The Next Dotcoms? CLECs Struggle In Search For Capital

Since when did CLEC become a dirty word?

Last year, venture capitalists flocked to pump money into the scores of competitive local exchange carriers hoping to challenge the incumbent Baby Bells and Internet service providers by offering similar telephone and data services at lower prices and unprecedented speeds. Now, however, the tables have turned and these one-time venture darlings are hard-pressed to squeeze a drop of new money from the VC bucket. What is more, many have renounced their CLEC heritage outright by adopting new names for their business models.

Indeed, some CLEC firms have gone under the guise of clever aliases such as integrated communications providers or broadband services providers. Still others have tried to disassociate themselves from their ancestors, claiming they cater specifically to small companies and residential customers, whereas traditional CLECs have historically provided services to large and medium-sized businesses.

Take venture-backed Carolina Broadband Inc., which earlier this week announced plans to issue pink slips to 80% of its workforce by summer?s end. The layoffs became necessary after the company?s board of directors determined it would not be able to obtain the $400 million debt facility necessary to build its fiber optic telecommunications network, which was intended to provide telephone, cable and high-speed Internet access to small businesses and residences to major cities throughout North and South Carolina.

“Just as I would not buy a house without a mortgage, or a car without a car loan, I am not going to build a billion-dollar network infrastructure without a debt line,” explained Bill Schuler, the company?s chief executive.

While the company blames its current money woes on the ill-performing capital markets, its financial forecast wasn?t always so bleak. Last May, Carolina Broadband garnered $402 million worth of private equity financing in one of the year?s largest venture transactions. At that time, fresh capital was basically free to any CLEC with a business plan.

Today, that?s no longer the case and, although his company is suffering from the same funding drought as many of its CLEC brethren, Schuler insisted they are not of the same ilk.

“We?re not a CLEC,” he said. “It?s next to impossible to even get a CLEC funded these days. We?re a residentially-focused broadband service provider, and we?ll build [a network] in front of the homes of all the residents we?re going to serve and potentially serve, along the way picking up some businesses as clients.”

He also said that the company doesn?t qualify as a CLEC because it offers cable service as well as telephone and Internet access, all in one bundled package. Nonetheless, it is building its own network to compete against the incumbent cable, telephone and Internet carriers in the Carolinas, thus it acts more like a CLEC than Schuler seemed willing to admit.

“I?ve been hearing a lot of this lately, because CLECs have been getting such a bad rap on Wall Street,” said Courtney Quinn, a senior analyst with Boston-based research firm The Yankee Group. “CLECs that never should have been funded gave [the rest of] the CLECs a bad name. It?s guilt by association, there?s a nasty little connotation to CLECs. [But the reality is], if they provide some kind of local telephone service, they are in some part a CLEC.”

Still, it isn?t surprising that Carolina Broadband hasn?t been able to get access to a debt line, especially with telecom and CLECs dragging down the high yield market.

“In the year 2000, what you saw is that high yield wasn?t a good place,” explained Gary Jacobi, a director of wireline equity research with Deutsche Banc Alex. Brown. “A basket of high yield bonds lost 6.8%, but telecom lost on average 19.9%, and CLECs were losing 24%. Those are big losses for bonds.

“[What is more], it wasn?t just a 2000 event. Through the 14th of June [2001], telecom lost 16% and CLEC lost 22%. This was while the high yield market was coming back, and the overall index made or returned 5.7%. However, the much more stable environment in high yield has in no way yet found its way into telecom, and there?s no sense it?s going to get better anytime soon.”

It could take as much as 12 to 18 months for the sector to shake itself out and make a turnaround, Jacobi added.

Digging For Alternatives

Despite having a strong equity position, though, Carolina Broadband is at some point going to have to dig up the debt it needs in order to survive. In the meantime, it will play a waiting game, keeping a vigilant eye on the markets and hoping for marked improvements on Wall Street.

With the imminent employee departures, the company plans to stay the worst of the economic slump by tackling regulatory issues, exploring new technologies, analyzing its target markets and revising business processes, all of which Schuler characterized as not terribly cash-intensive.

