The Oppy WCII initiation of coverage [part 1] (again, not proofed
after OCRing, so trust detail specifics at your own risk. Report
clarification rqsts will gladly be addressed ASAP):
CIBC Oppenheimer
April 14, 1999
WinStar Communications, Inc.
Initiating Coverage with Buy
Harry E. Blount, CFA
Timothy Horan, OFA
Gregory N. Kobrick
Investment Conclusion
UNEDITED: In the interest of timeliness,
this report has been made available to our
customers before editing has been completed.
It will be replaced with an edited version
shortly
Effective April 14. We are initiating
coverage of WinStar Communications Inc
(WCII) with a Buy rating and a $66 price
target.
There is little doubt that the demand for
bandwidth is exploding and we believe that
winstar is positioning itself to be a major
beneficiary of the computing trends that are
driving bandwidth demand.
We believe that WinStar's end-to-end
broadband network strategy is sound and that
Winstar should increasingly be viewed as a
broadband enabling technology (BET) company.
We expect Winstar's high speed point to
point and point to multipoint wireless
technology to be one of the three dominant
broadband technologies in the local market
together with digital subscriber line (DSL)
and cable modem technologies.
We look for Winstar to post a CAGR of more
than 50% over the next three years,
excluding acquisitions due principally to:
1) rapid domestic and international
expansion; 2) its positioning in the fastest
growing market segments such as data
services; and 3) the overall increasing
demand for broadband enabling technologies
and the associated increasing bandwidth
demand of its customers.
EBITDA should also grow rapidly due to: 1) a
rising "on-network" percentage, catalyzed by
creative marketing programs such as Project
Millennium; 2) implementation of automated
provisioning systems; 3) decreasing network
costs as a percentage of revenue as a result
of a long-haul capacity agreement with
Williams that will, in effect, lock in
Winstar's capital costs on favorable terms;
and 4) a shift to higher-margin products.
winstar's business plan is funded through
2000, thanks to an aggressive
capital-raising strategy and WinStar's $2
billion strategic relationship with Lucent-
WinStar should achieve positive free cash
flow after capital expenditures by 2003.
*EBITDA is used as the proxy for cash flow.
Winstar is a consolidation play as the means for a long-distance provider to
bypass the regional Bell operating companies (RBOCs) to provide local service.
Over the last 24 months, all but a few of the national independent integrated
communication providers (ICPs) larger than winstar have been acquired by
larger telecom companTes.
INVESTMENT THESIS
We are initiating coverage of WinStar with a Buy. WinStar is one of the best
strategically positioned ICPs. WinStar is establishing an end-to-end
broadband network by achieving a 10% market share shift in voice in the
buildings in the markets that it operates. WinStar is establishing in excess
of 670 lines of capacity using point to point and over 2,000 lines of capacity
with point to multipoint, to targeted buildings that will result in breakeven
on capital deployed with the acquisition of one customer (the average customer
uses 20 lines)
WinStar provides many of the same services as incumbent local-exchange
carriers (ILECS) and traditional competitive local-exchange carriers (CLECS),
however the local loop (last mile) is not a physical connection. Rather, a
microwave link is established between the customer facility and the local
switching center. Unlike wireline TCPs, WinStar's time to market is thus
greatly accelerated and capital costs are significantly lower. Further,
WinStar can avoid some or all of the interconnection fees charged by ILECs for
access to the local loop. Arguably, wireless service providers like WinStar
provide the quickest, cheapest and fastest solutions to the local area
bottleneck and we believe WinStar will continue to successfully tap into the
more than 750,000 commercial building market in the U.S., only a very small
percentage of which have broadband connections.
Winstar's revenue growth should be driven by the company's: 1) rapid domestic
and international expansion; 2) its positioning in the fastest growing market
segments such as data services; and 3) the overall increasing demand for
broadband enabling technologies and the associated increasing bandwidth demand
of its customers. We look for WinStar to post about a 55% CAGR over the next
three years with data revenue growing at a minimum of 100% CAGR, local
services at approximately 50%, and information services at approximately 30%
We expect international sales to contribute meaningfully to revenues by 2000
and to grow at a CAGR exceeding 100%.
We believe Winstar's EBITDA margins will grow from a negative margin to
approximately 10% by 2001. Our optimism is premised on the fact that
management is focused on selling on-network access lines spearheaded by
Project Millennium, is transitioning out of certain low-margin products lines,
is about to make significant strides in lowering its network costs as a
percentage of telecom revenue, and is migrating to common MIS platforms that
will reduce costs and increase management visibility.
