Bad consolidation credit debt load

Business; Carrying a heavy load - Industry Trend or Event

Debt levels high among service providers Service providers can hardly be surprised as vendors move to tighten their financing standards and increase their reserves for bad debt. Most carriers in the U.S. and Europe are highly leveraged and represent a credit risk for banks as well.

Just ask the investors who bought into the low-grade bond offerings of fledgling carriers such as ICG Communications and GST Telecommunications. Both competitive carriers defaulted on $1 billion or more of junk bonds, and if the equity markets continue to be unreceptive to telecom stocks, the industry could see more of the same.

Overall, carrier debt levels are high. According to a December 2000 report by Susan Kalla, analyst at BlueStone Capital, debt for carriers worldwide rose to about $340 billion in 2000 from about $227 billion in 1999. While carryover debt rose 49% in 2000, new debt issues were the bigger story: Incremental new debt increased to $113 billion in 2000 vs. new debt of $48 billion in 1999.

The credit problem has been building for years as deregulation produced a plethora of network builds and merger and acquisition activity, much of which was financed with borrowed money. "New carriers came to market, and it was a greenfield funding opportunity," Kalla said. "Lenders made a lot of capital available." It didn't hurt that interest rates were low, making equities attractive and money cheap.

On a micro level, demand for bandwidth seemed to grow faster than supply. "That scenario was obviously wrong," Kalla said. "[Bandwidth] prices [today] wouldn't be dropping 45% to 70% if there were more demand than supply."

The private and public equity markets began shutting down to service providers as financial returns didn't materialize, and as it turned out, addressable markets were smaller than anticipated. That also made high debt loads increasingly unwieldy and difficult to justify.

But large debt burdens are not only a public relations problem. If a company has a large proportion of debt in its capital structure, stockholders are at greater risk, making share price recoveries unlikely. And further attempts to raise money in the debt markets become more expensive as credit rating agencies downgrade outstanding borrowings. "Factors on the balance sheet, including higher costs for financing and greater reserves for bad debt, are putting stress on cash flow and earnings," Kalla said.

The current market for corporate bonds remains "treacherous" for investors and bankers, said Kenneth Hackel, chief U.S. fixed income strategist for Merrill Lynch. Issuances in the second half of 2000 were at record levels, and the rise in telecom debt products pushed the utility issues sector up 80% from 1999.

Because analysts expect weak earnings reports in January, a "cheapening" in the value of corporate bonds could make them relatively attractive once again. But "the liquidity difficulties facing [corporate bonds] at this stage mean that the penalty for being too early is still greater than that for being late," Hackel said.

Worries about collective debt in the telecom sector are prompting concerns about European banks that have lent carriers significant sums and even causing some to utter the words "growing risk to world economic stability." The expensive licenses for third generation mobile telephony has contributed to the skyrocketing indebtedness of many European carriers, according to a report by Samuel Theodore, managing director of European Banks for Moody's Investors Service in London. Moody's downgraded more than $124 billion in European telecom debt in 2000, compared with $13 billion that was upgraded.

However, according to Theodore, while extensive lending to carriers "constitutes a credit concern," it does not "foreshadow a banking crisis."

That's largely because the large global banks are the ones with the greatest exposure to the telecom sector and the borrowers are mostly large operators and vendors, according to Moody's. "With respect to these borrowers, sharp drops in share prices or even widening spreads on bonds do not necessarily signal a terminal illness," Theodore said.

In addition, while many European operators had their credit ratings downgraded in 2000, including Deutsche Telekom, BT and France Telecom, most of the debt remained in investment-grade territory. "An asset quality crisis will be the consequence of borrowers defaulting on loans, and at this stage, Moody's is not forecasting defaults by major telecoms," Theodore said.

In the U.S., for example, the largest carriers can still borrow even when carrying large debt loads. AT&T closed a $25 billion syndicated bank facility last week that will serve as a backup source of liquidity, according to the carrier. This is despite the fact that AT&T already has more than $62 billion of long-term debt on its books.

Overall, the heavy debt load of carriers will cause a ripple effect among telecom equipment suppliers during 2001, Kalla said. During the 1999-2000 time frame, capital expenditures for incumbent carriers increased about 12% to 15%. But Kalla expects capital spending growth to "trail off" this year because of carriers' cash constraints and the collapse of the dot-coms, which has reduced the number of capital equipment buyers.

"The cost of capital of many carriers is more than 10%," Kalla said. "We believe carriers will have to scale back their plans for spending on equipment, even next generation optical equipment, to preserve cash."

Vendors actually face double jeopardy - service provider defaults on equipment financing agreements and declining revenues because of a shrinking customer base.

"The impact is on both the [vendor's] income statement and the balance sheet," Kalla said. "But the slowdown in revenue growth is the bigger whammy. They can take a one-time write-downfor bad debt, and the liability disappears off the balance sheet."

What will be the endgame for carriers that fall behind on interest payments and violate loan covenants? Consolidation certainly will be one way out, as buyout specialists swoop in and gobble up distressed businesses, cut their costs and simplify their business models. But these white knights will wait until their targets go bankrupt before making their move, Kalla said, because they don't want to take on the large debts and there's no advantage to coming in early. "They will wait in the weeds until the company breathes its last breath and then come in at a lower price," she said.