A handful of brave souls are buying distressed telecom assets in the hope of building future empires. Published in Red Herring, February 12, 2003

On the edges of many cities in developing countries, a surreal sight greets visitors: thousands of poor people, rummaging through mounds of waste, rusty tins, brittle plastic, and cardboard, anything at all to eke out a meager existence. These hardworking folks, often called rag pickers, are considered troublemakers. But as the saying goes, one man’s trash is another’s treasure.

The situation in the telecommunications industry is no different. After the spending orgy of the late ’90s, telecom circa 2003 is a giant (and almost toxic) garbage heap of dozens of dead companies–bandwidth wholesalers, equipment makers, hosting service providers, and many local phone companies. In this pile are thousands of miles of unlit fiber, innumerable never-used routers and other gear, real estate, rights of way, and even wireless spectrum.

While most of the world is focused on the shenanigans of the analyst Jack Grubman or speculations of when the telecom head honchos will depart for the big house, telecom’s rag pickers–a few brave entrepreneurs and opportunist CEOs–are sifting through the industry’s remains, hoping to build sustainable and enduring businesses by accumulating the right assets cheaply.

They are a crew of virtual unknowns–Sean Doherty, founder and CEO of Odyssey Telecorp; Dave Schaeffer, CEO of Cogent Communications; Danny Bottoms, CEO of OnFiber Communications; Jonah Yokubaitis, founder and CEO of Texas.Net; and Joel Kocher, CEO of Interland–all of whom are hoping to become big players in the future of telecom (see “The Fearless Five,” right). And joining them are institutional bottom feeders like Wilbur Ross & Company and Leucadia National, which have invested in 360Networks and WilTel Communications (formerly Williams Communications), respectively.

These lesser-known players have a lot to choose from. Today’s telecom landscape can be divided into three categories that recall the classic Clint Eastwood Western The Good, the Bad and the Ugly: the Good are relatively stable phone companies like AT&T, NTT, SBC Communications, and Verizon; the Ugly are bankrupt companies like McLeodUSA and WorldCom; and the Bad, somewhere in the middle, are companies, like Level 3 Communications (see “Money Changes Everything,” page 32), that have managed to survive the telecom meltdown or, like WilTel, have used bankruptcy to get out from under their debt obligations.

In each of these categories, companies are either trying to or have been forced to unload assets as they reduce their business ambitions. For the lesser-known newcomers, the reshuffling of the telecom landscape presents the bargain of a lifetime.

Busy Signals

Typically, when an industry is undervalued, distressed, or enduring multiple bankruptcies, two types of investors jump in to buy assets: private-equity buyout funds that are looking for bargains at undervalued ongoing concerns, and funds (normally backed by large Wall Street banks) that gamble on the distressed assets of bankrupt companies. In the ’90s boom, buyout funds like Hicks Muse Tate & Furst, Forstmann Little, and Welsh Carson Anderson & Stowe invested more than $4 billion in the telecom sector only to see it evaporate in the last three years.

These buyout firms are now justifiably staying away from the telecom sector. And so are funds that started some ill-fated nibbling at distressed telecom assets in late 2001 and 2002. A senior New York investment banker described the situation as “Twice bitten, bled dry.”

The telecom industry went through a massive boom period following the signing of the Telecommunications Act of 1996, a broad legislative effort to open up competition in the local phone markets. Forgetting its own conservative tenets, the industry adopted a new catchphrase: “build it and they will come.”

In 1996 and 1997, this rapid expansion seemed justified (see “False Hopes,” right). For example, as more money flowed into nascent dot coms, the demand for bandwidth increased and the venture capital community funded more Web-hosting companies: three dozen network service providers and hundreds of small phone companies. Excessive funding created overcapacity, which led to price wars. When the dot-com bubble finally burst, the whole industry crashed, leaving behind a mountain of debt and unused assets. More than a trillion dollars in market capitalization vanished.

The total distressed and defaulted debt in the United States (private and public) at the end of third quarter 2002 had a face value of around $885 billion and a market value of about $488 billion, according to data collected by the Altman-NYU Salomon Center, a research group. But this includes the debt of many industrial and old-economy consumer-product companies like packaging plants and fast-food chains. Compared with telecom and other high-tech firms, these old-economy companies are less intimidating to investors and can be flipped quickly. “The big funds are not operators, and when they look at telecom, they see a lot of hand-holding,” says Mr. Doherty of Odyssey Telecorp. Even distressed-asset funds like Fir Tree Partners and the Avenue Group are keeping their distance from telecom and looking elsewhere for bargains.

