MCI’s Early Growth and Financing (Prior to 1983)
MCI began construction of its telecommunication network in June 1972, following the FCC’s adoption of a policy in 1971 allowing new companies to enter the market for specialized long distance services. MCI proceeded with the financing of the construction on three fronts. MCI rose net proceeds of $27.1 million through the sale of shares to the public, obtained a $64 million line of credit from a group of four banks, and obtained further loan promises of $6.45 million from private investors.
With these funds, MCI aggressively grew its telecommunications system, although still maintaining a dependency on AT&T’s facilities. By 1975, due to cumulated operational deficits, MCI was out of liquidity. In 1975, while having revenues of $6.8 million, MCI paid $11.6 million in interest expenses and posted a net loss of $38.7 million. In addition, MCI was unable to meet its interest payment obligations and had to negotiate with its creditors to defer interest payments. MCI’s shares fell to less than a dollar. It was in the midst of this financial crisis that MCI resorted to another round of financing critical to its survival. This round of financing was all equity and was carried out at a large disadvantage as compared to three years ago. MCI issued 9.6 million shares (with a 5-year warrant attached to each share) to the public and rose net proceeds of $8.2 million. As a basis for comparison, three years ago, MCI was able to raise $27.1 million with the sale of only 6 million shares.
Despite its critical financial position in 1975, MCI was able to reverse the losing trend in just three years to reach profitability in 1978. This was due to the sudden success of the “Execunet” service, which began to yield substantial revenues for MCI as of 1976. Hence, MCI revenues grew from $6.8 million in 1975 to $28.4 and $62.9 million in 1976 and 1977, respectively. The “Execunet” service accounted for about half of these revenues.
MCI’s profitability increased dramatically with the increase in revenues. As of 1983, it had $1.073 billion in revenues and $170.8 million in net earnings. MCI paid $54.1 million in interest in that same year. While interest payments for that year represented only 5% of its revenues ($5.4 million / $1,073 million), it amounted to 18.3% of its operating income ($5.4 million/ $295.1 million).
MCI’s early financing rounds were characterized by an underestimation of cash requirements and the resort to expensive means of financing while the company was still struggling to reach profitability.
These had for direct consequences to compromise the survival of the company in 1975 when MCI ran out of liquidity. As well, it forced the company to reach out for additional financing on numerous occasions and to negotiate financing under very disadvantageous conditions in 1975.
As of 1978, MCI adopted a strategy of issuing convertible preferred shares and debentures once or twice a year. The issuing of convertible preferred shares was judicious on many fronts. First, should the company not have sufficient operational cash flows, it could suspend the payment of dividends on preferred shares. The issuing of preferred shares instead of common shares prevented, according to Wayne English, dilution in common equity ownership and hence a potential significant drop in the share price of MCI. Should the price of common shares rise to a certain level, MCI could force the conversion of preferred shares to common shares by exercising a call provision. This feature, allowing MCI to manage the impact on its share price, created an increase in outstanding common shares. Investors, on the other hand, found the convertible preferred shares attractive as 85% of the dividends on preferred shares were tax deductible and the conversion feature on the preferred shares allowed them to benefit from a potential increase in the price of MCI’s common shares. As of 1981, as financing requirements intensified, MCI switched from issuing convertible preferred shares to issuing convertible bonds. This allowed MCI to raise significantly more capital.
As convertible preferred shares and bonds were converted to common shares, it increased MCI’s equity base, hence allowing the company to take on an even greater debt burden. Because MCI was experiencing rapid growth and was at the same time profitable from 1978 to 1983, Wayne English estimated that “Availability of funds [was] the paramount consideration”, cost was “secondary”. He meant by this that his primary concern was to fuel MCI’s growth which required substantial financing, and that the cost of these financings, during this period, which was relatively high, was only a “secondary” concern. This financing philosophy needs to be reassessed, however, in view of the new competitive climate and the challenges and uncertainties ahead.
