Corporate Finance

High-Wire Act

Coping with debt covenants is the name of the game for cash-rich telecom companies.
Jinny St. GoarSeptember 1, 1998

From the perspective of, say, a start-up PC company, local-service telecommunications companies have it made. Wall Street’s fervor to supply capital to those fledglings knows almost no bounds. Indeed, the industry is awash in cash.

But for all their wealth, young telecoms operate in a tough environment. With the industry consolidating rapidly, telecom managers must either spend vigorously to solidify their market positions or face extinction.

Absent investment-grade credit ratings, however, many of them can’t spend as freely as they would like. Aggressive competitors have tapped the high-yield debt market, burdening them with restrictive covenants and high interest payments. In a consolidating industry, such covenants impose a Catch-22 of sorts. By constraining acquisitions and other spending, covenants impede growth strategies that drove the companies to the debt market in the first place. Unless these managers find ways to sustain their growth within the constraints lenders impose, they may not be able to escape the clutches of competitors with deeper pockets.

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GST Telecommunications, in Vancouver, Washington, is a case in point. With a total of $775 million in long-term debt at the end of 1998’s first quarter, GST was still generating net operating losses and negative quarterly earnings before interest, taxes, depreciation, and amortization (EBITDA) of $14.8 million on revenues of approximately $30 million. That left the company with a hefty debt-to-equity ratio of 4.6 to 1, after having dipped to 4.2 to 1 as of the end of second- quarter 1997.

GST has four significant debt issues outstanding, all with interest deferred. In three offerings, the interest accretes or accrues until five years after the offering date, when cash interest payments start. The fourth offering was structured to finance the first three years of interest payments. The net result: GST faces the prospect of significant interest costs starting in the year 2000–about $80 million annually, and two more chunks of annual interest payments in 2002 and 2003. When the bell tolls, GST must redeem roughly $350 million in 1995 notes paying 137/8 percent, plus $265 million in 1997 notes paying 131/4 percent.

In the context of GST’s first quarter 1998 results, that debt load represents approximately 120 percent of EBITDA. To meet its debt service and satisfy its covenants, GST will have to expand an expensive telecommunications network while keeping costs under control–objectives that may sound mutually exclusive in the face of fierce competition.

“We have the money to launch our business,” says Daniel Trampush, GST’s chief financial officer since March 1997. Trampush is accustomed to cost controls; he spent 25 years on the other side of the aisle as an Ernst & Young LLP telecommunications-industry consultant.

A Stiff Price

Restrictive covenants, the price of growth capital, are stiff. Although GST can do certain types of equipment financings, it cannot exceed $100 million in general obligation debt (including $70 million in notes payable to Tomen, a Japanese telecommunications company). And, GST’s investment in international companies is limited to $13 million total, a restriction with less bite since the company’s recent decision to focus exclusively on opportunities in its home market. Domestically, GST cannot invest more than $10 million unless it obtains control, ruling out joint ventures and minority interests. Provided GST obtains control, however, its ceiling is limited only by the resulting debt-to-equity ratio.

GST cannot raise any additional debt financing, however, unless it simultaneously adds equity; any new financing must have a 2- to-1 debt-to-equity ratio. Those covenants date from two 10-year high-yield financings done in late 1995 that raised a total of about $180 million with interest costs of 137/8 percent.

A single transaction that closed early last year highlights how some restrictions also foster growth strategies. In February 1997, in an effort to shed noncore businesses, it sold its remaining 63 percent of NACT, a telecommunications manufacturer acquired in 1993 for $86.5 million, a steep gain since paying $8.9 million for all of NACT. Covenants ruled out keeping a minority interest or applying more than a fraction of the proceeds to operating expenses or debt reduction. Instead, GST was required to buy new telecom businesses or beef up its own infrastructure.

Given GST’s locale of service–in such West Coast cities as Vancouver, Washington, and Los Angeles, and in Hawaii–Trampush and his colleagues are still considering investment opportunities in both North America and overseas. Amid current difficulties in Asia, for example, Singapore still looks relatively attractive to Trampush. That assumes GST can keep within the $13 million limit on total investments.

