Forum Archive Index - April 2001

[Mike Stoke <mike@stoke.co.nz>]

For you telco watchers who may not have come across this interview -
very interesting discussion from the heart of the US finance industry
looking at the capitalization of the telcoms business.

Suria suggests that the capital base of the entire industry is unsound
and deteriorating rapidly, and recommends re-regulation of the industry!



The TSC Streetside Chat: Ravi Suria
By Brett D. Fromson Chief Markets Writer
3/28/01 10:41 AM ET
<a 
href="http://www.thestreet.com/markets/marketfeatures/1359535.html";>Thestreet.com</a>

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:Nasdaq - news). 
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 withTSC 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:NYSE - news) and WorldCom (WCOM:Nasdaq - news), 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:Nasdaq - news), Covad (COVD:Nasdaq - news), 
RSL Communications (RSLC:Nasdaq - news), Winstar Communications (WCII:Nasdaq - 
news) and Teligent (TGNT:Nasdaq - news), to those where the problems are a few 
quarters off still, like XO Communications (XOXO:Nasdaq - news), Williams 
Communications (WCG:NYSE - news), Exodus Communications (EXDS:Nasdaq - news) 
and Level 3 (LVLT:Nasdaq - news). 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:OTC SC - news) 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.