It does have some burn, however, as it has spent a significant amount of its venture money since last year on pre-engineering and facility costs.

While Schuler said he does not have a clear cut idea as to when the company will be able to secure the necessary debt and start breaking ground for its network, he did say that once that occurs, he hopes to hire back some of the employees that have been let go. For now, all have received generous severance packages, he added, although he declined to provide details.

“It?s not going away,” said a VC with M/C Venture Partners, one of Carolina Broadband?s founding investors. “When the markets clear up and when the telecom nuclear winter ends we?ll get going again. We like the markets, we like the management team, it?s just a question of funding while we wait out the winter. We see [the CLEC] sector from an investor standpoint as one of the best it?s been. We stepped away from the sector last year as valuations skyrocketed and management teams raised capital that was cheap for them, but it?s a great time to be investing. You just have to pick the right management team and the right climates.”

In a prepared statement, Watts Hamrick, an investor with First Union Capital Partners, said, “We strongly believe in the management team assembled to operate Carolina Broadband? It?s a sound business plan, and we?re confident of securing the necessary debt capital to proceed.”

Success In The Lone Star State

A few hundred miles to the south and west, it?s literally a different world for Austin, Texas-based Grande Communications. By all accounts, the company, which also doesn?t like the CLEC moniker much, has managed to weather the telecom storm and gain a sizeable foothold in the corridor it serves between Austin and San Antonio.

“Grande had an ambitious plan, but it focused its energies on two markets and demonstrated success within those markets, and it is on the brink of a fully funded business plan,” said Blaine Wesner, a general partner with Austin Ventures, which participated in the company?s $231.8 million Series A financing last February. J.H. Whitney and The Centennial Funds led the round, and AltaComm, Hoak Communications, CIBC, Trinity Ventures, BancBoston, Toronto Dominion, Kinetic, South Atlantic, Convergent and Weiss, Peck & Greer also participated.

In addition, the company pulled in an additional $25 million in strategic money from Houston-based Reliant Energy Inc. in September.

Since then, Grande has laid most of its network between Austin and San Antonio, and provides voice and data services to several thousand customers, which has translated into nearly $100 million in total revenue, according to Bill Morrow, the company?s chief executive.

Cream Of The CLEC Crop

It seems to be a universal consensus among analysts that whether they call themselves CLECs or not, companies like Grande have been able to rise above the rabble because they have strong management teams, are focused and have delivered on their promises to customers.

Morrow said he agrees with those ideals. “There were a fair amount of management teams that tried to do too much, and they had no focus,” he said. “What this downturn in the market has done is really positioned it as a survival of the fittest. Once we get through that, there will be greater pieces of pie for each player as some others don?t make it. Some of the things that are happening are positive to our business case, but we never like to see failures because it hurts the entire industry.”

As for Grande brethren Carolina Broadband, Morrow said he understood in part the company?s decision to wait until market conditions improve before pursuing its business plan any further.

“Their decision not to go forward at this time until they have access to the financial markets is purely a financial decision,” he said. “Their investors are still there, they still have equity committed. It may be a timing difference. We?re at the stage in our company where we?re able to push through the financial cloud to look at getting on the other side. Some of those companies [like Carolina Broadband] have no build or customers yet, and they?ve opted to just wait six months.”

Shaking Up The Market

While many analysts agree that the CLEC shakeout is indeed upon us, a few believe that although the death of more than a few is inevitable, several of the ones that survive may trend toward consolidation.

“The shakeout is not as bad as it was with the DSL providers, virtually all of them have been wiped away,” said Stephen Shook, a telecom analyst with Wachovia Securities, who covers publicly-traded US LEC Corp. “In the CLEC sector, some will go away, and there will be others that will combine assets even if the price today is not particularly attractive. Maybe some will get stock from an undervalued company, and they can create value together and see their combined value go up.”

While the CLECs dig out of the post-New Economy doldrums, however, it seems that while the spoils will go to the fittest, the sad reality is, the group as a whole may not ever fully recover.

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