Chapter 11 'Fix' is Doubtful

It may take many months before WorldCom Inc. (OTC: WCOEQ) can emerge from the largest bankruptcy process in history. Will it even help?

Many doubt that large-scale telecom tragedies will manage to transform themselves into feel-good stories with happy endings. The other option is that the whole industry could devolve into a cyclical situation with repetitive bankruptcies, just like the airline business.

According to a recent study by industry analysis firm i2 Partners LLC, troubled carriers have little chance of fixing their problems through a financial restructuring.

The study, titled “Telecom Distressed Assets: Bondholders Beware,” cautions that many of the companies that now seem to be emerging so confidently from their Chapter 11 slumber are setting themselves up for another, more fatal fall. This is because the companies appear to be doing little more than trimming down operations and cutting operational and capital expenses. The business plans -- the ones that failed -- stay the same.

“These companies are scrambling to shrink their business,” says i2 Partners analyst Andrei Jezierski, who is one of the co-authors of the report, “but the overall profile is pretty much the same as when the bomb went off. It’s not a question of returning to profitability. There never was any.”

Other observers not only question the validity of certain restructuring plans, but of Chapter 11 itself. Oliver Hart, a professor of economics at Harvard University and the author of the book Firms, Contracts and Financial Structure, says the main problem with most companies emerging from Chapter 11 is that the incumbent management is left in place. “If somebody has failed to pay their debts, they shouldn’t be left running the company,” he says. For example, none of the top executives at 360networks Inc. have been replaced since the company filed for bankruptcy.

There are plenty of test cases (see Global Crossing Finally Sold, Williams Amends Reorg Plan and 360networks Subs Plan Protection). And evidence shows things aren't progressing well. 360networks, the first of the large carriers to get the ball rolling by filing for bankruptcy in June last year, has yet to reemerge in a vaunted "restructuring" (see 360networks Calls It Quits).

For its report, i2 studied the proposed restructuring plans of three second-tier carriers, and although it won’t reveal which companies it looked at, 360networks is probably on the list. Other companies the firm may have looked at include Williams Communications Group Inc. and Global Crossing Holdings Ltd.

Indeed, some of the restructuring companies agree they're not changing their approach.

“We’re still concentrating on the same products… especially wholesale,” says Chris Mueller, treasurer and vice president of finance at 360networks. The company is also still concentrating on one area that even observers who don’t believe in a fiber glut have written off as unprofitable: dark fiber (see Solution for the Fiber Glut: Turn It Off?). Mueller claims that, while no one in the U.S. is buying dark fiber, 360networks can make a tidy profit selling it to Canadian service providers looking mainly for cross-border capacity. He says that even after filing for bankruptcy, the company has made several dark fiber sales in the $5 million to $10 million range.

Does such a scenario bode well for repairing the industry? There's plenty of reason to be skeptical.

Backbone-only carriers, which have already taken a severe beating, will be hit especially hard by the harsh competition, according to the i2 report. “A replay of the prior 'me too, but cheaper' business strategies is highly unlikely to result in successful reorganization of sub-scale players despite the enormous balance sheet advantages they are gaining from re-organization,” the report states.

Mueller insists that 360networks has a much better chance of survival this time around. The carrier, which once had nearly 2,000 employees, a network that stretched around the globe, and a debt load of about $3 billion, will reemerge with a little over 400 employees, a network covering only the U.S. and Canada, and, most importantly, a debt load of only $200 million.

“We are not far from being a cash-flow neutral company,” Mueller says, insisting that if the company lands a few good sales, it should be cash-flow neutral by the end of the year. Mueller does not, however, have any illusions that the company, which he says will probably emerge from bankruptcy in September, will be experiencing growth anytime soon. “It will be difficult for us to grow in the current environment. Ideally, we would like to do more than survive.”

Other industry analysts agree that getting rid of most of the financial baggage could help a company like 360networks survive. “Downscaled and with their debt payment removed is probably a lot of what these plans incorporate,” says Sean Doherty, managing partner of Venture Asset Group. “On the positive side, they’ve probably gotten a better handle on the financial side… and are more price-competitive.”

Frank Dzubeck, president of Communications Network Architects, says there wasn’t necessarily anything wrong with what bankrupt companies like 360networks were trying to sell. “What got them was the fact that debt-to-equity ratios were completely out of whack,” he says.

But there are other problems with restructuring plans, as pointed out in the i2 report. The plans also display an unrealistic view of the competitive landscape, the i2 report states. “Transport price assumptions of 20% compounded annual declines assume a relative stability which is as yet unlikely.” The report anticipates that on the most competitive routes, at least, prices will fall much lower.

Dzubeck disagrees. “Everybody now is working with such low margins that they can’t go much lower" without falling into bankruptcy themselves, he contends. That’s not to say that all the players will survive. “There might be too many of them. Towards the beginning of next year, we’ll see a lot of these guys merge.”

And what will happen if the companies now emerging from Chapter 11 fail again? “They’ll end up merging out if they’re not successful,” Dzubeck says. “They won’t get a second chance.”

— Eugénie Larson, Reporter, Light Reading
http://www.lightreading.com