Take a high-tech market, add a generous amount of easy money, mix in plenty of overcapacity and spice it all up with demand levels well below expert estimates and what do you get? In the submarine cable business bankers have already found the answer is not a funny one. With most private owners of submarine cable assets now in bankruptcy, including Global Crossing, Pacific Crossing and 360Networks, once highly-prized cable ventures face a tough time raising funds from a finance community still counting the cost of past lending.

Despite the gloom surrounding the sector, it is important to remember that base level corporate and consumer demand for internet access and broadband has not collapsed. Far from it, says Steve Weiss, head of Technology, Media and Telecommunications structured finance at ABN Amro in Hong Kong, ?in some key markets corporate data and Internet Service Provider (ISP) traffic is still doubling every year even if it isn't increasing at the rates seen two or three years ago.

The blame for the rapid deterioration in market conditions lies less with base level demand and more with the industry itself, in particular with a roll-out of capacity far in excess of what would have been needed except in the most optimistic demand scenarios.

This has led to what Robin Russell, CEO of Australia Japan Cable calls a paradigm shift in the underlying industry economics. ?From,? he says, ?a scarcity paradigm to a paradigm of abundant capacity.?

?In the era of scarce supply carriers would purchase more capacity for strategic purposes,? explains Russell, ?looking as much as three to four years ahead to ensure they had enough capacity to meet projected demand.? Industry buyers stocked up on capacity believing that if they did not, they might find it difficult to purchase more capacity at a later date. Bankers witnessed this phenomenon in the ventures they were asked to finance. ?A lot of buyers were prepared to take upfront commitments at a fixed price to buy cable capacity as the main concern was a future shortage,? says Richard Palmer at Barclays Capital in Sydney.

Today, what might be described as top tier demand, carrier demand for the activated capacity of cable operators, has plummeted. Now the name of the game is running down inventory levels, not buying more. When carriers do come back to the market, Russell expects a different behaviour, a just-in-time style purchasing approach. Improved technology and knowhow has played a hand here, and carriers recognize that the time it takes to roll out new capacity has shortened considerably, thus reducing the need to purchase well ahead of demand.

One natural consequence of excess supply is falling rates for capacity, a feature of the market which compounds the top tier demand problem. As Weiss comments: ?this is a deflationary environment and as in any deflationary environment, buyers are holding back on purchases.?

So whereas in the past when telecoms operators and ISPs would go out and purchase more when usage reached 50% of their network capacity, analysts say average network usage in certain Asia markets and elsewhere is now reaching 70% to 75%. As long as usage levels continue to rise, at a certain point service providers will have buy more capacity to prevent a deterioration in service levels. But when this will happen on a large scale is the billion-dollar, unanswered question.

Given that excess capacity is the key problem, financiers and industry players alike are hoping that the long list of cable company bankruptcies will lead to significant market consolidation. Ian Crow, a banker at TD Securities in New York comments, ?there certainly needs to be consolidation. In the earlier days there were very few barriers to entry, the principal one being capital. Too many ventures were set up and they all competed on price.?

Apart from market-driven consolidation, Russell raises the possibility of a global network run on a collaborative basis. But before that happens the CEO admits that there are significant practical difficulties. On the one hand the issue of industry technology and data standards needs to be resolved. Ownership of collaboratively operated cable networks is an even more thorny problem. With the submarine cables sector increasingly devolving into a low-margin, high-volume business and one that would not meet the levels of return expected by shareholders in telcos, major carriers are increasingly reluctant to finance cable projects on balance sheet, argues Russell. Ownership structures which bring together umpteen global carriers for one asset have also proved to be unwieldy and particularly unsuited to the dynamic communications environment.

In the short term, market forces provide the more likely route to consolidation. But while observers prefer to see incumbent players purchase stranded assets left in the wake of industry bankruptcies, interest in such assets from financially sound cable operators or the telecoms operators has been low, even with valuations at very depressed levels. Russell believes this is because the most knowledgeable potential buyers, the telecoms operators themselves, already have significant levels of inventory and are largely unwilling to acquire more. The financial markets, meanwhile, have proved to be inappropriate as owners of cable assets because of the specialized nature of the market. Few financial investors have been prepared to wade into a sector were others have so conspicuously failed.

Russell won't be drawn on whether AJC might be a purchaser but indicates that the company has been looking at the opportunities. ?We have made no committed plans. But we are reviewing our strategic options on a continuous basis. Obviously what we do has to be approved by all our shareholders and has to fit our core strategy.?

Despite the low levels of interest, Peter Stevenson, at WestLB's New York office, predicts that several cable ventures will emerge from bankruptcy in a way that keeps their networks intact. ?They'll emerge with minimal debt. They'll be majority-owned in some cases by the creditors and they won't be needing new debt for some time,? he suggests.