Project Millennium is the centerpiece of management's intense focus on selling
on-network access lines, which can carry gross margins of 60%-70% versus less
than 15% for resold lines- The Project Millennium marketing campaign features
up to a year of free local phone service for new WinStar customers in 1,000
newly-connected commercial buildings in 13 of 30 markets. The company has
made great strides with Project Millennium and significantly all Project
Millennium sales are on-net. In just the first two months of the Millennium
promotion, November and December, WinStar moved more than 7% of the market
share in the Millennium buildings from the incumbent exchange carriers to
WinStar. This is quite a significant first step considering the company's
stated long-term building penetration goal is approximately 11%.
Significantly, Project Millennium has led to the tripling of the company's
first visit close rate with prospective customers. Furthermore, we already
know that in the first two weeks of February in New York City, WinStar's most
mature market, WinStar took orders for LEC resale facilities for just 6% of
its lines sold. This is a dramatic reversal of the previous year when 80% of
new lines across WinStar's markets required the resale of LEC facilities.
Finally, the company has also reported that during the first two months of the
program 60% of the Millennium customers signed three-year agreements. These
customers should be ripe for upselling enhanced services as the world becomes
increasingly bandwidth intensive and clearly, by the long-term nature of the
agreements, the company should experience lower churn and higher margins
We expect waves of Millennium type programs over the coorse of the next
several months, which should drive WinStar's on-net percentages up further. We
wish to highlight that the company's reported end of year 20% on-net and 40%
on-switch statistics, do not account for Millennium buildings since those
buildings are being provisioned during 1099. Margins shonld improve steadily
throughout 1999, even with rapid network expansion and the continuation of
Millennium-type programs.
Winstar's business model seems to be squarely on track, with its mature
markets showing reduced EBITDA losses during 1998 and with the New York City
market, winstar's largest and most mature market, being EBITDA positive for
the entire 4Q98.
The ICP sector's long-term prospects should also benefit WinStar. We estimate
the addressable ICP business market at approximately $93 billion. The market
segment is experiencing strong volume and revenue growth (12%-plus and 8%,
respectively) and declining unit costs. Furthermore, business customers are
extraordinarily profitable due to the diffused focus of the ILECs on the small
business segments. WinStar, like many other CLECs, has also increasingly
focused on a bundled product offering of local, long-distance, and data and
enhanced services and we believe therefore that it is appropriately called an
integrated communication provider (rap).
We believe the ILECS will lose 5% of customer market share per year. The ICPs
should capture a significant portion, translating into at least $3 billion per
year in incremental revenues.
As occurred in the long-distance market, we believe the highest investment
returns will be generated by the emerging providers, rather than the
incumbents.
The bundled product offering of the raps allows them to leverage fixed assets,
generate greater revenue per line, higher margins, lower churn, and a higher
return on assets. Furthermore, bundling will be a source of competitive
differentiation until the RBOCs are allowed to provide long-distance
in-region. Even after that time, as discussed further below, we believe
WinStar will be able to differentiate itself from the RBOCs by, among other
things, offering its target customers (small and medium-sized businesses) more
personalized face-to-face, service and solutions as part of its
building-centric approach.
We expect significant investment "winners" to continue to emerge from the
sector. Not all ICPs are created equal, and the definition of a ICP is
changing rapidly. We favor raps that are pursuing profitable niche strategies
including: 1) data (e.g., intermedia) 2) fixed wireless (e.g., Winstar and
Teligent) and 3) international (e.g., Global Telesystems).
Stock selection is critical. There are currently over 20 publicly traded
ICPs. Given the attractive industry fundamentals, the question for portfolio
managers is not whether they should commit funds to the sector, but how much
and to whom. As a general statement, we favor the ICPs that possess the
majority of the following characteristics:
1.) Local facility-based infrastructure largely completed
2.) Well positioned in the fastest growing market segments
3.) Strong internal on-network access line growth
4.) Established, scaleable, integrated back-offices
5.) Data-knowledgeable salesforce capable of selling integrated solutions
6.) well-funded balance sheet
7.) scarce or franchise assets
We believe that WinStar will emerge as one of the "winners" because it enjoys
an attractive combination of these characteristics. The flexibility of
wireless access technology permits provisioning of smaller buildings that are
not economic for the installation of fiber optic lines. WinStar does not have
to lay underground fiber to establish broadband connections to customer
buildings
Winstar is the largest holder of wireless spectrum in the U.S. WinStar owns
licenses predominately in the 38 Ghz band in 120 major markets, including the
top-6O, covering over 200 million Pops and an estimated 80% of the country's
business access lines. WinStar also successfully bid on 15 licenses in 28 Ghz
LMDS auctions, where it acquired 16.8 million POPs. Winstar's spectrum
holding not only supports its end-to-end broadband strategy but presents a
barrier to entry to aspiring market entrants.
