No Wall Street analyst saved professional investors more money in 2000 than Ravi Suria, the convertible bond strategist who just left Lehman Brothers to join Stan Druckenmiller at Duquesne Capital Management. Druckenmiller is one of the top hedge fund managers of the past 20 years.

Suria presciently nailed the unwinding of the telecom services industry, as well as the stock market disaster known as Amazon.com (AMZN) - Get Report. People who listened to him either got out of those stocks or shorted them. While his work on Amazon.com has gotten more publicity because of the popularity of the Web site, Suria's analysis of the telecom services sector may stand as his most important contribution; after all, Amazon's peak market capitalization was $39 billion, which is dwarfed by the peak $640 billion market cap of the telecom services industry. (Amazon is now valued at about $4 billion and the telcos at about $220 billion.) Suria is a brainy analyst with a penchant for hardheaded, fundamental research. He actually knows his way around a balance sheet and pays attention to a company's credit structure. Unlike other analysts with higher profiles, Suria worries about the downside to investors -- he can connect the financial dots. For example, seeing credit spreads for the telecommunications services companies widen dramatically in the first quarter of 2000, Suria dug into their balance sheets. He found the soft underbelly of the tech boom -- the vast, debt-financed overcapitalization of untested companies swimming in uncharted waters. He wrote a devastating report on the sector in November. By late last year, he was making by-appointment-only presentations to Lehman's top institutional clients -- including many of the top hedge funds -- about his findings and their investment implications. Suria sat down with

TSC

Chief Markets Writer Brett D. Fromson and updated his views on the debt binge of the 1990s and the future of telecom service companies, telecom equipment companies, the overall economy, the IPO market and, oh, yes, Amazon.

Brett D. Fromson:

Ravi, let's start with your take on the telecom services sector.

Ravi Suria:

OK. The biggest problem for the telecommunications industry is clearly the fact that it is overcapitalized. Now, overcapitalization for an industry is not necessarily bad if it comes through the equity side.

Brett D. Fromson:

Meaning via stock offerings?

Ravi Suria:

Yes. Because then you just have a lower return on equity. At some point, it catches up with you. But your balance sheet is still fine. You can operate and survive. The problem with excess capitalization when it comes from the debt side is that if your business model is unable to support the debt, you go bust.

Brett D. Fromson:

Debt imposes different burdens on different companies, right?

Ravi Suria:

Yes. The debt problem in telecom services is split between two groups of companies. One is the old-line investment-grade company, the Old Economy telephone companies. They have investment-grade balance sheets. They are feeling what I call a credit pinch. These are the long-distance carriers like

AT&T

(T) - Get Report

and

WorldCom

(WCOM)

, the RBOCs and the PTTs

quasi-public telecommunications monopolies abroad. It's amazing how similar the credit stories for a lot of these companies are. You have companies that survived under regulation for 100 years suddenly deregulated over the past 10 years, and are now facing competitive pressure for the first time.

Brett D. Fromson:

What caused the credit pinch?

Ravi Suria:

Their cost of capital has gone up so substantially over the past 18 months that it truly is spectacular. For example, average debt spreads

the difference between what they must pay to borrow money in the capital markets vs. what, say, the

U.S. Treasury

pays have risen from 100

basis points

1% over Treasuries to about 300 basis points

3%.

Now, a 200-basis-point difference in your borrowing costs doesn't sound like a lot, but when you're running an industry with operating earnings or cash flow margins in the 8% to 10% range, two percentage points more is a lot. The interesting thing is that these companies have never had to do this before. They have never faced a period when their relative cost of capital has been so high. Over the past three years, their return on invested capital has moved below their weighted average cost of capital. Before deregulation, they had always been able to generate more in returns than it cost them to borrow. In part, that was because regulators made sure that happened. And because the companies always underinvested, they did not spend as much as they made. You cannot survive this long if you spend more than what you make.

Brett D. Fromson:

So bankruptcy is not an issue for these companies?

Ravi Suria:

Bankruptcy is less of an issue for them. The issue is more that their stock prices -- the equity portion of their total enterprise value -- is going to suffer over the next few years until they reach a point at which they can begin to reduce their debt levels and deleverage.

Brett D. Fromson:

When will we see that deleveraging?

Ravi Suria:

It could be anywhere from three to five years.

Brett D. Fromson:

What does that mean for shareholders in the old-line telecom service companies?

Ravi Suria:

As long as the companies' leverage ratios keep going up, equity valuations go down. Debt takes a bigger and bigger part of the total enterprise valuations. Until you see a stabilization of credit ratios that says the debt coverage ratios for these companies have stopped deteriorating and are getting better, the stock prices will have trouble.

