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January 1, 2002

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Wholesale Channel

Posted: 1/2002

Wholesale Channel

Are Utilicoms Pulling the Plug?
Energy Company Broadband Spinoffs Revisit Wholesale Strategies

By Josh Long

Touch America, the telecommunications subsidiary of Montana Power, has its work cut out in 2002.

As of November, The Montana Power Company was working to raise $40 million, after violating credit covenants while it awaited approval to sell its utility business to NorthWestern Corp. for $1.1 billion. The sale would leave Montana Power with only its wholesale telecommunications business, which it would try to increase market share in one of the most cutthroat sectors of the U.S. economy.

Some critics say Montana Power rolled the dice in the wrong industry at the wrong time. In 2000, it bought U.S. West’s dwindling long-distance residential business for roughly $200 million and divested its energy businesses.

But Kaufman Bros. L.P. managing director Vik Grover says the company has been operating in the telecom sector for some 15 years. Because of that, it would have a huge advantage over its wholesale competitors, if it can sell its utility and emerge as a national carrier’s carrier with no debt.

If this proves out, Montana Power would be an anomaly in an industry billions of dollars in the hole.

During a November interview, Grover said he had expected the Montana Public Service Commission to approve the deal months ago. He cited “political agendas” as a reason for delays.

Montana Power is one among several energy and electric utility giants to branch out into what once appeared to be a lucrative wholesale telecom sector. Now struggling to gain market share during a recession, none of those energy and utility companies is earning what they had projected. Some are retaining their wholesale strategies, while others either have retrenched or raised the white flag.

Utility in Big Sky Bets

on Telecom

Montana Power is laying all its chips on the table betting solely on telecom. So far the gamble hasn’t paid off.

Its residential long-distance business is dwindling and nasty legal disputes with Qwest Communications International Inc. mean an anticipated loss of $100 million to $120 million in annual wholesale long-distance termination traffic, according to Kaufman Bros.

The company’s third-quarter results in 2001 were not inspiring: Voice revenue alone declined $10 million compared to the first quarter of 2001.

Montana Power generated $54 million in earnings before interest, taxes, depreciation and amortization, down from Kaufman Bros’ expectations of $96 million.

Touch America Inc. (TA) will focus on selling ATM, frame relay, IP and private line services to service providers and enterprise customers in 2002

“Over a relatively short period we have seen many dramatic changes in the telecommunications environment and TA has been impacted by those changes,” Montana Power and Touch America chairman and CEO Bob Gannon told investors and analysts in a third-quarter earnings call. “Touch America has and will continue to respond appropriately to those changes. We have the expertise and business skills to weather this storm and continue to be a successful leader among the emerging telecom companies.”

Montana Power anticipated receiving approval to sell its utility to Northwestern in the first quarter of 2001. After the sale is complete, Touch America will operate a 26,000-mile fiber network with $1 billion in assets, cash in the bank and no debt, says Gannon.

El Paso Retrenches

Even before the telecom market crashed, consultant Fred Joyce, principal of Joyce Telecom Group LLC, advised utilities not to dabble in the telecom industry.

He explains the old-fashioned regulated utility monopolies had never had to worry about competition.

“They didn’t really know how to compete,” says Joyce. “Often times utilities think they have the in-house expertise to do this when in fact they need to … bring in the expertise from the telecom business in order to be successful.”

What is more, he and others point out, some energy and utility companies had

bad timing.

Says Joyce: “Overall utilities were in a mad scramble at the very tail end of the Internet gold rush.”

El Paso Corp. was one of them. The Houston-based natural gas and energy giant nixed plans in October to build a backbone network throughout the United States. It will continue operations in Texas and through its Chicago-based Lakeside Technology Center, a carrier hotel.

El Paso Global Networks had earmarked $1.5 billion during four years to build a backbone network across the country and within local cities. Executives now anticipate spending only $60 million in their broadband business this year.

“The regulatory environment in our judgment is skewed unfavorably against real competition and today the market fundamentals are very, very weak,” Greg Jenkins, CEO of El Paso Global Networks, said during a national conference call last fall. “Our merchant model does require a unique insight into value and without that unique insight into value we will not put money to work.”

AFN, Progress Telecom

Plow Ahead

Still, many regional wholesale providers with utility roots are plowing ahead. AFN Communications LLC, which is operating in secondary markets typically prone to generate higher margins than in clustered cities such as New York and Los Angeles, is one of them.

Having lit 2,000 of 8,000 route miles spanning 13 states in the Northeast, AFN announced selecting CIENA Corp. in November as its primary optical networking partner to provide private line and optical wave services.

Former AFN chief executive Gordon Martin has left the company to lead the

struggling wholesale unit of Qwest Communications International Inc. Brian Cantrell, former executive vice president and CFO, has been replaced as president of AFN.

Company executives say Martin’s decision to leave AFN was a painful one for him, adding that his departure does not signify a weakness at the company.

Martin, now Qwest’s executive vice president of global wholesale markets, did not return calls from PHONE+ seeking comment on his departure.

AFN, conceived through the asset contributions of several energy and telecom companies in exchange for equity, expects to reach EBITDA positive in 14 months and cash flow positive shortly thereafter, says AFN’s vice president of marketing Mike Friloux. The company also announced it was closing a $180 million senior term credit facility.

Executives have pointed out AFN had a financial advantage over other regional wholesale providers, because it tapped the assets of energy and telecom companies in exchange for equity, rather than borrowing billions of dollars on Wall Street.

