Description

**This is a recommendation to buy Williams Communication’s debt (currently trading in a 10-11 context), not the WCGRQ stock.**

Williams Communications (WCG) is the “other” (to Level 3) independent telecommunications network company. Like Level 3, the company’s main business strategy is to be a “carrier’s carrier.” That is, WCG does not market its services to retail or business customers. Rather, it focuses on providing services to “bandwidth-centric” customers (basically, phone and technology companies). Unlike Level 3, WCG is focused on both voice and data (Level 3 is focused primarily on data).

Bankruptcy Proceedings

Also unlike Level 3, WCG is currently in chapter 11. With similar network revenue and cash flow, Level 3 and WCG took divergent paths primarily (my opinion) due to better financing for Level 3. While Buffett and company gave an additional $500 mil to Level 3 for strategic acquisitions (with Level 3’s first attempt being WCG), the banks pulled the plug on WCG, demanding a financial restructuring.

WCG’s bankruptcy was somewhat unique due to its relationship with its parent, WMB (which obviously has its own issues). I would rather not get too much into it, as it has little to do with the current situation, but basically WMB initially submitted claims roughly equal to those of the bondholders. There was some debate as to whether WMB’s claims should be equal or subordinate to those of the bondholders, and, as this was going on, WMB almost entered bankruptcy itself.

In an effort to remove itself from the situation and to receive some cash for its claims, WMB agreed to sell most of its claims to Leucadia (LUK) for $180 mil. LUK also agreed to invest another $150 mil in the company (as required by the banks, per the plan). According to the approved deal, in return for its investment ($330 mil), LUK will receive 44% of the new equity; the bondholders will receive 54%, and the remaining 2% will go to holders of securities-related claims.

The bankruptcy court approved the deal outlined above on September 30th. Upon exiting bankruptcy, WCG will have $375 mil in bank debt, a $150 mil mortgage on its corporate headquarters (bought from its parent at a substantial discount) and about $240 mil in cash.

Relationship with SBC

Another unique factor regarding WCG is its relationship with SBC. In 1999, WCG and SBC signed a preferred provider contract whereby WCG would handle all the interstate long-distance voice and data traffic for SBC. The contract, while advantageous to SBC as it is a cost-plus deal, is of vital importance to WCG as SBC provided 40% of WCG’s revenue last quarter. The relationship also allowed WCG to grow revenues last quarter while in bankruptcy as competitors, including LVLT, saw a year over year decline in network revenue. Recently, there were rumors that SBC was trying to get out of the contract, possibly in an effort to acquire assets from WorldCom. Fortunately, WCG and SBC recently reached an agreement whereby the contract, for the most part, will remain as originally structured.

With the contract in place, WCG should see revenue growth from SBC as SBC enters more and more long distance markets and further penetrates the corporate segment. For example, the California PUC recently approved SBC’s application to provide long-distance service in the state (after years of effort). SBC still needs FCC approval to enter the market. However, that approval should be given either late this year or early next year. Access to the California market is obviously important to SBC, but it is even more important to WCG as ALL of the interstate long-distance traffic generated by SBC travels over the WCG network. Access to California will also help SBC serve corporate customers – a market SBC is dying to get more into (which, of course, will also be beneficial to WCG). Bottom line, over the next few years, SBC’s entry into the California and other states long-distance market should provide huge traffic and revenue growth to WCG. And, as network service providers struggle to get more and more traffic on their systems, WCG’s relationship with SBC is a tremendous advantage as it offers a large and “natural” source for that traffic.

Operations

Operationally, WCG reported slightly below $300 mil in revenues last quarter, a slight increase from the year ago period. 40% of the quarter’s revenue came from SBC (see above). Beyond SBC, WCG’s other major customers include Verizon, Yahoo, Boeing and various other telecommunications companies (including WorldCom). For the first 6 months of 2002, the company burned through roughly $150 mil in cash. However, that included cash interest expense of roughly $175 mil and various one-time receivables of around $100 mil. Basically, it appears WCG operationally (including cap ex) burned through slightly less than $100 mil for the first 6 months. Regardless of the exact number, WCG is not currently generating free cash flow, and will not be able to unless revenues continue to increase (see risks below).

Valuation

Currently, WCG’s bonds are trading in a .10-.11 context. (The claims are slightly different for each issue due to amortized interest going into chapter 11. For this discussion, I will assume they all have the same claim.) With a combined $2.45 bil in claims (face value), an 11-cent bond price computes into a new equity valuation of roughly $500 mil for the company, and an enterprise value of slightly over $1.0 bil. Is that a good value?