Brett D. Fromson:

Do you see their credit quality continuing to deteriorate over the next three years?

Ravi Suria:

Yes, that's why most of these companies are on credit watch-negative by the credit rating agencies, which says that their credit is getting worse. From a cash flow viewpoint, you can ask, "Are debt coverage ratios going to get better for these companies when, one, their interest costs are increasing, and, two, cash flow is not growing that fast?" I don't think so. Cash flow as a multiple of interest costs has been coming down for the past few years, and it will probably come down for the next two.

Brett D. Fromson:

What should investors look for as signs of an improvement?

Ravi Suria:

When that ratio,

EBITDA, as a multiple of interest costs stabilizes and starts moving up. That could take three to five years. Another inflection point will be when debt/total capitalization starts coming down. Again, I expect to see that over the next three to five years.

Brett D. Fromson:

Are any of these old-line telecom services companies likely to see an improvement sooner than others?

Ravi Suria:

It could happen earlier for the European PTTs. They have debt on the balance sheet that has to be repaid, and they are not making enough money to repay the debt. But what they could start doing is to sell assets and sell stock to redeem the debt. But then you run into problems like the

Orange

IPO or the

Verizon Wireless

IPO, which got pulled. That means the debt coming due may have to be refinanced with debt -- not equity -- so your leverage ratios don't go down. You simply refinance with higher-cost debt -- and it will be higher cost, as higher spreads will offset any interest-rate cuts. So, for European companies, a lot depends on how they can get the money. What they need is to sell shares and assets and then take the money they receive and start paying down the debt.

Brett D. Fromson:

How badly have their balance sheets eroded?

Ravi Suria:

A lot of European PTTs have been downgraded four credit notches in the past 12 months and are still on credit watch-negative. It probably takes 10 to 15 years of organic growth for a company that size to move up the four credit notches they just gave up. That gives you a sense of the magnitude of the deterioration that has happened to these companies' credit profiles.

Brett D. Fromson:

And these are the blue-chips in the sector?

Ravi Suria:

Yes. These are the companies that laid out the worldwide telecom network over the past 100 years.

"In some ways, the companies that borrowed in the '80s were a lot more creditworthy than the companies of the '90s."

Brett D. Fromson:

Let's talk about the New Economy telecom services companies that say they'll dominate the next 100 years.

Ravi Suria:

Basically, the New Economy telecom companies are those companies started around the time of the

Telecommunications Act of 1996

. These are the companies that were going to be the competitors to the incumbents. They are characterized by a few things. One, they have weak balance sheets because they are start-ups. Two, as companies, they have never been through a down cycle because they were started in a boom. Three, on average, they don't have revenues or customers, or they have minuscule revenues and few customers because they always depended on the capital markets to finance their businesses.

They are facing a credit crunch. They have borrowed so much money over the past few years. They can't borrow any more. The current debt on the balance sheets does not allow them to borrow any more, even in an environment where the

Fed is easing rates. Why? Because they have already borrowed too much money and even the current level of borrowing is not justified by their business models.

Brett D. Fromson:

Explain why they cannot borrow more.

Ravi Suria:

The more debt you borrow, the more your cost of borrowing goes up. Your credit spreads widen because, by definition, the more a company borrows the riskier the credit is for the lenders. I'll give you an example. When it was easiest for telecom companies to borrow money in 1998, the average telecom high-yield bond was 8.9% and total debt was about $70 billion. At the beginning of 2000, the yield was 10.75%. By December 2000, it had reached almost 18%, and total debt was approaching $200 billion. Now, it's back to around 15%. But still, if you had borrowed in 1998 at 8.9%, it's going to cost you a lot more to borrow today. Any business model started in 1998 and predicated on getting more debt funding at 8.9% is invalid right now. Their problem is that they have too much debt.

Brett D. Fromson:

Let's talk about some individual names.

Ravi Suria:

There is no shortage of examples from those where restructuring seems imminent, like

PSINet

(PSIX)

,

Covad

(COVD)

,

RSL Communications

(RSLC)

,

Winstar Communications

(WCII)

and

Teligent

(TGNT)

, to those where the problems are a few quarters off still, like

XO Communications

(XOXO)

,

Williams Communications

(WCG) - Get Report

,

Exodus Communications

(EXDS)

and

Level 3

(LVLT)

. Their common problem is that they simply have too much debt. The reason they can't sell out or expand is that their access to capital has been shut off because they have too much debt.

Brett D. Fromson:

I assume you're looking for a rash of bankruptcies among the New Economy telcos.

Ravi Suria:

Yes. Between 2001-04, I expect an unprecedented series of debt defaults. That basically means the debtholders will take over these companies, shareholders will not get anything and after the financial restructuring, the company comes out with little or no debt.

