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A Must Read I found on another board.
Business textbooks identify two types of costs: fixed costs and variable costs. Fixed costs are those that must be paid every quarter regardless of the level of operations. These costs include depreciation, interest expense, ad valorum taxes and other "fixed" items. Variable costs includes wages, raw materials, utilities (electric and gas), etc. However certain variable costs are also considered fixed costs. (These are known as Fixed Variable Costs.) For example whether a factory runs at 10% of capacity or 90% of capacity, the lights in the factory must be turned on. The cost of lighting a plant is typically considered a "variable" cost. However as the cost of lighting a plant does not vary significantly whether the plant runs at 10% or 90% of capacity the cost of lighting the plant can be considered fixed. Thus the electric bill can be considered a "fixed variable cost."
Operating a LD requires a high level of fixed variable costs. For example the Network operations center must be staffed whether the network is operating at 5% of capacity or 95%. Network engineers and technical personnel must be deployed (and on call) at key points throughout the network to respond to outages or provide customer service. Points-of-Presence must be established in many markets in order to facilitate network connections. Personnel must be available in each market to facilitate customer connections. Overall turning on the lights (so to speak) in a LD network requires substantial operating expenditures. I estimate that the baseload cost of running WCG's network is about $500-$600 million per year. Layered on top of this are variable expenses such as access charges, payments to off-network providers, sales taxes, etc. Once these base load costs are covered, I estimate that WCG's gross margin on incremental sales is about 65 cents on the dollar.
Before moving on I would like to discuss WCG's historical operating expenses. WCG did not complete network construction until June 2001. Consequently in 1999, 2000 and the first half of 2001, a substantial portion of WCG's traffic was moved on third party carriers i.e., WCG used other carriers to move its traffic. In 1999 and 2000 WCG paid third party carriers $200 million and $332 million respectively for services. In 2000 WCG reported network operating expenses of $683 million associated with recurring network revenues. Of this amount $332 million was paid to third party providers. In other words WCG's direct operating expenses (labor, power, access charges,etc.,) were just $351 million. As of year-end 2000, 82% of WCG's network traffic was carried on network.
For 2001 WCG reported in its 10-K that contractual commitments to 3rd party providers were $145 million. I estimate that the majority of these payments were made in the first six months of the year. As of 6/30/01 WCG's on-network traffic had increased to 90%. As of 9/30/01 on-network traffic had increased to 94%.
The impact of moving traffic on to WCG's network and reducing third party payments has been substantial. Below I show Network Recurring Revenues and Operating expenses by quarter for the first three quarters of 2001:
Revenues Operating Expenses
Q1: $241 mil. $227 mil.
Q2: 254 mil. 223
Q3: 271 mil. 222
As can be seen recurring network revenues have increased by $30 million from the first quarter to the third quareter. Meanwhile operating expenses have declined by $5 million over the same period. In other words WCG is moving more traffic at a lower cost.
Because WCG has very high fixed operating costs to understand the improvement in its margins it is necessary to examine the improvement in gross margins at the margin, i.e. the last dollar of revenue. To examine the effect of WCG's increasing the network load I look at the incremental gross margin on a year-over-year basis. I calculate this margin as follows:
Incremental Gross Margin =
1 - Current Oper. Exp. Less Prior Yr Oper.Exp./
Current Revs Minus Prior Yr. Revenues
For the third quarter the calculation would be as follows:
1 - (222,057 - 188,068)/(271,100 - 175,681)
= 1 - (33,989/95,419)
= 1 - .356
= .644 or 64.4%
This means that WCG realized a gross margin of 64.4% on each additional dollar of revenue generated in the third quarter of 2001 as compared to the third quarter of 2000. These funds were then available to cover selling, general and administrative costs and other costs. In contrast WCG's incremental gross margin was 35.5% in the first quarter of 2001 and 44.2% in the second quarter. The significant improvement in the third quarter was due to completion of the network, the loading of more traffic on to WCG's network and the corresponding drop in payments to third party network suppliers.
For the third quarter of 2001, the Network segment reported negative EBITDA of $15 million. (The EBITDA figure included a non-cash charge of about $10-11 million to cover additional reserves for accounts receiveable. W/O this one-time charge EBITDA would have been about negative $5 million.) In order for WCG to reach cash breakeven on network operations, the Network will need to generate recurring revenues of about $300 million. Thus WCG's projection that fourth quarter network recurring revenues will be between $300-$325 million implies that the Network will reach or surpass breakeven for the entire fourth quarter.
Once WCG passes breakeven, I estimate that 60%-65% of each incremental dollar of revenue will be available to cover interest expense because WCG has kept a tight cap on Selling, General and admin expenses. By quarter network SG&A is reported as follows:
Q1 2001: $66.3 million
Q2 2001: $69.7 million
Q3 2001: $72.5 million
However these figures include Allowance for Doubtful Accounts (failure of customers to pay their bills). WCG set aside substantial reserves for non-payment of accounts in the second and third quarters. (These were non-cash charges.) Excluding these provisions from SG&A results in the following figures for Network SG&A:
Q1 2001: $64.2 million
Q2 2001: $64.6 mil.
Q3 2001: $60.6 mil.
As can be seen the adjusted figures reveal the impact of the July layoff, with SG&A declining to $60.6 million from an average of about $64.5 million per quarter during the first half of the year. By keeping tight rein on its SG&A expense, WCG's will be able to retain 60-65 cents on each incremental dollar of revenue above $300 million to cover interest expense. Thus if WCG's network recurring revenues should grow to $1.5 billion in 2002, EBITDA would probably be about $180-$210 million.
Overall the third quarter report marked a significant milestone for WCG. With the network complete and fully loaded, incremental margins expanded to their full level of about 65%. Furthermore WCG came close to reaching breakeven on network operations in September. It appears that WCG will pass the critical breakeven point on network operations in either October or November and is likely to be EBITDA positive for the entire fourth quarter of 2001.

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