The Starting Line: Odds against bankruptcy comebacks

With bankruptcy filings stacking up, former Internet giants are telling their customers and shareholders that going bankrupt can help them emerge as stronger companies--but analysts are wary.

Last week, Exodus Communications and Excite@Home joined a long list of former highfliers such as Covad Communications and NorthPoint Communications in making bankruptcy filings.

In an effort to put bankruptcy in the best possible light, tech executives are talking about how filing Chapter 11 is a way to shed debt, boost balance sheets and emerge a stronger company.

Consider recent statements from bankrupt companies and their executives:

• Exodus CEO William Krause said last week that bankruptcy gives the company benefits such as paring debt and writing off unused facilities. Krause added that Chapter 11 doesn't mean the company is going out of business. "If you felt secure in doing business with Exodus six months ago, you should feel even more secure doing business today," he said.

• Excite@Home CEO Patti Hart said bankruptcy is "a tool to protect the value of the broadband business" and a way to "reassure our customers that service will continue uninterrupted through the restructuring process." Excite@Home is planning to sell its Internet access business to AT&T.

• Covad said its bankruptcy restructuring will "make the company virtually debt-free while putting it in a better position to obtain the additional capital necessary to achieve profitability."

Two shades of bankruptcy Bankrupt companies restructure in two ways: Chapter 7: A company stops all operations and goes entirely out of business. A trustee is appointed to "liquidate" (sell) the company's assets, and the money is used to pay off the debt. Chapter 11: A company tries to rehabilitate and to create a plan to turn a profit. Sometimes the company returns to profitability, but other times it ends up liquidating. Under a Chapter 11 reorganization, a company usually keeps doing business, and its stock and bonds may continue to trade. Source: SEC

According to these companies, bankruptcy can turn out to be a good thing. And it can be as long as a company can shed debt, fix its business and eventually turn profitable.

There's only one catch: Bankruptcy experts note that no Internet-related company has emerged from a financial restructuring to regain past glory. High profile companies such as Webvan and many smaller dot-coms have liquidated their assets.

"Bankruptcy has been a tool to liquidate, but we haven't seen any Internet company able to restructure with their creditors and make a comeback," said Warren Agin, a partner with Swiggart Agin, a Boston firm that specializes in Internet law.

Indeed, many tech companies have filed for bankruptcy to later sell assets for pennies on the dollar. Meanwhile, companies like Exodus and Covad are at the mercy of the court and a judge who may--or may not--restructure debt enough to give a company a fighting chance.

Toss in the fact that most of the companies declaring bankruptcy have never come close to being profitable and it's an uphill climb.

"Some of these companies will have no way to recover," said Steven Van Dyke, a partner with Bay Harbour Investments, a New York company that invests in distressed businesses. "A company may come out with a clean balance sheet, but it still needs a business plan that will make money."

Bargains or bombs?
Nevertheless, the spate of bankruptcies in the tech sector has some analysts scouring their databases looking to history for investment opportunities.

If a company with shares trading for less than a pack of gum can rebound, it could offer a nice return for investors willing to gamble.

A Morgan Stanley study found that returns were strong for companies that emerged from bankruptcy from 1980 through 1993, the last period of multiple recessions.

According to Morgan Stanley analyst Jeffrey Camp, shares of bankrupt companies fared best 200 days after the restructuring was completed, with gains 24.6 percent above average market returns at the time.

Who gets what Bankruptcy proceedings vary by company, but in most cases shareholders don't get a lot. Here's the pecking order of where the money goes first: 1. Secured creditors: Often a bank 2. Unsecured creditors: Banks, suppliers and bondholders 3. Shareholders Source: SEC

However, market timing is everything. Investors who bought companies before and during bankruptcy proceedings often lost out.

Camp said the characteristics of surviving companies are clear. Smaller companies with a high ratio of convertible debt--liabilities that can be converted to shares--strong research-and-development efforts, and a need to restructure because of strategic reasons such as a lawsuit seem to survive Chapter 11.

"If investors choose the right companies to invest in that are currently in the restructuring process, they will likely achieve strong average returns," Camp said.

Although Camp's research is notable, analysts pointed out that companies in the 1980s were saddled with debt but still made money on an operating basis--something the latest class of tech bankruptcies can't claim.

Simply put, trying to bet on restructured companies is akin to playing the lottery: There's no way to tell which companies will survive.

Meanwhile, shareholders of bankrupt companies are the lowest on the totem pole when it comes to getting their money back. Creditors come first, and shareholders usually wind up with nothing but a worthless stock certificate, analysts said.

"You'd be better off buying a PowerBall ticket," said Ken Irvin, a partner of Morrison & Foerster, a Washington, D.C., law firm.

Breaking through
Although no former New Economy darling has recovered from bankruptcy, analysts note it's just a matter of time before one makes it back.

With Covad still needing $200 million in funding once its bankruptcy restructuring is complete, experts tend to agree that Exodus is a favorite to recover--as long as it can keep its customers in the fold.

"Exodus may be the first one to pull through," Agin said. "It has real customers and real revenue. The big question is whether it can be profitable as a standalone company or as part of something else."