During the last few years many other natural gas and energy companies used their rights of way to build regional and national fiber-optic networks for other service providers or to start their own broadband unit.

Progress Telecom, a subsidiary of Progress Energy, is one of those regional companies. (Progress Energy was formed through the merger of Carolina Power & Light and Florida Progress in December 2000.)

In October, Progress Telecom announced an alliance with New York-based Con Edison Communications Inc., a subsidiary of electric utility Con Edison Company, and Edison Carrier Solutions, a division of electric utility Southern California Edison to market each other’s products and services. The alliance underlines the movement among regional and national wholesale providers to forge alliances rather than to build networks.

Progress Telecom has focused on building a network in second- and third-tier markets, according to Frank Dane, the company’s vice president of sales and marketing. The company serves the eastern United States, operating roughly 150 points of presence (PoPs) from Miami to New York.

Progress Telecom had access to communications infrastructure through Florida Progress, which used the network to monitor voltage in substations, says Dane.

In 1985, Florida Progress began providing service to telecom companies, leasing microwave towers to government agencies and wireless companies. More than 15 years later, Progress Telecom is selling back-haul capacity and wireless attachment space through its parent’s electrical assets.

Enron Prepares for Chapter 11

The electric utilities have not been the only ones eyeing the broadband sector with enthusiasm since the mid to late ’90s.

The natural gas and energy companies with expertise in risk management and trading had reckoned they would make a fortune selling bandwidth in a liquid market.

In 1996, Williams Communications, Enron Corp. and Montana Power entered the long-haul fiber-optic market by building a West Coast route along their respective rights of way.

As of November, Enron owned an 18,000-mile network for which analysts say the company paid way too much. The Houston-based company was embroiled in controversy and one setback after another last fall, and its stock fell to its lowest point in six years, according to Reuters.

Shortly after the U.S. Securities and Exchange Commission (SEC) launched an investigation into partnership arrangements made by its former CFO, Andrew Fastow, Enron rival Dynegy Inc. announced an agreement to acquire the struggling energy company. Subsequently, Dynegy withdrew from the agreement and as of deadline Enron preparing to file Chapter 11 bankruptcy protection, according to Reuters.

Perceived by many as the potential market maker in broadband trading, Enron took Draconian measures in its retrenchment because of several lackluster quarters. The company took a $180 million charge in the third quarter associated with the restructuring of its broadband unit; and subsequently wrote down the value of its $600 million broadband investment, designating its telecom business a noncore asset, Enron spokeswoman Shelly Mansfield says.

The company is expected to try and sell its broadband network at a time when network assets are being scooped up for dimes and pennies on the dollar.

“Noncore businesses do not provide value to Enron’s core franchise and as such we plan to exit these businesses in an orderly fashion,” the company stated in a Nov. 16 filing with the SEC.

Other energy companies also have divested their telecom assets, including energy giant Conectiv. The Wilmington, Del.-based company completed in November the sale of competitive carrier, Conectiv Communications to Cavalier Telephone.

“Completing the sale of Conectiv Communications is another milestone in our effort to focus on our core energy businesses,” says Conectiv president Thomas Shaw.

Meanwhile, Dynegy still remains committed to broadband. It lit its 16,000-mile all-optical mesh network in October and anticipated completing its metro network in 18 cities by the end of 2001.

Deanna Cox, a Dynegy spokeswoman, says the company negotiated smoking deals in the United States and Europe at the appropriate time — after the market peaked. Dynegy purchased London-based iaxis Ltd., now Dynegy Europe Communications taking over an 8,750-mile network reaching 22 cities in seven countries; and bought Colorado-based communications solutions company, Extant Inc., which was building a U.S. data network.

Dynegy’s total broadband investment is $700 million. “We waited and watched for the market to slow before we made those purchases. We did not buy at the peak,” says Cox. “We were able to build a global presence for millions, not billions.”

Utilities Limit Debt

Hampering Global Carriers

The investment is no small change, but may seem paltry compared with the mighty builds of Level 3 Communications Inc., Williams Communications and Global Crossing Ltd.

In that respect, some electric utilities have salvaged a good night’s rest by limiting their builds to specific regions. And the privately-held telecom companies with utility backing have another advantage — their parents have money.

Level 3, Williams and Global Crossing have no such fortune, and they are hustling to reduce their mountain of debt.

In what it called a modified Dutch auction, Level 3 bought back $1.7 billion in debt for $721 million, reducing its red ink to roughly $6.2 billion.

In a less public manner, Williams, $5.276 billion debt, as of November, retired $550 million in debt on the market for $236 million, representing 43 percent of its face value. For every dollar spent on retiring debt, the company saves $6 to $7 on future cash outflows, explains spokesman Anthony Hoffman.

Global Crossing, saddled with $7.7 billion in debt, has not ruled out such a strategy.

Williams, which has the least amount of debt among those three carriers, plans to be cash-flow positive by the end of 2003. Hoffman says the company reported growth each quarter since going public in 1999, and he predicted 10 percent to 20 percent growth during the last quarter of 2001.

Williams executives say they can thank Williams, their parent company, for helping them complete a 33,000-mile network a year ahead of schedule — and before the market crashed.

The telecom company spun off from its parent last year in order to retain shareholder value, say executives.

But Williams Communications has retained a perk through its parent. If for some reason the telecom carrier defaults on a $1.4 billion structured note, Williams, a 4.35 percent public stakeholder in the telecom company, has committed to issue stock to those holders equivalent to the face value of the bonds.

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