Russell believes that a distinctive three-tiered industry structure could also start to emerge in the next few years. He classifies the three layers as: capacity producers, such as AJC itself, wholesalers, and traditional retailers including the major telecoms operators. In the past a distinction between these layers has not been clear cut. Notably, capacity producers have often been wholesalers leading to conflicts of interest if the capacity producer was partly owned by telecoms companies and to problems associated with inappropriate overhead structures. The capacity producers business demands very low overheads, while the nature of the wholesale and retail businesses, clearly calls for larger overheads.

Future financings

Given that the process of market shake-out through mergers, acquisitions will be prolonged by the Chapter 11 proceedings currently taking place in the US, a recovery in banking appetite for submarine cable deals is also likely to be delayed.

Industry bankruptcies have had a varied impact on surviving cable operators. Russell says that AJC has seen no financial impact from the Worldcom bankruptcy. ?We expect Worldcom to continue to meet its obligations to AJC,? he says.

For other companies, such as Asia Global Crossing (AGC), the bankruptcy of Global Crossing has had more severe consequences. ?AGC was supposed to get a shareholder loan from Global Crossing but didn't,? says a banker in Singapore. ?That left a big hole in AGC's plans. They subsequently cut back very heavily on capex and sold 50% to Hutchinson Global Crossing to increase liquidity. They are not expected to need more financing until 2003 at least,? the source adds.

Not surprisingly, given the general supply/demand imbalance, there are very few cable projects awaiting finance. ?Even in Asia where the market did not see as much overbuild, there are few projects on the table,? notes Christian Nordstrom, assistant vice president, telecoms project finance at Citibank, ?and all those that are likely to come to market in the short term, are small scale, with total project costs of no more than $100 million each.?

When submarine cable operators, either incumbents or new market entrants, do eventually return to the debt markets for funds, they should generally expect a reception quite different from that of two years ago.

Bankers stress that each project will be judged on its own merits but several general observations about future financings can be made. First and foremost, as Nordstrom points out, it is currently much more difficult to raise debt. Substantially more equity finance will typically be required to cover project costs than was the case just two years ago.

Stevenson at WestLB argues that there will be few real project financings going forward. ?The project finance approach hasn't worked well in this market as banks progressively took on more and more market risk.? Figures from consultants concerning usage and demand growth are now viewed with considerable skepticism. Market risk tranches, even those which are small in absolute terms or small relative to the overall size of the project will be extremely difficult to put away. Instead, projects will need to be backed by capacity contracts from quality, often investment grade offtakers.

Nordstrom says that the sub-sea cable projects which have done relatively well are those backed by large incumbent carriers. ?Those built with substantial backing through the equity markets, and on a more speculative basis, have experienced greater difficulties. Incumbent telecoms majors, on the other hand, have the network connections to support cable ventures and have been much more effective in selling capacity contracts,? he says.

But although the banking community is more likely to favour projects sponsored or indirectly backed by major carriers, Richard Palmer argues that the level of leverage is dependent more on how strong the capacity contracts are. ?If the offtakers are of a high quality then even a project with no major carrier sponsors could still be highly leveraged.?

Even where the project has a strong business case, sponsors should be looking to bring their relationship banks into new deals, adds another banker.

Asia will lead the recovery?

Generalization about industry level supply and demand are only useful up to a point, says Robin Russell. ?For the real analysis one needs to look at the supply and demand equation on a route-by-route basis.? Although technology will allow an electronic signal to pass through any number of cable routes, different routes are, Russell points out, not necessarily interchangeable from a commercial perspective.

But observers do note that in the intra-Asian market there has not been the same amount of overbuild as in the transatlantic or transpacific sectors. ?That's partly because a lot more landing rights and regulations are involved,? says Nordstrom. ?Its not so easy for a cable project to get all the relevant permissions as one proposed scheme might need the permission of up to a dozen countries.?

That is not to say that Asian submarine projects have not faced financial difficulties, but these difficulties are more typically the result of previous financing strategies than severe supply and demand imbalances. Several projects were not fully funded before launch and expected to use operating cashflow for their future finance needs, says one financier. They have subsequently found that cashflows have been well below original forecasts.

The Asian telecoms market has other strengths relative to its European or US cousins, says Steve Weiss. ?In most case Asian telcos' gearing is lower. When 3G licenses were sold off governments in the region didn't necessarily try to maximize revenue at the expense of the telecoms operators. In addition, much of the Asian market is still in the growth phase.?

But, bankers in the region admit it will still be a hard job selling projects to credit committee in Europe or the US. ?Whatever argument and data is presented these days is greeted with considerable cynicism,? one source admits.

For the moment the Asian market, like all the rest is, on hold. Projects such as Singtel's Australia undersea cable are on the back burner. For AJC Cable, Russell believes that it will still take 12 months before capacity inventory on route into and out of Australia is run down, given current rates of demand growth. In the meantime, industry players and bankers have, at least, got time to think. n