Well, valuing WCG is a fairly difficult task. Like LVLT and various other telecom companies, the company’s prospects are contingent upon voice and data traffic growing substantially over the next few years. The company’s projections show moderate growth in 2002, steady growth in 2003, and exceptional growth in 2004. Of course, these projections are reliant upon numerous highly variable factors, and a large discount factor should be applied in using them for a valuation analysis. But even with a large discount, WCG appears to be substantially undervalued at its current implied enterprise value. And, if the company’s results come anywhere near its projected results, WCG should be valued far in excess of $1.0 bil over the next 12 to 18 months.

The company can also be valued based on LUK’s bid. For a $330 mil investment, LUK will receive 44% of the new equity. This translates into roughly a $400 mil implied value for the bondholders’ claims, or 16.5 cents per bond. Hence, you have the opportunity to purchase the new equity of WCG at a substantial discount to LUK’s cost. Also, I would assume LUK is expecting some sort of return on its investment. So, I would consider LUK’s cost the floor valuation when valuing WCG off of the LUK transaction. Of course, you might assume LUK overpaid for their stake, but I consider LUK’s management to be pretty good investors.

Finally, a comp analysis can be applied using LVLT. As stated above, the networks of LVLT and WCG are currently generating similar revenues and cash flow. There are a few differences, but I would contend the intrinsic value of the two networks are roughly the same – I could even argue WCG’s network is more valuable given its ability to handle voice traffic and its relationship with SBC (the market obviously differs with me). Now, LVLT itself could be valued numerous ways. The company has roughly $4.9 billion in net debt – $1.1 bil bank debt and the rest in bond debt. And, I believe (although I may be wrong) LVLT’s bonds (not including the recently issued convertible) are trading at 52 to 53 cents on the dollar. So, a back of the envelope calculation based solely on the debt would value LVLT at roughly $2.6 billion. LVLT has the two new software-reselling companies and a coal operation that combined could be valued at around $300 mil combined – leaving a rough network valuation of $2.3 billion. Applying that same EV to the restructured WCG implies an equity value of $1.8 billion and a bond recovery of roughly 40 cents on the dollar. Quite a return from the current quote of 11 cents! Of course, you could value LVLT even higher considering the current stock price, what EV is required for Buffett and Co to be made whole on its convertible, or considering net debt should be higher since LVLT will use a substantial portion of its “excess” cash going forward. Regardless, the comp valuation analysis implies tremendous upside for the bondholders.

Risks

Cash Drain/Credit Crunch
Based on the company’s filings and some assumptions of costs going forward, it appears at the current rough $1.2 bil revenue run rate the company is cash flow break-even to slightly negative operationally before interest and cap ex expenditures. With a much reduced debt structure, interest expense going forward will be nominal. And, over the next 18 months or so, the company should spend roughly $200-$250 mil in cap ex. Therefore, if revenues do not increase, the company could be facing another credit crunch as soon as late 2003/early 2004. However, with the SBC relationship and SBC’s growth in the long-distance market, the risk of stagnant growth is somewhat diminished.

The Telecom Industry
This needs little explanation – bankruptcies, stagnant demand, corporate and executive scandals, etc. All this leads to little investor interest in the industry, and the potential for irrational competition and increased regulation, among numerous other issues. The industry is obviously also in flux right now, with the likely (my opinion) outcome being some sort of consolidation followed by stabilization. If left out of this consolidation, WCG would obviously be in serious trouble. Conversely, WCG shareholders should benefit tremendously if the company were included in industry rationalization.

WorldCom
Beyond the soap opera that is this company, a stand-alone WorldCom with little to no debt or an asset sale at massively depressed prices could lead to lower and lower (irrational) telecom prices. This obviously would be a problem for WCG, as well as other competitors in the industry.

Conclusion

I see this situation as a tremendous opportunity. You are investing side by side with what I consider one of the best investment firms out there in an opportunity that has tremendous upside if the company can execute anywhere close to its projections. It obviously comes with a certain degree of risk, both from the industry in general and the company specifically. However, I believe this is the best and cheapest way to play telecom with the company’s strong and versatile network, deleveraged balance sheet and unique relationship with SBC.

Catalyst

·Emergence from bankruptcy
·Short-term revenue growth from SBC relationship
·Long-term revenue growth from customer wins and increased telecom demand
·Possible involvement in telecom industry consolidation/restructuring