PSINet Bets the Ranch

October 9, 1997

BR PSINet Bets the Ranch By Bob Starzynski PSINet Inc. will close a deal this month that could mean an eventual change in control for one of the largest Internet companies in the United States. Herndon, Va.-based PSINet plans to give 20 percent of its stock to IXC Communications Inc. of Austin, Texas, in return for a new high-speed fiber network. When the terms of the deal were drawn up in late July, that 20-p

PSINet officials have denounced such marriages, instead focusing on Internet purity. "We can stay Internet focused and not have to be controlled by telecommunications interests," Cary said.

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PSINet Bets the Ranch

By Bob Starzynski

PSINet Inc. will close a deal this month that could mean an eventual change in control for one of the largest Internet companies in the United States.

Herndon, Va.-based PSINet plans to give 20 percent of its stock to IXC Communications Inc. of Austin, Texas, in return for a new high-speed fiber network. When the terms of the deal were drawn up in late July, that 20-percent stake was valued at $80 million. PSINet is buying 10,000 miles of fiber for that amount of money.

But a small codicil in the deal actually makes it a much bigger gamble for PSINet.

If IXC's stake of PSINet stock does not appreciate in value to $240 million by one year after delivery of the network, PSINet must make up the difference in cash or stock. Thus PSINet's stock must triple in value during that period.

If instead the stock holds steady at its Oct. 3 value of $7.50 a share, IXC's 10 million shares would be worth $75 million. PSINet would owe IXC another $165 million in stock. In other words, IXC would get 64 percent of PSINet, thereby owning a majority of the company.

"Yes, we are betting big on this," said Charles Cary, director of planning for PSINet, one of the largest providers of Internet access to businesses.

PSINet Chief Operating Officer Pete Wills heralds the IXC deal as a way to have the best of both worlds - the network infrastructure of a telecom company with the tight focus of an Internet service provider, or ISP. "We are situated to become the only independent ISP with its own fiber," he said.

Several large ISPs have teamed with telecommunications companies to build fiber networks. Most of the remaining independent ISPs don't have the wherewithal to finance such a network. Instead, they must rely on reselling services using larger companies' networks.

So, the deal puts PSINet on a playing field above the other independents, with companies like Bell Atlantic Corp. of New York, GTE Corp. of Stamford, Conn., and WorldCom Inc. of Jackson, Miss.

The network, which will give PSINet bandwidth to handle major video and data transmission, is also on the to-do list of other major industry players. Still, the company sees such technology as a key part of its future success and a catalyst for financial growth.

Investment analysts are not too confident PSINet can deliver on such a promise.

"The way things are going with that company, tripling the stock price seems highly unlikely," said Youssef Squali, a securities analyst with Laidlaw Equities Inc. in New York. "They are very much out of favor on Wall Street right now."

"Promises have not been kept," said Ulric Weil, an analyst with Friedman Billings Ramsey and Co. in Arlington, Va. "It's not easy to re-acquire credibility once it is lost. One can only say 'good luck' on getting the price up."

William Schrader, chairman, chief executive and founder of PSINet, has long bucked Internet industry trends. Most large Internet providers, namely UUNet Technologies of Fairfax, Va., Digex Inc. of Beltsville, Md., and BBN Corp. of Cambridge, Mass., have been gobbled up by telecommunications companies wanting to buy their way into new markets.

Tom Horan photo

William Schrader,
Chairman, CEO and
Founder of PSINet

But if the IXC deal backfires on PSINet, the telecom interests could take over after all.

IXC, dubbed a carrier's carrier, sells telephone network capacity to 200 regional telephone companies. The fiber the company is selling to PSINet is OC-48, which can carry 2.4 billion bits of information per second, 50 times faster than today's high-end T3 lines.

While other companies are employing OC technology and should have similar capacity before or at the same time as PSINet, officials at PSINet believe that such capacity will be a boost to their company. Smaller independent providers, who are not developing the same technology, would then want to resell PSINet's service.

Although PSINet's strategy is risky, the company needs to try a new approach to win favor with investors, analysts said.

When rival UUNet was sold to MFS Communications last year for $2 billion, investors thought PSINet would also team with a telecom company. In fact, PSINet retained Merrill Lynch to assist in handling any offers that came its way. But a deal was not signed. And that, combined with some other bad blows, sent the stock price south.

PSINet made false starts into two markets. First, the company added the consumer Internet market to its existing base of business customers several years ago. Then, the company bought InterCon Systems, a Herndon, Va., software company, in 1995. Schrader called both of those ventures a mistake, and both were subsequently sold in the past year.

Investors also have been soured by PSINet's poor earnings performance. The company repeatedly pushed back the estimated date when it would turn cash flow positive and profitable. Just this year, the company has stopped giving profitability estimates altogether.

Several analysts lowered their ratings for PSINet at the beginning of this year, because the company waited until two weeks after the quarter to say that earnings would be lower than expected. Analysts were dealt another surprise Oct. 3, when the company said that its third-quarter performance would be worse than expected.

"They are getting beaten on sales and marketing," said Miles Russ, an analyst with Wheat First Butcher Singer in Richmond, Va. "It's going to be a struggle to get the stock price up, especially with this type of announcement," he said, referring to the third-quarter earnings.

PSINet said that the company lost between 25 and 28 cents per share in the third quarter, compared with a loss of 31 cents a share in the same quarter last year. Analysts had expected those losses to be less.

Before the deal between IXC and PSINet goes through, shareholders of both companies must vote to approve it. Approval should be completed this month, Cary said. A specific date has not been set.

Once approved, IXC will begin delivery of the network. Delivery should take a year or two, which means that PSINet has two to three years to get its stock price up to $23.

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