Insight into risks is Carlyle strength
By Sean Hao
Advertiser Staff Writer
Like many traditional telephone companies, Verizon Hawaii is losing customers amid increasing competition from other communications providers, including cable and wireless carriers.
Richard Ambo • The Honolulu Advertiser
Verizon Hawaii also faces an uncertain threat from new technologies that allow consumers to place cut-rate calls via the Internet. On top of that, the tele-communications industry overall remains in a downturn few expect will end anytime soon.
Verizon technician Sean Cross hooks up a headset to a telephone terminal high above Kapi'olani Park. The Carlyle global investment group has bid $1.65 billion for Verizon Hawaii despite an uncertain threat from new technologies that has made investors skittish.
That's made investing in tele-communications less than profitable, with sector mutual funds losing an average 5.7 percent over the last three years, according to research firm Lipper. While some telecommunications investors are seeking the exits, that hasn't discouraged The Carlyle Group from placing a $1.65 billion bid for Verizon Hawaii. Even though the trend in the telecommunications is consolidation, Carlyle wants to create an independent, stand-alone phone company called Hawaiian Telcom.
That contrarian approach is in line with the $18 billion global investment group's strategy of investing in undervalued companies in industries that attract government scrutiny. Whether that strategy works for Verizon Hawaii could have a significant impact on the availability, quality and cost of services to phone customers.
Under the deal, Carlyle would acquire Verizon Hawaii's local telephone operations and print directory, long-distance and Internet service-provider businesses, but not Verizon Wireless.
As with other acquisitions it has made, Washington, D.C.-based Carlyle is banking on its expertise in a particular sector and knowledge of regulatory issues to mitigate the risks of investing in other companies' cast-offs.
"One of the reasons that we at The Carlyle Group are particularly good investors is that we understand those risks probably better than most people," said Bill Kennard, managing director for Carlyle, referring to uncertainties surrounding telecommunications regulations.
"I chaired the (Federal Communications Commission). In fact, some of the decisions that I started to make at the FCC are still in the process, so I have a pretty good understanding of where those policies are going and where they can end up."
Among Carlyle's other companies is Arlington, Va.-based United Defense Industries Inc., which this year purchased Honolulu Shipyard Inc., a naval ship-repair business, for $16 million.
Insight profitable
Carlyle's insight seems to serve its investors well. Between 2003 and its inception in 1987, the privately held company has returned $8.2 billion to investors from $3.5 billion in investments. That excludes profits from the sale of Honolulu-based Horizon Lines LLC for $650 million this past summer.
Richard Ambo • The Honolulu Advertiser
Carlyle's purchase of Horizon from CSX Corp. in February 2003 for $315 million was initially considered a gamble on the shaky shipping industry. In Horizon's Puerto Rico market in particular, shipping rates were under pressure because of competition between five companies.
Carlyle sold Honolulu-based Horizon Lines LLC for $650 million this summer after buying it in February 2003 for $315 million.
However, Carlyle's purchase of Horizon benefited from a rebound in shipping rates when a key competitor, which had been in bankruptcy, exited the Puerto Rico market. The threat of added competition is minimized by the Jones Act, which provides high barriers to entry.
Horizon's success was a result of Carlyle's insight into how the shipping market would evolve and greater focus on results, said Brian Taylor, Horizon vice president and general manager.
In a manner similar to the proposed Verizon deal, Carlyle's goal with Horizon was to give the ocean shipper more attention than it received as part of a larger company.
Carlyle "clearly had the foresight to see what potentially could happen in terms of a potential rebound in that market," Taylor said. "They left the company significantly better than when they bought it," he added, noting the company's employment grew about 20 percent to 100 people during the last 18 months.
Ultimately, the Horizon deal exceeded expectations, Carlyle said. And while it's unlikely that Hawaiian Telcom would be resold in such a short period, both deals feature similar strategies. Carlyle's purchase of Verizon Hawaii from Verizon Communications is expected to close in the first quarter of next year pending state and federal approval.
"I think the opportunity is to do what Verizon really can't do with the company and that is to make it a locally operated, locally branded, locally managed company," Kennard said. "Verizon has 55 million access lines, so it has to manage this company differently.
"We can come in and focus management's attention on the state of Hawai'i. That will make us a more nimble, focused company."
New regulations help
Whether Carlyle can duplicate its Horizon success with Verizon remains to be seen. Working in Carlyle's favor are two recent major regulatory victories for phone companies such as Verizon that limit competition in the residential phone market. One allowed telephone companies to deploy advanced fiber-opticibased broadband Internet networks without having to share them with competitors. The other forces long-distance companies such as AT&T to pay more to use the phone lines of local phone companies.
However, industry analysts say boosting profitability in the troubled telecommunications industry is challenging. Many remain saddled with debt resulting from a 1990s network build-out in anticipation of an Internet boom that never fully materialized.
"I don't see an upswing for the foreseeable future five years, which I think is in the time frame of most people investing," said Daryl Schoolar, a senior telcom analyst with industry research firm In-StatMDR.
Profits at companies in Standard & Poor's 500 communications-services index, such as AT&T, Sprint and Verizon Communications, are projected to fall 7 percent in the current quarter, compared with the prior year's quarter, according to Thomson First Call. In the first quarter of next year, profits are expected to dip 3 percent.
Despite that tepid outlook, phone companies such as Verizon Hawaii remain attractive investments because they generate stable cash flow, Schoolar said.
Under Carlyle's financial plan, Hawaiian Telcom is expected to generate $624.9 million in revenues next year — a 2 percent increase on this year's anticipated sales of $609.9 million. Net income is forecast to drop from about $107 million this year to a loss of $60 million in 2005 as the company spends heavily to shift Mainland operations to Hawai'i. Net income is expected to rebound to $33 million in 2006.
Industry experts said the company's long-term success will hinge on its ability to attract new customers while offering new services that can help prevent the loss of existing customers, among other things. However, phone companies such as Verizon Hawaii face numerous threats, including a loss of customers to wireless phone services and cable.
In addition, they face a growing threat from companies that offer telephone calls via the Internet, said Albert Lin, a telcom analyst for American Technology Research in San Francisco. Currently Internet calls aren't as heavily regulated or taxed as traditional phone calls.
"So what happens is it's very hard for a (telephone company) to compete against these new entrants because the consumers, which are sensitive to the pricing of their total bill, must deal with the taxes and they consider that as part of their overall cost," Lin said.
Stand-alone problems
As a stand-alone company, Hawaiian Telcom also faces a disadvantage compared to larger competitors such as Verizon, which can offer consumers the convenience and cost savings that come from bundling communications services such as broadband Internet and wireless phones.
"People don't want to be hassled with multiple bills, multiple contact points," Lin added. "There's a high correlation that as customers take on more services ... the chances of them churning (or switching providers) decreases dramatically. Anything you can do to reduce that customer churn is extremely valuable.
"Big companies have a tremendous advantage here because they have a greater likelihood of owning the assets to deliver multiple services."
Large phone companies such as Verizon Communications also can afford to spend more developing new technologies and services and cut better deals with suppliers, Schoolar said. Additionally Carlyle's plan to add jobs, increase operating costs and raise Verizon Hawaii's debt from $425 million to $1.5 billion could make it difficult to pay for needed network upgrades and the rollout of new services.
However, being small could present advantages for Hawaiian Telcom.
"Certainly their ability to buy in volume has been cut, but they probably can be much more aggressive and nimble in adopting new technologies than most (telephone companies)," Schoolar said. "Most of those companies are very large and have many layers of bureaucracy."
With "Hawai'i working as a very small independent company, you very well could benefit from seeing new services faster."