Financing Needs for the Period from 1984 to 1990
MCI’s primary needs for financing during this period come from two sources: capital expenditures and expansion into new services, business segments, and geographical areas. As is detailed in MCI’s baseline forecast from 1983 to 1990 (Exhibit 9A), it will need to invest $10.645 billion (sum of line 13 and 14, except 1983) in capital expenditures during this period. The requirements for capital expenditures investments will increase until 1987, and will decline for the years thereafter.
Financing requirements for MCI’s expansion plan is not as clearly detailed in MCI’s baseline forecast. We can, however, analyze MCI’s growth and operating assumptions for this period. MCI forecasts that the interstate long distance market will grow 10% per year, hence growing from $27 billion in 1983 to $52.8 billion in 1990. MCI estimates that it can increase its market share of this growing market from 4% in 1983 to 20% in 1990. This will generate a significant revenue increase for MCI, which will be multiplied 10 fold from $1.073 billion in 1983 to $10.560 in 1990. However, this revenue increase will be marked by a significant drop in its operating margin, which will decline from 27.5% in 1983 to a low of 12% as early as 1985 and will stabilize between 12% and 15% until 1990. A key question needs to be asked at this point: how does MCI expect to finance such an aggressive growth while its operating margin is being cut by half?
From 1978 to 1983, MCI managed to maintain an operating margin above 21.9%. With substantial increases in access charges, the high cost of executing large scale promotional campaigns, and the increased administrative support that will be required to manage the projected growth, it can be questioned whether MCI will be able to finance its commercialization strategy strictly from its operational cash flows.
Table 1: MCI’s Operating Margins from 1978 to 1983
MCI faces many other risks. The interstate market may grow at a slower pace than 10% per year, MCI may not be able to reach its aggressive market share targets, a new more flexible AT&T may prove to be a more ferocious competitor than initially expected. Should MCI engage into an expensive commercialization and expansion campaign that fails to generate the expected revenues, it could come in tight with regard to its working capital.
The financing strategy MCI decides to adopt needs to take into account these potential risks together with the potential for MCI’s growth. This effectively means that the financing strategy should, from the start, raise sufficient funds to carry forward the expansion plan. Even with the eventuality of a pessimistic scenario occuring, MCI should not have to be forced to negotiate additional financing under disadvantageous terms. This being said, the financing means chosen should avoid significant drains on the company’s operational cash flows and allow for the possibility of additional incremental financing. The financing tools shall also maximize shareholder value by adequately financing the company’s growth while not over-diluting current shareholders’ equity.
Suggested Financing Methods
In view of the previous analysis, an interesting financing mix would be constituted of part common shares and part convertible debt. By issuing common shares, MCI will be relieved from payment of interests and repayment of capital. This will give MCI more flexibility to deal with unexpected events while spreading the risks of current shareholders to a wider base of shareholders. The issuance of common equity will also increase MCI’s equity base, hence allowing it to take on a heavier debt burden. It is recommended that MCI, given its recent track record and future growth prospects, goes for a major public offering early in 1984 instead of many smaller ones.
The issuing of common shares should only constitute part of MCI’s financing plan (maybe half). MCI should also use debt in order to leverage future growth. The suggested debt vehicle is the long-term convertible debt. The long-term nature of the debt (at least 10 years) will allow MCI to not having to refinance its debt during difficult times. The conversion option that the debt provides investors will allow MCI to negotiate lower interest rates on its debt by allowing investors to participate to a potential increase in MCI’s share price.
Table 2: Suggested Financing Schedule
Total Financing Requirements
Common Share Issuance (% of Total Financing Needs)
Common Share Issuance ($ Amounts)
Convertible Debt Issuance (% of Total Financing Needs)
Convertible Debt Issuance ($ Amounts)
As can be seen from Table 2, it is suggested that an initial amount representing 50% of the financing needs for the period be raised early in the form of common share issuance. Additional incremental financing can be raised using convertible long-term debt. The amounts raised from these convertible debts can be re-adjusted in order to account for unexpected capital needs.
This plan gives MCI ample capital to start its expansion plan, while providing it with the flexibility to readjust its financing according to its future needs.