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Broadwing's Stock Price Plunges

Driven by a wave of concerns over debt levels and questionable network capacity sales disclosed in a recent regulatory filing, Broadwing Tuesday watched its stock plunge 29.9 percent, about $1.58, to a close of $3.70 a share.

In midday trading the stock had fallen as much as 49 percent, to $2.58 a share, in furious trading that made it the most active issue on the NYSE.

The plunge followed Merrill Lynch's decision Tuesday morning to lower its ratings on the telecom, citing concerns over its liquidity and ability to refinance upcoming debt obligations. Merrill's Adam Quinton changed his intermediate rating on the company from neutral to reduce. He also switched the long-term rating from buy to reduce.

"Our analysis indicates that Broadwing should remain compliant with its debt covenants this year," Quinton wrote. "However, there appears to be little scope for error and we suspect the company may seek to reduce debt through a bond buyback or possibly even a debt-for-equity swap."

Morgan Stanley later joined Merrill in expressing concern over Broadwing's position.

In a 10-Q filed with the U.S. Securities and Exchange Commission (SEC) on May 15, Broadwing revealed that it drew down about $1.66 billion of its $1.93 billion credit facility, bringing its debt to $2.12 billion as of March 31 (as defined in its debt-EBITDA covenant calculation). The company is obligated to repay about $1.3 billion in debt through 2004, according to analysts.

Analysts were also concerned by signs that Broadwing may have sought to inflate revenues through the manipulation of capacity swaps, also known as IRUs (Indefeasible Rights of Use), a practice that has come to haunt a number of other telcos, including rivals Global Crossing and Qwest.

Broadwing restructured IRU agreements with PSINet in 2Q 2001, allowing it to recognize the sales over a shorter period of time.

An IRU is the right to use a fixed amount of communications capacity, or a certain communications facility, for a defined period of time. IRUs came into vogue back in the days of Ma Bell's monopoly, when they allowed competitors to utilize the large undersea cables that were part of the AT&T's fief. To this day, the IRU remains a legitimate business tool.

For instance, a company might purchase an IRU giving it the right to use an OC-48 wavelength (the equivalent of about 32,000 simultaneous telephone calls) for five years, or might purchase two fibers in a network for 20 years. Most IRUs seem to average between 20 and 25 years.

A long-haul carrier might be interested in extending its business into a region it believes will be lucrative but where it has no capacity or facilities. Through an IRU, that firm could lease capacity or a facility in the region, allowing it to enter the market but bypass the costs associated with a buildout.

As a general rule, IRUs are paid for up front in a single cash payment.

So far, so good. However, accounting for IRUs, even under Generally Accepted Accounting Principles (GAAP), can be a tricky business with large gray areas. Buying an IRU is a little like leasing a fleet of trucks to make deliveries for your business. That fleet becomes a capitalized asset that depreciates over time. Companies can sell or even trade IRUs, either back to the party they originally bought them from or even to a third party, and this can be used to inflate revenues.

Under current GAAP, if the IRU is for capacity in a land-based network, the revenue from the sale is reported in GAAP financial statements over the term of the IRU. For submarine capacity, to the extent that certain conditions are met, GAAP generally requires that the entire amount of the revenue be recorded in the current period. In most cases, the cost of the IRU for the buyer is considered a capital expense and is depreciated over the IRU term.

If two companies sell each other IRUs for substantially the same capacity, or facility, at approximately the same time, the transaction may be a 'hollow swap,' in which the two companies traded capacity that neither needed. No real assets change hands, and yet both can report the capacity sold as revenue and the capacity bought as a legitimate capital expense.

But Broadwing Chairman and CEO Rick Ellenberger Tuesday took issue with the idea that the company's goal in renegotiating IRUs with PSINet were inspired by an effort to artificially inflate revenues. In a letter to shareholders, employees and customers, he wrote: "In recent days, there has been much written about the financial position and future of Broadwing Inc., much of it misunderstood, misconstrued, and misleading. Unfortunately, in the challenging times that our industry is facing, the market is susceptible to the forces of innuendo and rumor over those of fact and execution."

Ellenberger noted that Broadwing has accounted for its IRUs in the method outlined by the SEC. He said it accounts for all IRUs in a manner that recognizes the revenue over the life of the agreement, and added that it has been consistent with its use of the deferral and amortization approach.

He also offered an explanation for the company's renegotiation of IRU agreements with PSINet: "In order for these agreements to survive PSINet's bankruptcy, the agreements were adjusted to reduce the services provided, update the operations and maintenance fees to a current market rate and shorten the lives of the agreements. Currently, this agreement is in good standing and is operating today through the purchaser of the former PSINet assets. As a result of the renegotiation, the company preserved the agreement, which continues to generate revenue and cash flow for Broadwing today. The renegotiation of this agreement has been disclosed in each of the company's quarterly 10Q filings since the second quarter 2001, and in Broadwing's 2001 form 10K."

As for debt, Ellenberger said Broadwing is in compliance with all its covenants, and has reduced its bank debt by 15 percent since the beginning of 2002. He also said the company's debt ratio of 3.27 percent is "well within the requirement of 4.75." Additionally, he said the company plans to refinance a portion of its existing indebtedness and that it has reduced its cash burn and lowered its rate of borrowing.