
each has the ability to employ the latest and greatest advances
in technology (i.e., xDSL or cable modems) in order to soup-up
the existing network infrastructure of the incumbents (i.e.,
ILECs or Cable MSOs) and provide broadband connections to homes
or businesses.
Covad & MGC Offer Compelling Relative Valuations. We believe
that @Home Network offers the high-water mark by which some of
the xDSL CLECs can be measured. Weighing in at an enterprise
value of $20.1 billion, the company commands approximately $1,500
in enterprise value per addressable line. The company certainly
deserves some premium for its near-term exclusivity in gaining
access to the cable networks and for its ownership by the likes
of AT&T, Comcast, Cox, etc. However, we do not think that
companies like Covad or Rhythms should trade at a 75% discount on
the basis of total enterprise value or a 55% discount on the
basis of enterprise value per addressable line. After all, Covad
and Rhythms are the clear leaders in the xDSL space and boast
such strategic partners as AT&T, Cisco, Intel, MCI WorldCom,
Microsoft, and Qwest Communications. We would expect the
valuation gap between @Home and the xDSL CLECs to narrow over
time as the xDSL players demonstrate further success in executing
their business plans. Among the xDSL CLECs we think that Covad
and MGC Communications offer the most attractive valuations. At
the high end, Covad and Rhythms trade essentially at parity with
respect to total enterprise value and enterprise value per
addressable line. We believe that Covad should trade at a
significant premium to Rhythms given its lead-time to market, its
substantially higher revenue run-rate, and the significantly
greater degree of execution risk inherent in the Rhythms business
plan. On the other hand, we believe that MGC is the dark horse
in the race to deliver broadband. The company sells at an 85%+
discount to its peers on the basis of total enterprise value per
addressable line.
Table 1. Local Broadband Relative Valuation ($ in millions except for
network stats and per share data)
ALGX ATHM COVD MGCX RTHM Average
Stock Price $38.38 $162.44 $70.00 $37.50 $71.00
Fully-Dil. Shares 62.5 125.0 65.0 25.1 75.0
Market Cap. 2,398.8 20304.7 4,550.0 941.3 5,325.0
Long-Term Debt 471.7 257.2 347.6 157.3 158.3
Cash & Equiv 815.2 419.3 480.5 171.8 396.3
Entpr Val 2,055.3 20142.6 4,417.1 926.8 5,087.0
Mkts In Operation 9 59 6 7 10
Targeted Mkts 15 41 16 11 40
Total Mkts 24 100 22 18 50
CO Colloc. 101 - 168 207 200
Addressable Lines 3.6 13.2 6.0 11.4 8.0
1999E Rev 92.5 165.0 56.7 45.7 12.5
2000E Rev 285.0 405.0 200.5 129.3 55.0
EV/Addr. Line $448.70 $1526 $724.50 $81 $137.20 710
EV/1999E Rev 22.2x 122.1 76.7x 20.3x 407.0x 129.9x
EV/2000E Rev 7.2x 49.7 21.7x 7.2x 92.5x 35.7x
Source: Bear, Stearns & Co. Inc. ALGX data is pro forma for the
company's pending offering of 10.0 million shares of common
stock. ATHM "Addressable Lines" data reflects the number of
homes that it could reach with upgraded cable plant at year-end
1998. COVD data is pro forma for the company's IPO and follow-on
high yield offering. MGCX data is pro forma for the Providence
Equity investment. RTHM data is pro forma for the company's IPO.
RTHM Collocations data was available as of January 31, 1998 and
therefore is overstated relative to the other comparables, which
are based on December 31, 1998 data. RTHM "Addressable Lines"
data was derived assuming an average of 40,000 access lines per
central office.
Covad Communications - The Standard Bearer. Covad is the clear
leader in the xDSL space with a business plan focused on
providing true blanket coverage of each market it serves in order
to provide an optimum connectivity solution to its telecom and
ISP wholesale customers. The company's network footprint
consisted of 168 CO collocations at year-end 1998, enabling the
company to reach 6.0 million business and residential access
lines. By year-end 1999 the company will have 1,000+ CO
collocations in 22 markets enabling it to reach 28.6 million
homes and businesses. We believe that the company's focus on
network development and provisioning throughput will enable it to
gain ground rapidly as it leverages the powerful sales channels
of its strategic partners and wholesale customers. Over and
above its compelling 22-market business plan, we believe that the
company has significant opportunities to expand its business plan
both at home and abroad. Covad is currently targeting 22 markets
and we would bet that it will ultimately target the top 50 to 75
markets in the US, which would have the effect of more than
doubling its addressable market opportunity and corresponding
revenue potential. Moreover, the company is well positioned to
leverage the xDSL opportunity outside the US in markets like
Canada and Europe that have developed or are in the process of
making unbundled network elements available. We expect that
Covad will trade in excess of $100 per share over time as it
demonstrates further successful execution of its business plan
and shows some of the additional opportunities that it can pursue
in order to create incremental shareholder value.