Brett D. Fromson:

How common do you think that will be?

Ravi Suria:

It's hard to put a number on it. So far this year, you have had

Northpoint

,

Metrocall

(MCLLC)

and now PSINet on the brink. But this is just the beginning. I would say that about 80% of the New Economy telcos will have to restructure.

Brett D. Fromson:

How much debt have these new-era telecom services companies taken on?

Ravi Suria:

Between 1996-2000, the high-yield market raised $502 billion, of which $240 billion was for telecom and media. To put this in perspective, throughout the 1980s, it raised only $160 billion. A key difference is that the companies that raised money using junk bonds in the 1980s were industrial companies with hard assets that generated positive cash flow and had products. So when you lent them money, you could say, "This company can generate enough cash flow to repay the debt." You wouldn't give them money otherwise. So, in some ways, the companies that borrowed in the '80s were a lot more creditworthy than the companies of the '90s.

"The new guys said, 'We can borrow money from the markets, build out the networks and then sell to the guys who have the customers.' "

Brett D. Fromson:

Why did the high-yield market give so much money to these companies to begin with?

Ravi Suria:

There are two important reasons. One, by the time of the Telecommunications Act of 1996, we were in the sixth year of an economic expansion. All the traditional issuers of high-yield bonds were actually buying back debt -- the airlines, for example. So investors needed a place to reinvest the money. The act comes around and essentially creates an industry that promises the future and needs a lot of capital. But even so, I don't believe the market would have given these companies all this money if it wasn't for the endgame.

The endgame for these companies was always to sell out. Nobody was looking to run a telecom services company 15 years down the line. The money allowed companies to go out and build networks and go after customers in competition with the old-line telecom companies, which had networks that were 30 to 40 years old. The argument of the New Economy companies was that the Old Economy companies had the customers and the revenue base, but they didn't have the networks. The new guys said, "We can borrow money from the markets, build out the networks and then sell to the guys who have the customers."

Brett D. Fromson:

I can imagine how appealing that might have seemed to the junk bond market.

Ravi Suria:

For a high-yield manager loaning money at 10% to 11% to these new companies with CCC credit ratings, the prospect of the new companies being sold out down the road to AAA-rated old-line companies was as good as it could get. It looked like a 10-bagger. As long as you believed in the value of the network, as long as you believed in management's strategy, as long as you believed that the endgame would work and they could sell out, you gave these companies money.

Brett D. Fromson:

What happened in 2000 to change the game?

Ravi Suria:

A couple of things caused the endgame to fall apart, which is why you are seeing the problems right now. First, look at the companies that were supposed to be the buyers of the New Economy companies. They had gone on their own buying and borrowing binge in the wake of the Telecommunications Act.

First, the big guys started consolidating. So, among the long-distance carriers and the Baby Bells, you came down from about 13 companies to seven. So, the number of potential buyers sharply contracted. And second, they borrowed more money to do this. Between 1997-2000, EBITDA in the big telecom companies grew by 65%, but interest costs grew by 85% and debt grew by 140%. The leveraging up by the old-line companies limited their ability to take on the debt that comes with acquiring a New Economy company. So the business plans of 1996 that envisioned the old-line companies with pristine balance sheets swooping in to buy the new guys fell apart with each passing year. Then, in 2000, credit spreads really exploded for the big guys. Their credit quality started falling off a cliff, and their borrowing costs started going way up.

Brett D. Fromson:

What spooked the market?

Ravi Suria:

What really spooked the bond market was the amount of money the companies were expected to spend on 3G over the next five to seven years.

Brett D. Fromson:

By "3G," you mean the next-generation wireless networks, right?

Ravi Suria:

Yes. Wireless is the next big thing, but it must be financed off the same balance sheet that is supposed to finance the current wire-line networks. And the companies don't have the cash flow to do both. When people started to realize this, things started falling apart for the whole industry.

Brett D. Fromson:

How much do you expect 3G to cost?

Ravi Suria:

I look at 3G as a new project for the global industry. I don't believe it happens via individual companies. At the end of the day, you'll probably have four to six global companies offering end-to-end solutions via 3G wireless. We conservatively expect that to cost $300 billion; $150 billion is in buying the spectrums at auction, and the remaining $150 million is in build-out costs.

Brett D. Fromson:

$300 billion is a lot of money.

Ravi Suria:

Yes. If you assume that the $300 billion is financed 50% by debt and 50% by equity. Say $150 billion at 8% for the debt. That's $12 billion a year in interest costs. The entire industry is not supposed to generate

revenues

of $12 billion from 3G for four years and incremental cash flow for seven years.

So, what spooked the bond market is the fact that the old wire-line businesses that are in decline will have to sustain the interest payments on 3G for the next seven years. The repayment of the debt and ultimately the value flowing to equity holders is much further off.

