The <I>TSC</I> Streetside Chat: Ravi Suria (cont'd)

This is Part 2 of the TSC Streetside Chat with Ravi Suria. To go back to Part 1, click here.

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. "Debt for the new-era companies was 60% more than the value of plant and equipment."

Brett D. Fromson: Level 3 management has told shareholders that the company is "fully funded to break even." What do you make of that?

Ravi Suria: Here's my definition of fully funded. It means you already have enough money so that you do not need any more money from anybody else. It means that you should generate enough money to at least make your interest payments. That is fully funded. A company may say it's fully funded to break even, but if it still needs more money to make its interest payments, it's not fully funded.

Brett D. Fromson: Who ends up owning these companies?

Ravi Suria: What we're seeing is a shift of ownership of that value of the network from stockholders to debtholders. Because when the industry goes through its restructuring, the people who will end up owning the assets are the debtholders. Considering that we expect debt to be a big problem over the next few years and that the value is flowing from equity holders to debtholders, you want to be a debtholder at the right price. In an unregulated industry characterized by a short obsolescence cycle, it's very hard to estimate what your payback is going to be or what your asset values are.

Brett D. Fromson: What's the right price for the debt here?

Ravi Suria: That is not clear even to professionals in the high-yield market. Historically, you found some kind of bottom in the debt by using replacement cost or asset value. This is a new industry, and you don't truly know what the asset value is. I think the asset values will be defined through the bankruptcy process over the next few years.

Brett D. Fromson: So for most individual investors, you would advise they basically avoid even the debt of these companies?

Ravi Suria: Absolutely. Now is not the time to be brave.

Brett D. Fromson: Let's sum up on the telecom service companies.

Ravi Suria: This industry has by far the most egregious misallocation of capital -- of spending money when you are not making money, of borrowing money when you don't have the ability to pay it back. The sad part is that the industry that has done this never really existed before in the sense that the new companies did not exist before the Telecommunications Act of 1996, and the old guys had been in a regulated environment -- i.e., they never borrowed this much money before.

What we're seeing right now is totally unprecedented. You don't know how bad it could get because we have never been here before. We have never seen balance sheets like this before. I will say one thing in general about balance sheets and distressed companies: Things are always worse than what you think. You learn that from any number of companies that have gone Chapter 11. Look at any number of companies -- from Boston Chicken ( BOSTQ) to Discovery Zone ( DVZN) to ICG -- people were optimistic until the last moment.

Brett D. Fromson: Let's talk about telecommunications equipment makers. First of all, which companies are we talking about?

Ravi Suria: Cisco ( CSCO), Lucent ( LU), Nortel ( NT), Corning ( GLW) and others. "The problem for the industry is the debt. Bankruptcy is the solution."

Brett D. Fromson: What are their problems?

Ravi Suria: One, over the past five years, cash flow in the telecom services sector has been growing between 8% and 12%. But the money they have been spending on plant and equipment has been growing at about 40% a year. This is clear example of the recent investment-driven economy, that capex spending was dependent on the telecom services companies borrowing money. This is a great example of what I call overstimulation of demand through easy availability of credit. In the long run, investment demand is tied to how much money companies actually make. What this implies for the next three to five years is that telecom spending growth rates will be down to the actual cash flow growth, which is 8% to 12% a year. This is the best-case scenario -- assuming the cash flow is not used to start repaying debt -- which is an heroic assumption.

Brett D. Fromson: Does the level of telecom service capex spending have to drop before it starts growing at all? Does the absolute level of capex spending increase from current levels, or does it have to go down substantially before it begins increasing?

Ravi Suria: I expect aggregate capex will have to go down to 1998 levels, at least, before it resumes growing again.

Brett D. Fromson: Why?

Ravi Suria: Because a substantial amount of what was spent in 1999 and 2000 was money that companies did not have and had to borrow. A lot of the money borrowed by the big guys over the past few years is coming due in 2001. For example, European telcos alone have to raise about $190 billion this year to refinance existing debt. That is not to repay or bring down debt. That is a lot of money.

So, the first $190 billion raised through bank loans, bond market offerings and wireless IPOs will be used to refinance existing debt. If they manage to borrow that much money, then they may start spending on capex. Maybe. In the U.S., for example, AT&T has $25 billion of commercial paper coming due this year. None of these financial pressures existed over the last several years. The debt that you borrowed you could spend on equipment.

Brett D. Fromson: So how do those financial pressures hit the equipment makers?

Ravi Suria: Look at Nortel ( NT). The company's revenues went from about $17 billion in 1998 to $30 billion in 2000, some because of acquisitions. Ask yourself who were all the new buyers of Nortel equipment? I would say they were people who had borrowed in the capital markets. I would say that Nortel's revenues may have to decline to the $20 billion level before they actually become sustainable, and that could take a couple of years.

Brett D. Fromson: What about Lucent and Cisco?