While WinStar owns spectrum in 120 major markets, WinStar operates in 30
markets. WinStar plans to double the U.S. reach of its broadband network to
60 major markets over the next two years and to serve an additional 50 major
international markets within five years.
WinStar's plans are ambitious and, although. there is certainly execution risk,
we believe the risk is mitigated by a highly experienced management team and
various other factors including its: 1) extensive ownership of spectrum; 2)
impressive headway in securing the critical building access rights necessary
to build out broadband wireless networks; 3) ability to install wireless
radio equipment and establish a broadband last mile connection to a customer
building within a few weeks after obtaining building access; 4) scaleable
technology with which it can create wireless broadband connectivity to a
building at a fraction of the cost of a fiber link; and 5) its ability to
generally match capital expenditures with revenue generating customers.
A wireless versus a fiber buildout offers clear economic advantages as the
cost of constructinq a wireless last mile connection is significantly less
than the cost of creating the same connection using fiber Further, the
overwhelming percentage of construction costs for wireless is attributable to
technology, whereas only a small percentage is attributable to labor.
Accordingly, the company's cost of establishing broadband last mile
connections to buildings using wireless service is falling as an increasing
number of vendors are manufacturing wireless radio equipment and as more
advances are being made in radio technology. We expect these trends to
continue and in fact be accentuated in light of the recently introduced
point-to-multipoint (PMP) technology which will cut the capital cost of adding
a subscriber roughly in half by eliminating one of the two radios necessary to
complete a "link".
Winstar should also benefit from what we expect to be the evolution of a
business customer's needs from principally voice services to high-speed data
and multimedia and video conferencing. We believe winStar will have the
ability to scale the amount of bandwidth to the customer, enabling it to
capture incremental revenue in these fast growing market segments with little,
if any, incremental cost. Central to the scalability of WinStar's broadband
network, is its "Wireless Fiber" which uses the 38 GHz, 28 Ghz and other
portions of the radio spectrum to carry voice, data and video transmissions.
Its wireless technology services can provide fiber-quality transmission at
speeds more than 350 times faster than ISDN and far greater than DSL
(currently point-to-point supports speeds of up to 45 megabits/second and by
2H99 PMP should support 155 megabits/second) - It is an attractive alternative
to T-1 lines (leased phone lines), as it is less expensive and provides
equivalent or even greater bandwidth.
WinStar should benefit from the "parachutting" or "airdropping" of personal
computers to the desktop. With increased computing power due to the evolution
of processors - Pentium I, to II, to III - and the development of advanced
applications, more sophisticated networks will be required to enable PCs to
run applications such as streaming video or eventually full motion interactive
video. WinStar is focused on providing the network connections and
professional services to small and medium sized businesses that will enable
these businesses to benefit from such applications.
Winstar currently has over 4,200 roof rights and should reach over 8000 by
year-end. WinStar has 23 switches in the ground currently (and over 100 data
switches) with approximately 20% of all access lines on-net and 40% of lines
on-switch. Therefore, most of WinStar's revenue is still derived from the
lower margin resale business. This is changing. As discussed above, through
programs such as "Project Millennium," the company has begun to intensify the
focus of its sales and marketing efforts on customers located in buildings
connected to its local broadband network. These efforts should result in
higher margins as its local broadband networks continue to expand and a
greater percentage of its customers are located in on-net buildings.
Over the course of 1998, WinStar entered into two agreements to purchase fiber
capacity, in July 1998 with Metromedia Fiber and in December 1998 with
Williams. These agreements provide WinStar with a substantial portion of the
intercity fiber necessary to interconnect its local broadband networks; a
large amount of intracity fiber in six major cities in the nnited States,
which WinStar will use to interconnect its hub and switch facilities in such
cities; available capacity for future growth; and reduced costs related to the
transmission of the company's long-haul traffic and intracity back-haul
traffic.
We expect gross margins to run in the 15-20% range in the first quarter of
1999 and improv'e by the fourth quarter to 35-40%. This improvement will occur
as WinStar dri~res a higher percentage of traffic onto its network and realizes
the positive impact of both the Metromedia and Williams agreements on its
long-haul costs. We note, however, that part of this dramatic improvement in
gross margins is attributable to the fact that network costs incurred under
these agreements will be capitalized and therefore not included in costs of
services.
