Broadwing: A Potential Phoenix

12/03/2004 12:00 am EST

Focus:

George Gilder

Founder and President, Gilder Publishing, LLC

"Is there life after death?" asks George Gilder , regarding the telecom industry. "Amid the debris at the bottom of the pit, I seem to descry distinct signs of life." Here, in his review of Broadwing, once known as Corvis, he sees a "glimmer of a phoenix, deep in the shadows".

"A core vision of the telecom paradigm that we envision is an all-optical network, which in our opinion, is being pioneered by Broadwing (BWNG NASDAQ). Broadwing, formerly known as Corvis, is an all-optical carrier. Harvard Business School professor Clayton Christensen notes that in the telecom sector, existing technology is too complex and expensive and fraught with delay to enable desired applications such as robust and reliable Internet broadband, video teleconferencing, and interactive multiplayer 3D gaming. In this type of situation, Christensen prescribes an integration strategy, in which all the interfaces are optimized and customized for ultimate system performance, usually by one company. In optical networks, that company is Broadwing.

"Reminiscent of the vertical structure of the original Bell system, Broadwing is an integrated pure play in all-optical networks, inventing the equipment and running its subsidiary. As such, it is a prime mover of this paradigm. In March 2004, Broadwing acquired Focal Communications, a provider of voice and data services to 4,000 enterprise customers with networks in 23 tier-one markets. The deal advanced the company’s strategy of substantially lowering local network leasing charges by building or buying its own facilities on the edge of the network. In nine markets, Focal owns its own fiber optic facilities. Focal sales in 2003 were about $320 million, but bargain shopper Broadwing paid just $210 million.

"Broadwing’s third quarter results, which included one month of newly acquired Focal Communications, showed early signs that management’s strategy both to lower network access charges and to take market share, may be bearing fruit. While competitors AT&T, MCI, and Level 3 continue to decay as revenues decline, Broadwing’s sales held steady (before adding in Focal revenues) while margins improved. Gross margin of 31%, up from the 20s last year, is expected to climb to 35%-40% next year. Network migrations and capital build-outs have already reduced domestic average termination costs per minute by 54% year-over-year and lowered average cost per customer access circuit by 17% year-over-year. Focal’s local networks should add yet more to access savings while increasing top-line growth through cross-selling to Broadwing customers.

"The balance sheet took a hit, due mostly to one-time charges related to the acquisition. This greatly increases the likelihood that Broadwing will continue to pay its $225 million convertible in stock. The firm has repeatedly emphasized that a strong balance sheet is a major marketing tool with which to lure large customers. In a worst-case scenario, if Broadwing pays the remaining $166.7million in principal and interest in stock, the current share count of about 68.8 million will dilute a further 46% by February 2006. If by that time investors award a successful Broadwing with a more reasonable enterprise-value-to-sales multiple of 2.0 versus today’s 0.67, they will have tripled the stock price to nearly $18 despite the dilution. If the dilution ends earlier and/or revenues increase, then we can expect even more upside in the price.

"Do I see a glimmer of a Broadwing phoenix or merely a comatose Corvis? Who cares? By any name, it's a buy, I say. It's all-optical. It's two generations ahead. It's a ten-bagger. While my view of this stock may not be fair or balanced, I consider it a raving buy. It's not going to die and if it survives, it prevails. Go for it folks. That has been my message for the last two years.  Look at it as survival of the fittest fiber. Only Broadwing can follow the prices down into the pit and still make a profit. With the best network, Broadwing will be the survivor and champion."

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