“We are exploring other options, perhaps creating other companies out of GST–a special- purpose corporation that would be outside of this covenant. We could get the benefits without having to toil under these limitations that restrict us in making investments that we believe could be pretty good,” says Trampush ruefully.

“It’s not a package you’re thrilled to have, but it’s not crippling to the company’s business pros-pects,” says telecommunications analyst James H. Henry of Bear Stearns & Co., in New York, a co-underwriter of deals subsequent to the NACT transaction. Expectations are pinned, though, on continued steep growth. So far, so good. In the second quarter of 1998, GST logged a 25 percent quarterly increase in the number of local access lines sold. That substantial improvement in revenues is sufficient cause for confidence.

Because of constraints, Trampush is particularly focused on two aspects of GST’s business now: he brings the wealth of his industry experience to bear on both the strategic considerations to increase revenues and the cost-control measures.

“We are always thinking about whether other channels [of revenue creation] exist, and whether we are finding all the appropriate customers,” says Trampush. And to reinforce his strategies, he is pushing his accounting staff to provide the most up-to-date information to GST’s sales staff. “We are constantly looking at our tracking strategy: Does it need to be adjusted?” he says.

And as for cost control, Trampush has instituted more management reporting requirements since joining GST 15 months ago. “We are challenging the way we spend money, with budgets by market–both geographically and by business lines,” says Trampush. “In the simplest terms, we are asking a lot more questions to create a far more robust accounting system than existed before.” Capital projects are evaluated to gauge whether, for example, the company should build its own network or buy capacity from another carrier. And the new budget process highlights which individuals are responsible– both fiscally and operationally–for delivering new products to customers.

Headquartered in Washington State, GST has homed in on small-business customers in the western continental United States and Hawaii. Offering local dial-tone service in 14 markets, GST can do it all for a small enterprise: long distance, Internet, data transmission, private lines, and local dial tone.

The last category showed a 41 percent growth in revenues from the fourth quarter of 1997 through the first quarter of 1998, analysts estimate, generating $4.86 million in first- quarter 1998 revenues (up from $3.45 million in fourth-quarter 1997). And as a percentage of GST’s total telecommunications revenues, switched local services have climbed from 11.5 percent in the first quarter of 1997 to 16 percent in the first quarter of 1998 (excluding revenues from a subsidiary that was sold during the quarter). Bear Stearns’s Henry projects that ratio will hit 30 percent by the fourth quarter of 1998. Trampush’s target: local services should account for 40 percent of total telecommunications revenues by the end of 1999.

Adding to his challenge, Trampush presides over GST’s finances during a period of unprecedented regulatory and technological change. With the Telecommunications Act of 1996, the entire business changed. In late 1996, Congress finally enacted long- anticipated changes to the telecommunications laws, permitting, for the first time, competition to provide local telephone services–the arena in which GST has focused ever since. The changed rules actually have the effect of making the restrictive covenants seem less restrictive, as GST now has the prospect of generating more revenues from local telephony than would have been possible under the laws that governed in 1995, when the company agreed to the covenants. In the past 18 months, meanwhile, old-line circuit- switched systems with high-profit margins have been giving way to newer packet-switched systems that supply the underpinning for the Internet protocol that works on asynchronous transfer mode lines. “Those calls from New York City to Afghanistan, for example, that long-distance companies have been charging $1.94 per minute for become just as easy and cheap to complete as the 30-cent-per-minute calls from New York City to New Jersey,” explains telecommunications consultant Anton Self, of New York­based Telephant LLC.

GST already relies on packet switching. In May, GST formally announced a network architecture that will enable customers to embrace simultaneous voice, data, and video transmissions–the same architecture that Sprint announced two weeks later with much ballyhoo.

Ironically, the developments that foster the growth of efficient upstarts like GST put a damper on one exit strategy that investors envision. Those who anticipate GST’s acquisition by a more-seasoned, investment- grade telecom carrier will find fewer such candidates around. Absent a big brother, GST might have to live with uncomfortable covenants longer than expected.