<nettime> TheStreet interview with Ravi Suria on telecoms

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Market News : Market Features
The TSC Streetside Chat: Ravi Suria
By Brett D. Fromson 
Chief Markets Writer
3/28/01 10:41 AM ET 

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.

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.

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.

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.

Don't miss Part 2 of this interview.

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