Finally, thanks to an aggressive capital-raising strategy and WinStar's
strategic financing arrangement with Lucent, WinStar has sufficient capital to
fund its business plan through at least 2000. As of December 31, 1998, WinStar
had approximately $208 million in cash, and $105 million in short term
investments. The cash position has since been strengthened with the sale of
4.2 million shares of stock in February, adding an additional $167 million to
its cash position, which was approximately $375 million as of the end of
February. As discussed in detail below, the agreement with Lucent provides an
up to $2 billion in additional vendor financing over the next five years.
VALUATION
Over the last three years, three other national ICPs (MFS, Brooks, and
Teleport) have been acquired at 5x-7x gross PPE to 18x-33x latest 12-month
revenue. If we look at a broader universe of regional and national
acquisitions, ICPs have been acquired for a median of 4.9x gross PPE and l8.2x
latest 12 month revenue. Finally, regional ICPs have been acquired for 3.4x
gross PPE and 7.9x latest 12-month revenue. WinStar is currently trading at
6.Ox gross PPE and 14.3x annualized latest-quarter revenue.
While the Street has historically valued ICPs on multiples of property, plant
and equipment, we do not believe this metric is valid. In the absence of
earnings, we believe discounted cash flow analysis is more appropriate (see
Exhibit 1) and also consider enterprise value multiples to revenue and EBITDA.
Exhibit 1 - Discounted Cash Flow valuation
WinStar is currently trading at a premium to the industry median of
comparables based on enterprise value to latest-quarter annualized revenue
(see Exhibit 2), but a discount to the mean. We believe the industry median
is the more accurate measure and the premium reflects investor confidence in
WinStar's favorable long-term growth prospects. We note that among the
universe of fixed wireless providers, including Teligent and Advanced Radio
Telecom, WinStar is trading at a significant discount based on the enterprise
value to latest-quarter annualized revenue metric.
Exhibit 2 -- Industry Comparables
Exhibit 3 - - Broadband Enabling Technologies Comparable Company Table
As Exhibit 4 shows, WinStar is also trading at the mid-range of its historical
trading range.
Exhibit 4 WinStar Price to Multiple of Enterprise Value/Last Quarter Revenue
Annualized
Source; FactSet, CIBC Oppenheimer.
RECENT DEVELOPMENTS
We would like to highlight several recent developments that we expect to have
a particularly significant impact on the direction of WinStar.
Strategic Relationship with Lucent
The cornerstone of winstar's aggressive expansion plans is its strategic
relationship with Lucent. In October 1996, the two companies entered into a
$2 billion long-term strategic supply and financing relationship. WinStar
agreed to purchase Lucent equipment for a significant portion of the
components needed for its network, to the extent this equipment represents the
"best-of-breed~ in the marketplace Ci.e. the best and most cost-effective with
regard to the particular requirernents of the network) . The company reports
that it is paying less than list price for the equipment purchases. In
addition, if Lucent's equipment is not the best-of-breed, WinStar may purchase
up to 35% of its network components from other vendors through Lucent or
directly from such vendors. Lucent would finance up to 35% of network
components from other vendors.
As of December 31, 1998, WinStar had borrowed $77.5 million under this
financing arrangement at a floating annual interest rate at 8% (Libor + 350
basis points). Management indicated during its 4Q98 conference call in early
March that the number was then just north of $100.
Under WinStar's direction, a team of Lucent professionals is to provide
WinStar with design, engineering, deployment, installation and other services
in connection with the buildout of Winstarts network domestically and abroad.
Lucent will also provide WinStar with other assets and services such as access
rights to buildings it controls and certain services of its Bell Labs testing
facilities.
The importance of WinStar's relationship with Lucent can hardly be
overemphasized. Not only will WinStar benefit from the breadth of Lucent's
product lines and its expertise in designing, building and turning networks,
but the Lucent deal should provide WinStar with enough capital to execute it
aggressive expansion plans well beyond the year 2000 when we estimate WinStar
will be EBITDA positive. Without the Lucent relationship, WinStar would
likely have had to scale back its aggressive expansion plans and possibly
forfeit its chance to be an early market entrant in its target markets.
WinStar International: Exploiting Early Market Advantage
WinStar sees significant opportunities in the international telecommunications
market. Its belief is premised on the notion that the rapidly growing demand
for high-speed communications capabilities is a global phenomenon and that,
even more so than in the United States, a large majority of commercial office
buildings in major cities abroad are not directly connected to fiber or any
other broadband alternative. We believe WinStar's strategy is sound and
evidences foresight. However, as further discussed in our Risk Factor
section, the regulatory and execution risks of this leg of WinStar's buildout
is high, although WinStar has taken prudent steps to minimize such risk.