MGC Communications - The Most Compelling Valuation. Despite the
fact that MGC Communications just announced its entry in the xDSL
derby on Monday, it has a very strong position in the market by
virtue of its network assets, product portfolio, and sales
channels. At year-end 1998 the company had 207 CO collocations -
the largest collocation footprint of any CLEC - enabling its to
address a base of 11.4 million access lines. We expect the
company to have 250 CO collocations at the end of 1Q99 and 350+
at year-end 1999, enabling it to address nearly 20 million lines.
Aside from its prime real-estate in the ILEC's central offices,
MGC also has a fully integrated bundle of local, long distance,
and high-speed Internet services that it will sell to small and
medium-size businesses (SMBs) over its xDSL lines. To put MGC's
market opportunity in perspective, there are about 8 million SMBs
with an average of 1 to 10 access lines and another 1 million
SMBs with an average of 10 to 200 lines. The ability for MGC to
bundle 10+ lines of voice with high-speed Internet all over a
shared broadband xDSL circuit presents a very powerful business
model. We believe that Monday's news of the $37.5 million
investment by Providence Equity Partners is a very positive
catalyst for MGC. As a result of its direct involvement in
success stories such as Brooks Fiber, MetroNet, and Verio,
Providence has substantial strategic expertise, operational
savvy, and access to high-caliber management talent that it will
bring to bear on MGC's behalf. We note MGC is the only US CLEC
in which Providence is a current investor. We would expect MGC
to narrow the gap between its current valuation and the levels at
which Allegiance Telecom and the xDSL CLECs trade. At $100 per
share, MGC would still be trading at a 50% discount to the group
on the basis of enterprise value per home passed.
Rhythms NetConnections - Neither Fish Nor Fowl. Rhythms
NetConnections is the latest xDSL IPO to follow on the coattails
of Covad. The company is targeting a total of 50 US cities and
exited January with approximately 200 CO collocations in service
enabling it to reach an estimated 8 million access lines.
Rhythms plans to be in 1,500 COs by year-end 2000 in its 50
markets, implying significantly less density of network footprint
than Covad. Moreover, the company offers a significantly more
complex business model in that it is simultaneously pursuing a
hybrid retail-wholesale strategy. We believe that the company
brings to the table a significantly higher degree of execution
risk than its peers do given the complexity of its strategy.
Consider the difficulties of a company pursuing a retail and
wholesale strategy. Not only is it competing directly with its
largest wholesale customers at all times, but Rhythms plans to
juggle the installation and provisioning of 16 different flavors
of xDSL technology, develop its own sales, marketing and
distribution channels, and establish a sophisticated product
portfolio that includes at least 10 different services. In the
face of that risk profile, we are significantly more comfortable
with the industry leader Covad. In addition to its execution
risk, Rhythms' revenue ramp up (please refer back to Table 1)
appears to be relatively anemic versus both Covad and MGC.
Despite the fact that they are essentially launching their
businesses at the same time, Covad appears to have a 12-month
head start over Rhythms in ramping up its sales. Lastly, while
some have suggested that Rhythms brings a higher speed xDSL
product to the table, bear in mind that Covad has vendor
relationships with Cisco and Diamond Lane - the leaders in this
space - and is fully capable of providing any xDSL speed that a
customer would want. In the face of greater execution risk, a
more complex business model, and an inexplicably modest revenue
ramp up, we would clearly favor Covad and MGC over Rhythms as
pureplays on this historic opportunity.
Company Mentioned:
Allegiance Telecom, Inc.* (ALGX-$22 1/8)
AT&T Corp. (T-$83 7/8)
Covad Communications Group* (COVD-$70)
MCI WorldCom (WCOM-$87 11/16)
MGC Communications, Inc.* (MGCX-$37 1/2)
Microsoft Corp. (MSFT-$94 9/16)
NEXTLINK Communications* (NXLK-$63 1/8)
Qwest Communications (QWST-$85 1/16)
Rhythms NetConnect (RTHM-$70 7/8)
Verio, Inc. (VRIO-$47 1/2)
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