This is Part 2 of the TSC Streetside Chat with Ravi Suria. To go back to Part 1, click
Brett D. Fromson: So how does this play out, since the endgame is evidently not going to be as rosy as was expected some years ago? Ravi Suria: The big borrowing -- high-yield debt issuance -- ramped in late 1996 and early 1997, stayed high in 1998 through early 2000. Now, default rates tend to lag issuance by about four years, historically. Add on four years and you get 2001-03 as the period of peak defaults. So you have a string of defaults that will come. The problem for the companies is that they are still in the denial phase and are focusing more on how to stay out of Chapter 11. Look at PSINet, which over the past four months has been slashing jobs and laying off people and selling assets. And now it looks like it will still file for Chapter 11. Covad is doing the same thing. Brett D. Fromson: Some new-era companies say that they plan to be the last man standing. Ravi Suria: A lot of people think that the last man standing will be the last company to go into Chapter 11. Wrong. The last man standing is the company that doesn't have the debt. The industry is going to shake out in one of three ways. One, some companies will be liquidated in Chapter 7 bankruptcy proceedings. The networks will be stripped and sold back into the market. Second, some companies will file for Chapter 11 and sell the whole business to another company. This is what happened to GST Telecommunications. In this case, stockholders did not get anything, and debtholders got about 50 cents on the dollar. Third, you file for Chapter 11, but remain an independent company. ICG ( ICGXQ), for example, wrote down $2.8 billion in debt when it filed for Chapter 11. It has approximately $2 billion in plant and equipment. Immediately after the debt was wiped out, they got $350 million in debtor-in-possession financing from Chase, which allows them to operate. The lender was willing to lend $350 million because it has $2 billion in plant and equipment backing the debt. The lender is overcollateralized. Now, ICG does not have to pay interest on $2.8 billion in debt. That takes the company from negative cash flow to positive cash flow. So ICG can survive as a company. Brett D. Fromson: So what does this mean for companies that are not going to get bought and still have to make debt payments? Ravi Suria: They become less competitive. Look, for example, at XO. It has arguably the best network, some of the best management, the best customer base, the most powerful equity base. But XO has annual interest payments of about $700 million. It has negative cash flow, negative EBITDA. It has a bit over $1 billion in revenues. Even by 2003, 20% of its revenues will be taken up by interest payments if all current optimistic projections are right. The company won't be able to generate enough EBITDA to cover interest payments until 2004. That is not a competitive advantage. Companies that go into Chapter 11 first wipe their debt payments down to zero. Suppose you are XO in 2003, and you have a competitor that has gone through Chapter 11 and is not burdened with interest payments. When both of you make a sales pitch to a potential customer, you have 20 percentage points of gross profit margin that a competitor with no debt can undercut you with and make more money. You cannot match the pricing because of your interest payments. This same problem faces a company like Level 3. That company talks about its declining incremental network costs. As it adds new customers to its network, the incremental cost is close to zero. The problem for Level 3 and others is that you cannot go down the cost curve below where interest payments are. In a competitive industry like this, 20 percentage points of gross margin is a lot to defend. So, if I'm XO or Level 3, what is my problem? I have a better network. I have a better sales force. I have better management. Why is the other guy getting the business? Because he is undercutting me by 15% and still making more money than I am. That is the problem they will face. Their financial burdens tremendously decrease their operating flexibility. Why? Your interest payments are fixed. Brett D. Fromson: How do you view Level 3? Ravi Suria: The problem is that their interest payments are too high, at about $700 million a year. The question is, how effective are they going to be in competitively pricing the network? That's where Level 3's ultimate problems lie. I don't think anyone wants to take over Level 3 with $8 billion in debt, especially since Level 3 may not generate the cash flow to support and repay the debt.