With the field of small telcos rapidly becoming a boneyard, Wall Street is gaining a new appreciation for phone companies whose businesses work.

Talking Telco
'GigE,' the Next Big Thing in Telco Land
Here is what they are finding: Behind every strong company is sound management, and behind two of the three still-healthy upstart telcos is a former MFS Communications exec. You'll recall that MFS basically invented local phone competition in the late '80s, relying heavily on its knack for skimming the cream off the top of the Baby Bells' customer lists.

Maybe the MFS connection puts too fine a point on it; clearly, not all the brightest minds in the competitive local exchange carrier business came from one outfit. But as investors jostle to choose the CLEC that will not only survive the economic downturn but thrive in coming years, they're putting a premium on experience. Notably, the MFS executives emphasize organizational strength over lofty national ambitions and they recognize the value of the lowly phone-service business, analysts say.

Fitness to Serve

If you believe the believers, the three fittest survivors are Time Warner Telecom ( TWTC, McLeodUSA ( MCLD and Allegiance ( ALGX. Shares of all three rallied sharply Tuesday and again Wednesday during a marketwide updraft: Time Warner Telecom jumped $3.24 to $43.90; McLeod added 28 cents to $9.25; and Allegiance added 76 cents to $16.01.

Time Warner Telecom, a 44%-owned affiliate of AOL's ( AOL Time Warner unit, and Allegiance were founded by ex-MFSers. CLECs are the would-be Bells. Typically they target businesses with a laundry list of services from local calling to high-speed data lines and private networks.

Learning Tree?
CLEC execs not falling far from the MFS tree
Source: Royce Holland, Chairman, Allegiance Telecom

"There is a distinction between companies founded by people with a lot of experience in this sector," says Thomas Weisel's Peter DeCaprio. "And then there's the rest of the world." DeCaprio rates Allegiance a strong buy and McLeod a buy and has no rating on Time Warner Telecom. Weisel has no underwriting ties to these companies.

Call it the MFS class of 1996.

In 1996, when MFS became part of Worldcom ( WCOM in $12 billion deal, dozens of executives and managers jumped ship. Many, though not all, parlayed their phone experience into jobs building start-up telecom outfits.

Rule No. 1 for phone companies: Provide phone service. What some CLEC leaders didn't forget is that while data services will one day lead to profits, operating basic local and long distance phone service are what pay the bills. One of the common mistakes of failing CLECs was to push data services first and backfill with phone service. Observers call that a fatal flip of priorities.

"Voice has been a stable product and good revenue generator," says Weisel's DeCaprio, referring to some of the stronger CLECs' ability to win phone-service contracts. "Monthly, recurring voice payments are their biggest asset, I think."
Balancing Act
Profits in sight for some telcos
Company Stock Debt* 2001 Debt Expense** 2000 Cash Flow*** Profitability target
Time Warner Telecom (TWTC:Nasdaq) $40.66 $585M $126M $139M 2003
McLeod (MCLD:Nasdaq) 8.97 4.02B 415M -13M 2003
Allegiance (ALGX:Nasdaq) 15.25 566M 79M -76M 2004
XO (XOXO:Nasdaq) 3.93 6.5B 651M 356M --
Winstar (WCII:Nasdaq) 36 cents 4.2B 651M -461M --
*Total debt and preferred stock. **Estimated payments on interest and preferred dividends. ***Operating cash flow before expenses.
Source: Lehman Brothers, companies.

Royce Holland, the granddaddy of the CLECs, is often cited for his emphasis on building back-office support for the basic functions like billing, service orders, and handing off information between competing phone companies.

Here's Why

It's not that the weaker players didn't get their hands dirty with the nitty-gritty, but rah-rah investors wanted growth and were willing to underwrite grand dreams.

And when the funding was big, dreams got even bigger.

Initially, with copious amounts of investor cash at their disposal, upstarts took aim at the complacent Baby Bells and planned to run loops around them, picking off lucrative business customers in big cities with new technologies like digital subscriber lines.

But those overreaching, underfunded plans soon became unsustainable as TheStreet.com explained in a recent story about debt-service pressures crushing small telcos.

Just how unsustainable? As a group, CLECs are will be running a cash flow deficit of $3.2 billion this year, Lehman Brothers analyst Blake Bath wrote last week.

Notably, among the have and have-nots of the CLEC industry, there are a handful that have the wherewithal to service their debts and expand their businesses (see table, above).

To be sure, while financing is a company's air supply, actually delivering service is the make-or-break proposition. Whether caused by tech glitches or uncooperative regional Bells, many the small telcos have achieved starkly different results in signing up customers and in actually providing service.

And it's important to remember that the very same analyst shops that now love Time Warner Telecom, McLeod and Allegiance were a year ago trying their best to convince investors that companies like Winstar ( WCII, Covad ( COVD and even Mpower ( MPWR - Get Report) were richly deserving of $2 billion-plus market caps. All three now trade for less than a tenth of that. And the MFS connection is visible as well in any number of small telcos that have already gone belly-up, as the chart above shows.

"The MFS folks knew how to deal with the Bells, they knew how to deal with business customers, they basically knew what it took to run a phone company," says Weisel's DeCaprio. "Ten years ago, some of these other folks were selling ski clothing."

As originally published, this story contained an error. Please see Corrections and Clarifications.