WinStar plans to build Wireless Fiber-based local networks and to sell
communications services in six overseas markets by the end of 1999 and 50
overseas markets by the end of 2004. These 50 markets are located primarily in
Western Europe, the Asia/Pacific region and the Americas. Its initial target
markets include Amsterdam, Buenos Aires, London, Paris, and Tokyo.
Initially, WinStar intends to establish a direct sales force to sell data
transport services, Internet access and nonswitched voice services to large
commercial customers in its targeted overseas markets. Since data switching
equipment is smaller and significantly less expensive than that used for voice
traffic, the capital requirements for starting a data transport business are
less than for a voice telephone business. Moreover, the current prices and
profit margins on sales of data services in WinStar's target international
markets are substantially higher than those in the United States. In
addition, WinStar avoids the long lead time required to deploy Voice switches
and to enter interconnection agreements. Finally, the regulatory environment
is generally more favorable (less restrictive) for data services versus voice.
In Europe, WinStar is already building out Amsterdam and has recently been
granted a nationwide grant of spectrum in the 38 Ghz bane in the United
Kingdom, including London, WinStar's fourth-largest targeted international
market. WinStar has also filed for commercial licenses in Gertaany and France.
With the grant in February of a fixed wireless access radio license and
spectrum in Japan and the United Kingdom grant, WinStar has now acquired
spectrum license in four of its top 10 targeted international markets: Tokyo
- No. 1, Osaka - No. 2, London - No. 4, and Buenos Aires - No. S.
While WinStar has aggressively pursued international expansion, it has not
proceeded with an "expand at any cost" mindset. Rather, it appears that
WinStar has proceeded prudently in acquiring spectrum. In the case of the
spectrum grant in Japan, as part of a joint venture with KDn Corporation and
Sumitomo, WinStar obtained spectrum at no cost to the joint venture. Also
illustrative of WinStar's measured approach was the company's stepping away
from the auction block in Australia when bidding exceeded WinStar's target.
Once WinStar obtains sufficient spectrum in its overseas markets, we expect
WinStar to forge overseas relationships, like it has with Metromedia and
Williams in the U.S. to provide end-to-end broadband service in its
international markets. We also expect WinStar to leverage its strategic supply
and financing relationship with Lucent.
Acquisitions
WinStar's recent acquisitions reflect its evolution from a CLEC to an TCP and
a provider of high-speed broadband access. Two strategic acquisitions in
1998 included coodflet and MIDCOM Communications. While both acquisitions
expanded WinStar's Internet services product offerings, we believe the company
must become more aggressive in the Web-hosting space to drive demand for its
high-speed access business.
In January, 1998, WinStar acquired Telesoft's Internet services subsidiary,
Goodnet, for a purchase price of approximately $22.0, Goodnet, a national
provider of Internet services, offering high-capacity data communication
services, has a revenue run rate in excess of $100 million.
We find the merger strategically significant in that 1) it increased traffic
on WinStar's networks; and 2) it improved WinStar's Internet capabilities so
it could offer an industrial-strength Internet product on top of its
frame-relay and other data/broadband products.
We believe this merger has proven beneficial, from both an operating and
marketing standpoint, primarily because it enables WinStar to provide business
users a cost-efficient bundled communications package. A strong data/internet
product makes it easier to gain access to business customers and leverage the
contacts by bundling these products with voice products (both local and
long-distance).
Also in January 1998, WinStar completed its $92 million purchase of MIDCOM, a
provider of long distance voice and data telecommunications services primarily
to small and medium-sized businesses, most of which are located in major
metropolitan areas of California, Florida, Illinois, New York, Ohio and
Washington.
The acquisition not only provided WinStar with an existing revenue base but
also a customer base to which it may market local service. As part of the
MIDCOM deal, WinStar also acquired the assets of PacNet, which included frame
relay Pops in 20 markets. PacNet is also a member of Unispan, a consortium of
frame-relay carriers, which gives WinStar access to frame-relay services
throughout the U.S. and internationally.
In April 1998, WinStar purchased 3.3 million shares of Advanced Radio Telecom
from private investors for shares of WinStar stock. The deal valued ART
shares at $17.39 per share. WinStar issued 1.525 million shares in the deal,
which resulted in a 14.9% ownership of ART. WinStar's ownership currently
stands at 12.9%, after accounting for ART's recent spectrum acquisitions in
exchange for its stock. |
