XO Lights Up

The telecom industry is certainly a dynamic one. Allies can become competitors at the flip of the switch. And competitors can become merger partners even faster. It’s not clear which will be the case with Level 3 Communications Inc. and XO Communications Inc.

On the one hand, XO is moving its backbone network off the current wavelength platform it’s been leasing from Level 3 in an effort to become a significant competitor in the long haul against Level 3. At the same time, reports have been circulating that Level 3 — fresh off its acquisitions of ICG Communications Inc., Progress Telecom LLC and WilTel Communications, and planning to buy Looking Glass Networks Inc. and TelCove — still has $920 million to play with and is eyeing XO as its next conquest. (AboveNet Inc., the other large U.S. data network provider, is reportedly also a prospect.)

Level 3 and XO declined to comment on the merger rumors. In fact, Level 3 spokesman Chris Hardman told xchange in early July that the company isn’t accepting any interviews to discuss its overall acquisition strategy.

Brian Washburn, an analyst at Current Analysis Inc., says XO Holdings Inc. Chairman and Director Carl Icahn has “been trying to shop XO around forever.” While XO has been talking less lately about exploring strategic alternatives, Washburn says he doesn’t see any reason why XO would have moved away from that thinking. XO Holdings’ market cap as of early July was around $773 million.

Washburn adds there long has been speculation that Qwest Communications International Inc. would buy XO. Meanwhile, a June story in Denver Business Journal suggests that Qwest would be an ideal suitor for Level 3. The piece says that Level 3 is within Qwest’s price range, with a market capitalization of $3.5 billion. But Level 3’s massive debt of more than $6 billion would make any acquisition of the company hard to swallow.

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Whatever the future holds, XO and Level 3 have a history of being intertwined. In July 1998, XO agreed to purchase for $700 million 24 fibers and an empty conduit in the 16,000-mile North American intercity fiber network built by Level 3. Then, in November 2000, XO signed a deal to buy nine European metro fiber networks and a pan-European intercity fiber network from Level 3 for approximately $148 million, as well as transatlantic capacity for approximately $15 million. However, the companies in 2001 agreed to a revised deal that changed some of those terms and set guidelines for XO to purchase approximately $30 million worth of wavelength services on Level 3’s intercity network in North America.

But now, affordable technology has become available and XO is lighting the dark fiber it got from Level 3 so it can enter the intercity network — a marketplace in which XO wasn’t able to compete before because it had to resell Level 3’s network, says Ernie Ortega, president of carrier sales at XO.

“Over the years, we’ve lit a portion of that network, but really it just didn’t make economic sense for us to do that at that point in time,” says Ortega. “With this new deal with Infinera to use their optical gear to light our network, we’re probably going to use a portion of the 18 fibers [acquired from Level 3 under the revised deal], thus giving us a significant amount of excess capacity, first of all. Second of all, it will put us in the game to now start to sell services such as your 10-gig and 40-gig circuits, and wavelengths, Ethernet, etc.”

Until this recent change in strategy, XO had lit only about 10 to 15 percent of its fiber, but the affordability of the Infinera gear, which is also in use at Level 3, will allow XO to light the other approximately 85 percent of fiber by the end of the year, says Ortega, noting the Infinera gear will allow XO to reduce its costs by about 30 percent.

The Infinera DTN is the first optical telecom system based on photonic integrated circuits (PICs), which enable multiple wavelengths of light, carrying hundreds of gigabits per second of traffic, to be managed digitally, rather than as analog waves. In contrast, conventional WDM products, built without the benefit of PICs, use analog techniques for many networking functions. A key selling point of the optical gear from Infinera, a relatively new, small equipment provider, was its ability to scale from 10-gig to 40-gig with the addition of just a chip — rather than a card or a whole new box, says Ortega.

That will be important for XO as it aims to address the growing bandwidth requirements of IP portals like eBay, Google and Yahoo!, as well as large enterprise customers like American Express and Morgan Stanley, which are building 10-gig metro, intercity and regional rings. Ortega says these two customer groups have prompted a “significant rebound” for the telecommunications industry in recent months.

“With this new deal with Infinera to use their optical gear to light our network, we’re probably going to use a portion of the 18 fibers [acquired from Level 3 under the revised deal], thus giving us a significant amount of excess capacity, first of all. Second of all, it will put us in the game to now start to sell services such as your 10-gig and 40-gig circuits, and wave lengths, Ethernet, etc.“— XO’s Ernie Ortega

“You’ve seen the commercials of ESPN,” says Ortega. “You can now download all of the scores. You can download live-action film clips of your favorite basketball teams — how they did last night — on your cell phone. Well, all of that data has to be stored somewhere, hence the need for colocation. Then, in order to traverse somebody’s network, they’re going to have to tie [together] all of those data centers somehow. And they’re tying them together either via a lit 10-gig network or just buying pieces of dark fiber across the country.”

Ortega says XO is “making significant traction with IP portals,” some of which just want dark fiber to operate their own networks and others which are interested in leasing fiber-based services initially and then possibly moving to IRU deals over time. “We don’t have an issue with selling any of our intercity fiber dark,” Ortega adds, noting that some of the larger transport providers don’t like to sell dark fiber because they feel it dilutes their lit fiber offerings.

Beyond just delivering intercity transport using the same cost basis as market leader Level 3, however, Ortega says XO also can carry traffic into the metro space over its existing metropolitan fiber, and even right into customer buildings via the fixed wireless networks XO subsidiary Nextlink Wireless Inc. now is turning up on a city-by-city basis.

Despite XO’s strengths, Washburn of Current Analysis says becoming a major player in delivering telecom services to large enterprises will be an uphill battle for XO, whose bread and butter today is in integrated access services targeting small and medium businesses. Indeed, a recent Yankee Group report says XO leads all CLECs in terms of market share among small and medium businesses.

But who knows what the future may hold.

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