XO's Woes

It's worth paying attention to last week's cash infusion into XO Communications (XOXO Quote) for no other reason than there are likely to be many similar deals in the coming months.

In case you missed the news, Forstmann Little pumped $250 million of fresh equity into the embattled broadband company that was formerly known as Nextlink. XO belongs to a sector of similarly situated firms engaged in massive infrastructure build-outs financed largely by junk bonds. Many are running out of money and need to raise large amounts of new capital, radically restructure their balance sheets and/or file for protection under the bankruptcy code.

In the previous, more optimistic environment that existed from 1998 through the middle of 2000, raising successive rounds of financing in the bank loan, high-yield bond and equity markets was no problem.

In fact, it appears Global Crossing (GX Quote) may have made it to the finish line, fully financing its ambitions. Many others, including XO, 360Networks (TSIX Quote), Teligent (TGNT Quote), Primus Telecommunications (PRTL Quote), PSINet (PSIX Quote) and the entire independent DSL industry have been left stranded by the capital markets with half-built networks, diminishing cash reserves and very unhappy investors.

The announcements by these companies that they have located new capital are greeted by a cheer from Wall Street, raising share prices of not just the company that gets to cash the new check, but of all the equities and bonds of the distressed telecom issuers.

In the case of XO, its stock rallied from about $4 to more than $5 on the announcement. But are these developments as favorable as they appear to public shareholders? I am skeptical. These deals are done under duress, and the benefits to the buyer are sometimes not immediately apparent in the initial announcement. Sometimes you need to scour the accompanying 8-Ks to understand the complete terms of the investment, which frequently involve senior status in the capital structure, board seats and reset provisions that protect the value of the new investor's stake to the detriment of the public shareholders.

All of these companies are scrambling to come up with viable fallback plans, most of which involve reducing the capacity of the networks, truncating its geographic reach and reducing overhead expenses in an attempt to expedite the date of positive cash flow before the cash till runs dry. One expense that is not adjustable (without extraordinary steps -- such as filing for Chapter 11 bankruptcy protection) is the enormous cash drain of servicing massive amounts of junk bonds, most of which carry double-digit interest rates.

With the bonds of these companies trading at 20% and 30% of current yields, there is no way for these companies to further access the new-issue high-yield market. All of the hard assets have been hocked to banks already, tapping out that source of capital. The only remaining avenue is equity, and doing underwritten deals for stocks down 75% (or worse) from the levels when they last accessed the public equity markets -- sometimes within the last six months -- is too humiliating for the bankers that sponsored these companies to attempt.

That leaves the deep-pocketed private equity sponsors of these companies. In the case of XO, that sponsor is Forstmann Little, which had purchased in two tranches a total of $1.25 billion of convertible preferred shares last year when the stock was in the mid-$20's.

So how significant is Forstmann Little putting up another $250 million? Well, let's see what it got for its money:

First of all, Forstmann Little gets 50 million common shares. But less prominent in the press release is a provision that lowers the strike price on last year's purchase of $1.25 billion of convertible preferred from $31.625 a share down to $17.

Using the Black-Scholes model to value that feature reveals a benefit of $81 million to Forstmann Little. Applied against the $250 million investment, that reduces the price paid for the common shares to an effective price of $3.36 a share. Not exactly the same vote of confidence the apparent $5 price implied. And also, where is company founder and major holder Craig McCaw's financial vote of confidence? Did he choose simply to not invest further? If so, what is more relevant, the affirmation of the shares by a leverage buyout firm best known for its successful round trip in corporate jet maker Gulfstream, or the abstinence of a lifelong communications industry visionary and the man most closely associated with XO in the minds of the investing public.

As time passes and cash balances dwindle within this cohort, deals cut from the XO template will increase in frequency. Of course, for companies such as Teligent and PSINet, it is already too late, and all they have to look forward to is a trip to the bankruptcy court. For those deals that do occur, read the fine print closely before drawing premature conclusions.