Brett D. Fromson:

Are there any historical comparisons?

Ravi Suria:

I compare 3G to prior massive capital expenditures in history like the building of the

Interstate Highway System

or the electricity grid or the nuclear reactors. All these projects required a lot of spending initially, but the reason the industries survived over the next 30 to 40 years was that they were regulated, and thus cash flows to repay the initial investments were guaranteed.

This time you're borrowing to spend the money and letting loose a bunch of companies in a highly competitive free market under disinflationary pricing and telling them to make enough money to repay the original investment. This is an experiment that has never been tried before. It's hard to see a happy ending to this experiment under the current spending scenario.

Brett D. Fromson:

When did it become apparent that the old-line companies were in no shape to take over the new-era guys?

Ravi Suria:

In April 2000, with the British auctions, when companies spent $35 billion just buying spectrum. Six weeks later they spent about $45 billion in Germany. Suddenly all these costs became a reality, and the bond market fell apart. That was when debt spreads exploded across the board. It became apparent that the ability of the potential Old Economy buyers to take over the debt of the new companies had substantially deteriorated in the past three years. You can see the debt problems of WorldCom and AT&T.

At the same time, the New Economy companies had messed up their balance sheets a lot more than had been expected. We did an aggregate balance sheet for about 150 of the new telecom companies that came public in the past four years. As of the third quarter of last year, the noninvestment-grade companies had $189.9 billion of debt, but the book value of the network was only $127 billion.

This is the key reason why the endgame for so many of these new companies won't work. If the network is worth $127 billion, I should be able to build it for roughly that amount, maybe a bit more. The Old Economy companies will never buy the new companies if their total debt is significantly more than the value of their plant and equipment, because you can build the network yourself for close to its book value. Debt for the new-era companies was 60% more than the value of plant and equipment. We have not seen a single transaction where a company has been taken over when the debt was more than 100% of plant and equipment.

"So the business plans of 1996 that envisioned the old-line companies with pristine balance sheets swooping in to buy the new guys fell apart with each passing year."

Brett D. Fromson:

And your analysis assumes that the value of the plant and equipment is not overstated.

Ravi Suria:

Yes. The potential problem is that the plant and equipment on the books of the New Economy companies is rapidly deteriorating because of the short life cycle of the network. They are amortizing the value of these networks a lot faster than they thought they would because of technological obsolescence.

Brett D. Fromson:

Do you have a problem with the underlying fundamentals of the telecom service sector?

Ravi Suria:

No. I definitely believe that telecom convergence is the future. The network has value. The subscribers have value. The fiber has value. The bandwidth has value. But the capital structure is all wrong, which means the debtholders will likely realize all the future value of the networks. If these companies are not getting bought, then you have to ask whether they can survive by themselves. As of the end of the third quarter of last year, these New Economy companies had $55.5 billion in cash. In the prior 12 months, they had only $500 million, essentially breakeven. Expected interest and dividend payments were about $24 billion. The industry as a whole is not expected to get to $24 billion of positive cash flow until 2004. In the last 12 months, capital expenditures were about $52 billion.

So, if the companies slash capex, they have about three or four quarters of cash left. That's why neither the debt nor equity markets are going to give them any more money. On average, they're not getting any more money. They are not generating enough cash flow to pay their existing obligations. They are not getting taken over.

Brett D. Fromson:

So, what will they do?

Ravi Suria:

They will restructure. You go Chapter 11. The problem for the industry is the debt. Bankruptcy is the solution. This is how many other industries have looked at bankruptcy in the past. The airlines. Retailers. Steel companies. Movie theater companies. They run into debt problems, and they seek protection from creditors so they can continue to operate. They keep their employees and customers.

Unfortunately, this industry looks at Chapter 11 as the problem and at additional debt as the solution. Additional debt is never the solution for a company that has too much debt. You can pray all you want, but the debt is not going away. These companies are in denial, and so they are laying off people when they should be seeking protection from creditors. A lot of these companies got funding into early 2000. If you really start cutting back on expenses, funding can get you through a year or a year and a half. But then I think you'll see a wave of defaults.

Brett D. Fromson:

Explain.

Ravi Suria:

Defaults begin to rise roughly four quarters after the last wave of financing. There's statistical evidence that defaults in the high-yield market reach a peak three to five years after issuance of debt.

Brett D. Fromson:

Obviously, this has been a disaster for stockholders in these companies with loads of debt. I assume you think many of them are going to zero.

Ravi Suria:

Well, if the companies restructure and debtholders get paid less than 100 cents on the dollar, obviously the value of the current equity is zero.

Don't miss Part 2 of this interview.