Ravi Suria: Lucent's revenue estimates for 2001 have come down all the way from $45 billion to $25 billion. That is a contraction. The telecom equipment companies that will show the biggest contractions are those with the largest revenues, because they are the ones that captured the most dollar amount of revenues from money that was borrowed over the last couple of years. You could see the revenue bases of companies like Nortel and Lucent actually come down by 30% to 40% before the revenues stabilize. Cisco is getting to that revenue level, too. Just to show flat revenue growth, Cisco must replace more than $20 billion in revenues.

On the other hand, Ciena ( CIEN), with $1 billion in revenues, needs to find only $1.5 billion in revenues to show 50% revenue growth. The point is that once you get big, it becomes harder to show growth, especially if you're in a capital goods industry like these companies. You have to convince the person who bought 10 routers this year to buy 10 more next year and then another guy to buy another five routers to show 50% growth. The larger the company, the more I expect to see a contraction in revenues.

Brett D. Fromson: Obviously, you do not see a return to the growth rates of 1998-2000 to return anytime soon.

Ravi Suria: I do not. The extra lump of demand for this equipment just does not exist from sustainable cash flows. It just doesn't exist.

Brett D. Fromson: After the revenue contraction, when would you expect revenue levels to return to 1999-2000 levels?

Ravi Suria: That's hard to say. For companies to spend money on telecom equipment, they have to get it from somewhere -- internal cash flow or the capital markets. In the last few years, it has come from the markets. On the telecom services side, people are beginning to understand that these are no longer growth companies -- they are highly leveraged companies. On the telecom equipment side, the market will realize that they never were secular growth companies. They are capital equipment companies; they're cyclical just like the semiconductor equipment companies. You don't find semiconductor equipment companies giving vendor financing for customers to buy their equipment because they know there's always a downside to a cycle. This is something the telecom equipment manufacturers forgot. "It's ironic that the unprofitable tech IPO cycle started with Netscape, the first Marc Andreeson IPO, and probably ended with his next IPO, Loudcloud."

Brett D. Fromson: How then do you think these telecom equipment stocks should trade?

Ravi Suria: As capital goods stocks. That's what they are. They are not growth companies. The smaller ones can show good growth for a few years, but once they hit a critical mass of revenues, they are cyclicals.

Brett D. Fromson: That means lower P/Es, of course.

Ravi Suria: Yes. Absolutely.

Brett D. Fromson: Telecom services and equipment have been two of the fastest-growing sectors of the economy in recent years. What does it mean to the overall economy that they are contracting?

Ravi Suria: This economic cycle has been driven by investment spending. If you look at GDP growth, investment growth has been greater than consumer spending growth. Government spending has been going down. And we have been running a trade deficit. So most of the demand has been spurred by investment spending. Now, you slow that down. What you could see in the next few years is a sharp falloff in investment spending.

It's hard to say that companies won't be spending more on technology. But I think we went through a substantial upgrade cycle over the past five years, and unfortunately cash flow growth, which at the end of the day actually gives you the ability to spend more, has not substantially improved for corporate America. I do not know how much of a crimp it will put on economic growth, but I would say that if you think that investment spending is going to fall off a cliff, you could make an argument for lower GDP growth more closely linked to the growth in consumer spending. And that would not be a four-quarter phenomenon. It would be a phenomenon until debt leverage across the board starts coming down.

Brett D. Fromson: What is your outlook for IPOs?

Ravi Suria: I think we're going into a severe down cycle for IPOs.

It's very simple. Go back and look at history. Before 1995, most companies that came public had four to six years of operating history and a year of profitability. What we had in the past several years were companies that had been around for less than two years going public. So when they came public they were still in that very fast part of the growth curve.

The public mistakenly thought that was the rate at which these companies would be growing forever. They did not understand that all new companies grow that fast. It was just that before 1995 the public didn't see these companies because they were still privately owned. Here is the key part. A lot of the private companies that would normally have done an IPO between 2001-04 would have been founded between 1996 and 1999. Unfortunately, most of the companies founded between 1996 and 1999 have already been taken public. So, the next crop of IPOs that will come through will be companies founded in 1999-2001. So, over the next few years, there will be a much smaller number of new company IPOs. The replacement will be big IPOs like Agere from Lucent and Kraft Foods from Philip Morris ( MO). And you'll see more seasoned companies like energy companies that have been around for 20 or 30 years come public. The boom for tech IPOs is gone. You took about 10 years' worth of IPOs and compressed them into four. I think it's ironic that the unprofitable tech IPO cycle started with Netscape, the first Marc Andreeson IPO, and probably ended with his next IPO, Loudcloud ( LDCL).

Brett D. Fromson: Let's change gears and talk briefly about a company that you know well,

Ravi Suria: Amazon is a retailer that was masquerading as a tech company for a number of years. It borrowed too much money. And the money is running out. Unless somebody comes and gives it more, the company will have to go through restructuring in the next 12 months. That doesn't mean it goes out of business. The Web site survives. It's a great asset and it will be a great asset to somebody. It just means that the current capital structure and the current operating model don't work. Their operating model clearly does not work. Why not? Because it doesn't make money. As somebody said the other day, "Anybody who sold one paper bag for a 10-cent profit made more money, a heck of a lot more money, than Amazon has over the past five years." Debtholders will most likely end up owning the company.

Click here to go back to Part 1.

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