By Olga Kharif Warren Buffett is, to say the least, a pretty savvy investor. So when the Sage of Omaha's company, Berkshire Hathaway, recently invested $100 million in notes of fiber-optic network operator Level 3 Communications, it was a big deal to some money managers.
Level 3 announced that it would use the funds, part of a $500 million financing package, to consolidate the industry by buying up troubled rivals for pennies on the dollar. Many investors took the move to mean that some fiber-optic cable operators finally might be a buy again after two depressed years in the industry.
However, investors should think twice before following Buffett's lead. So far, the scenario he envisions for the fiber-optics business doesn't seem to be playing out on a large scale. Instead of selling out to stronger rivals like Level 3, even deeply troubled companies still hope to make it on their own.
FRESH STARTS? In some cases, they're going through Chapter 11 reorganizations that will substantially reduce their debt. But when they come out of bankruptcy, most of them will be forced to go right back to the fierce price-slashing that got them in trouble in the first place. So, it seems unlikely that the industry will stabilize, as Buffett expects, anytime soon.
The latest example is Williams Communications, which filed for Chapter 11 in April and recently rejected Level 3's bid to buy its assets. Instead, Williams hopes to get a fresh start at its Sept. 25 bankruptcy court hearing. All told, 15 fiber-optic network operators that entered Chapter 11 in the past 18 months could emerge this fall.
These rebirths spell trouble for the industry because the operators' business models haven't changed, says Andrei Jezierski, a founder of Internet infrastructure consultancy i2 Partners in New York. That means prices, which already are falling by 50% annually, will come under even greater pressure as competition heats up.
"HORRIBLE" MARKET. Jezierski predicts that most of the revived companies will be forced out of business within a year after coming out of bankruptcy. In the meantime, the industry's suffering will continue.
The bankrupt companies' attempts to hold on are understandable. At this point, their assets will fetch a penny or two on the dollar if they sell out to rivals like Level 3. "The market for assets right now is horrible," says Sean Mitchell, manager of special risks at Canada's Export Development Corp. bank in Ottawa, which sunk nearly $100 million in 360networks, a Vancouver-based company that owns 24,500 miles of intercity fiber optic networks.
Creditors hope to ride out the slump by keeping troubled network operators like 360networks alive at least until the market improves. The company then may be able to generate enough revenues to pay off its debt, Mitchell says. 360networks' bankruptcy court hearings are scheduled for Aug. 27 in Canada and Sept. 24 in the U.S. Even if the business fails within a year, "the market is going to change, and demand for assets might come back," Mitchell says.
COMMODITY OFFERINGS. Such hopes may turn out to be pipe dreams, says Melanie Swan, an analyst with telecom consultancy RHK. For most service providers, building a new network at today's prices and using today's more efficient technology would cost, perhaps, only a quarter of getting an old network up to speed, she estimates.
The other problem is that the fiber operators mainly plan on offering the same commodity service they did before: transporting data along their networks. Some companies, such as Metromedia Fiber Network, which have built up extensive inner-city networks, also try to offer services, such as helping corporations secure their data flows. But it's unclear how much demand there is for such offerings.
In any case, most of the network providers will be badly strapped for cash after emerging from Chapter 11. Marketing budgets will have to be savaged. And most of the companies probably will be unable to afford the tens of thousands of dollars in infrastructure investment required to sign up each new corporate customer.
Metromedia, for one, has been asking new users to pay for the cost of network additions out of their own pockets, but that's hardly a way to quickly ramp up revenues. After all, with their budgets squeezed, many corporations can't afford such a major lump-sum investment.
LOWER DEBT BURDENS. Of course, reorganization should help troubled companies cut their costs. For instance, 360networks's annual interest payments should fall from about $300 million to $20 million, estimates company Treasurer Chris Muller. If it reappears from bankruptcy, Williams' debt -- which stood at $5.91 billion at the end of last year -- will be largely wiped out.
By contrast, Level 3 avoided bankruptcy but still had $5.94 billion in long-term debt as of midyear. The staffing costs of companies going through Chapter 11 will also be way down. 360networks has pared its workforce from 1,900 to just 430.
Another company that has benefited from reorganizing is privately held Ethernet provider Yipes Communications, which entered Chapter 11 reorganization in March. Its cash burn rate is now just 20% of its prebankruptcy levels, reports CEO Dennis Muse. Now, Yipes believes it has enough funds to get to break-even, and it should be generating a positive cash flow within about 20 months, says Muse.
ANOTHER STRATEGY. Some see bankruptcy filings giving a few companies a competitive advantage. "People are using Chapter 11 as part of the business process," says industry veteran Danny Bottoms, who has built networks for everyone from Global Crossing, which filed for Chapter 11 in January, to Level 3 and Qwest.
By contrast, Bottoms' latest company, privately held OnFiber, where he is CEO, has been revamping its operations for the past 18 months without resorting to bankruptcy. It's trying to grow its way out of its problems: Revenues are up 400% since January, half of that through acquisitions of small, distressed telecom players.
Level 3 would like to do something similar on a much larger scale. But most of the rivals it might want to acquire have opted for reorganization and going it alone, instead.
BETTER DEAL. If Level 3 has to wait a year or two before going on an acquisition binge, it won't bother Buffett. As usual, he has hedged his bets. He can keep close tabs on his investment through his tight ties with Level 3 Chairman Walter Scott Jr., who sits on the board of Berkshire, where Buffett is CEO.
And Berkshire will receive annual interest of 9% on Level 3's convertible subordinated notes due in 2012. That's a nice return considering today's low interest rates. At the option of the holder, the notes can be converted into common stock for $3.41 a share. The stock is trading at $5.57 today.
But most investors would be unlikely to get such a good deal. So, following Buffett's example by investing in fiber optics players would be unwise, says Jezierski. Many of those going through reorganization may not make it. In the meantime, they'll be a drag on the whole industry -- and no one can be sure for exactly how long. Kharif covers technology for BusinessWeek Online from Portland, Ore.