Carlyle's Hawaiian Adventure

The firm wants Verizon's landline and directory business, betting that a modest investment in back-office operations will pay off big

By Alex Salkever

William Kennard is buying a big piece of paradise. The charismatic former Federal Communications Commission chairman in the Clinton Administration is spearheading an effort by Carlyle Group to purchase Verizon's (VZ ) telecom assets in Hawaii. Kennard has been a partner at the secretive and often controversial Washington (D.C.) private-equity firm since May, 2001.

If the Hawaii Public Utilities Commission (PUC) approves it, the $1.65 billion deal is expected to close in early 2005. The operation would then be renamed Hawaiian Telcom.

In many ways, it's a classic Carlyle play -- one that goes against conventional wisdom. Left out of the deal are Verizon's faster-growing and profitable wireless assets. Carlyle is buying only the local, long-distance, and phone-directory assets, and Wall Street has been discounting the local phone business at a furious clip.


  But Kennard believes that the $24 million Carlyle plans to invest in modernizing Hawaiian Telecom's back-office operations will reap big cost savings, while Carlyle's handpicked management team makes the new Hawaiian Telcom more efficient and profitable. Kennard will sit on the new company's board, and Carlyle has already announced that Michael Ruley, CEO of Houston-based business-telecom-services company Nextira One, will serve as CEO.

The question now: Will Kennard and his Carlyle partners extract a profit from paradise as they expect? Or will they end up with the rough end of the pineapple?

On the surface, it's hard to see much to like in the deal. Cable and media giant Time Warner (TWX ) is poised to launch local phone service in the islands. And the regulatory climate for rural regional phone carriers remains uncertain as the FCC continues to evaluate how much of a premium rural carriers should be allowed to charge for phone calls terminating on their local networks.


  Verizon Hawaii has 707,000 lines in Hawaii and 1,700 employees. It logged 2003 revenues of $610 million and operating income of $58 million. But both measures have been falling for the past three years. Verizon has been hurt as more businesses and consumers switch to wireless phones or replace second phone lines used for dial-up Internet access with broadband cable modems.

The entry of Time Warner into the Hawaii local phone market could accelerate that trend. In Portland, Me., 40% of Time Warner's cable customers elected to add phone service. The heightened competition may be why, in its filing with the Hawaii PUC, Carlyle estimated that Verizon Hawaii's top-line revenues will increase by only $96 million over the next decade, a compound annual growth rate of just 1.5%.

Worse still, Verizon Hawaii has such antiquated back-office systems that customers cannot pay their bills online via credit card. Since most of those operations are based on the mainland, Carlyle will need to rebuild them from scratch. Kennard's pledge to bring all operations back to the high-cost environment of Hawaii could add further drag to the bottom line.


  However, Kennard is optimistic about Carlyle's ability to pare expenses. "We think the operational costs here are heavier than you would need to run a company of this size," he says.

The deal could saddle the new phone company with as much as $1.5 billion in debt, so analysts wonder how Carlyle will ever justify the already low price of $2,300 per local line it's paying in the acquisition. "Although they'll get some nice, stable free cash flow out of the business, it appears this is not a high-growth operation," says Standard & Poor's telecom analyst Todd Rosenbluth. Bond-rating agency Fitch downgraded Verizon Hawaii's commercial paper one notch on word of the deal and has the operation on a further negative-watch list.

Carlyle, however, is hardly a telecom newbie. In addition to Kennard, the firm -- which controls $19 billion, primarily in private-equity investments -- boasts among its partners a former executive vice-president of Verizon, a former chief financial officer of long-distance company MCI, and a former CEO of the red-hot mobile-phone company Nextel (NXTL ).


  "If you look at Bill's talents, as well as the talents of the other guys at Carlyle, you would say they have pretty good odds," says Blair Levin, a managing director at asset-management firm Legg Mason and a former FCC chief of staff under Chairman Reed Hundt.

Kennard sees an undernourished, undervalued asset. The deal includes not only access lines but the valuable directory business, one reason he insists the operation is well worth the price Carlyle is offering.

He also argues that revenue growth could end up being higher than expected. "The company was chartered by the King of Hawaii in the 1880s, and it has huge brand recognition. We think that reconnecting the company to its local roots and empowering the company to make local decisions will create significant opportunities for growth," says Kennard. He maintains that Verizon Hawaii lost touch with local customers when it shifted marketing and customer-support operations to mainland locations.


  Verizon Hawaii lagged behind its mainland counterparts in offering bundled calling plans that would include flat-rate local and long-distance calls alongside digital subscriber line broadband Internet service. But Kennard also believes that the network is modern enough to support some revenue-generating whiz-bang technologies, such as delivery of video programming.

In Kennard's view, customers have fled Verizon Hawaii at a significantly lower rate than comparable mainland companies. As for the Time Warner challenge, "We're fully prepared and will mount a compelling, competitive response," says Kennard, who rules out nothing -- including bundles with wireless carriers and satellite-TV providers.

At the same time, Kennard & Co. are placing what looks like a safe bet that Hawaii's phone company will be protected by the big guns in Washington, D.C. The FCC's leadership is in limbo since Chairman Michael Powell isn't expected to return regardless of the Presidential election outcome, so action to rebalance rural phone rates seems to be several years out.


  Even better for Carlyle, the chairman of the Senate Commerce Committee, which has a huge say in determining the content of telecom legislation, will be either Democratic Senator Daniel Inouye of Hawaii, if John Kerry wins, or GOP Senator Ted Stevens of Alaska, should the President be reelected. As representatives from states far from the Capitol's center of power, the two have a long history of protecting each other's interests.

The ultimate endgame could be a recapitalization of Hawaiian Telecom or even a public offering, says Kennard. Local opponents to the deal fear that Carlyle will flip the company quickly for a profit. To mitigate that worry, Carlyle is recruiting a roster of prominent Hawaii business figures to invest their own money in the venture. With the support of the telcom unions, the deal looks set to sail through final regulatory approvals next year.

Of course, should Carlyle fail to spawn new growth out of Hawaiian Telecom, it may someday regret the deal. For now, though, it sees a deal crafted in paradise.

Salkever is Technology editor for BusinessWeek Online

Edited by Thane Peterson

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