Last year, when the U.K.-based network services company Energis crashed and burned, there was some interest in its assets but no follow-through from Apax Partners and Kohlberg Kravis Roberts & Company. KKR’s other effort, a telecom buyout fund in partnership with Accel Partners, has also stalled. Other big players, like Oak Tree Capital Management, have been maintaining radio silence about telecom investments. The only large player making serious moves is Providence Equity Partners, which has been buying assets of distressed telecoms and companies that are restructuring, particularly in Europe, most recently the Dutch cable-TV operator Casema.

Like the distressed-asset investors, buyout shops are staying away because they can’t deal with the operational complexity of a local phone company, says a senior telecom investment banker at a leading Wall Street firm. But some investors, like Leucadia National, are bucking the trend. Leucadia’s investment in WilTel is its first-ever telecom investment.

Many limited partners, typically large pension funds or university endowments that invest in buyout funds, VC funds, and other investment vehicles, told Red Herring that they don’t know of any new or upcoming telecom buyout funds. James Henry, a former telecom analyst at Bear Stearns, tried to start a telecom distressed-asset fund, but couldn’t get it off the ground, according to those familiar with Mr. Henry’s plans. And one large investor said he would not even entertain such a proposal.

International Calls

Mike Scheele, a 20-year veteran of the telecom industry who last year set up Telecom Asset Management to broker sales of distressed telecom assets, views the glass as half full. “This is a once-in-a-decade opportunity to buy some really expensive and large assets on the cheap as they are being reallocated,” says Mr. Scheele, who adds that about half-a-dozen Sand Hill Road VC firms have expressed interest in investing in distressed assets, though no investments have been made.

But as these domestic firms ponder and delay, investors overseas–many from Asia–are exploiting the opportunity. For instance, a group of investors led by the telecom operator China Netcom and including Newbridge Capital and the Softbank Asia Infrastructure Fund, snapped up the assets of the bankrupt network carrier Asia Global Crossing for about $120 million and assumed debt. Singapore Technologies Telemedia and Hong Kong’s Hutchison Whampoa bought Global Crossing of Bermuda for $250 million. Singapore Technologies Telemedia is proving to be a major consolidator: the company recently merged its iSTT division with the data-center operators Pihana Pacific and Equinix. The newly merged company now operates under the Equinix name and management. As part of the transaction, Singapore Technologies made a $30 million strategic investment in Equinix.

Other large overseas telecom companies, particularly those that have made early forays into the U.S. market, are looking to acquire distressed assets, analysts say. Deutsche Telekom, France Telecom, and NTT are some of the names being bandied about. The market research firm Probe Research predicts a global telecom consolidation for 2003, and that Hutchison Whampoa, Singapore Telecom, and perhaps Japan’s NTT, despite its weakness, will accumulate the majority of Asian assets. The firm also predicts that the telecom services companies AT&T, Equant, and Infonet Services will pick up assets of smaller telecom carriers and undersea communication pipes (FLAG Telecom and Tyco, for example) to expand globally.

However, distressed-asset brokers say, don’t expect any major moves in the first half of 2003. Hasty forays into the market could create trouble for the telecom giants. Consider the London-based telecom services company Cable & Wireless: it went on a shopping spree, bet big on transport and hosting services to make itself an IP-based service provider, and watched its efforts come unglued because of a faltering voice business.

Cable & Wireless bought MCI Internet for $1.8 billion and acquired assets of Exodus Communications, Digital Island, and PSINet’s global network (mostly in Japan). But with the tanking telecom market and a whopping loss of $7.4 billion for 2001, it is pulling back from its Web-hosting efforts. And the company’s CEO, Graham Wallace, who has been under pressure to step down, will be departing as soon as a successor is found. Lesson from the Cable & Wireless debacle: don’t try to get in before the market bottoms out. “I think if you look at various stages of recovery the first stage is when the assets hit the bottom and stay there,” says an investment banker specializing in telecom. “We are at a point where asset valuations are still trying to stabilize.”

Smart Assets

Others agree that regional focus and concentration on specific segments of the telecom business, like Web hosting or metro-area transport services, can be lucrative. Adding heft to these regional footprints by buying distressed assets is a sound strategy. “Most of the consolidation is happening in the regional markets, and only a handful of companies are making the moves right now,” says Darren Johnston, founder and principal at Intellectual Capital Associates, a market research and advisory firm. Many believe that at least one facilities-based independent phone company can carve out a nice living in almost every market, largely by providing an alternative to Baby Bell phone service.

Whether they are regional carriers, ISPs, or Web-hosting companies, the niche approach is the only way these small companies can survive and perhaps prosper in this risky market. The assets that telecom’s rag pickers are currently accumulating may look unsightly now, but the hope is that the salvaged assets will eventually form the foundation of a more rational and economically viable telecommunications market.

Om Malik’s first book, Broadbandits: Inside the $750 Billion Telecom Heist, will be published in May by John Wiley & Sons. Write to om.malik@redherring.com.