On March 5, 2001, the Wall Street Journal marked an anniversary nobody wanted to celebrate. A year earlier, on March 10, 2000, the Nasdaq had closed at 5048.62. Now it stood at 2117.63, down 58 percent. Of the stocks on the Nasdaq, 428 had fallen more than 90 percent.
For the hosting companies, the reckoning came a few months later. In June 2001, the Journal ran a short article under the headline "Overcapacity Jitters Hurt Web-Hosting Stocks." Stephen Murphy, an analyst at CIBC, estimated that only 22 percent of the data-center space in North America would be used or sold that year. Gartner cut its forecast for growth in colocation demand from 25 to 35 percent a year to 2 to 5 percent.
Gartner's Ted Chamberlin summed it up: "There's a glut of data-center space." PSINet and a company called Colo.com were already in bankruptcy.
Think about what that 22 percent meant. Four months earlier, the Yankee Group had counted 9 million square feet of server-farm space in the United States, headed for 25 million. CIBC was now saying that most of the space would go unused or unsold that year.
The developers felt it too. In Boston, a telecom hotel was being converted into space for biotech companies. Wiring a building for telecom tenants cost $500 to $1,000 a square foot, and now that money was buried in walls nobody needed. Bradley Olson of Cornell compared the overbuilding to "four gas stations on the same intersection." In Jersey City, a $100 million conversion of 1.1 million square feet at 50 Dey Street was still going ahead, and MetroNexis and Global Gateway, the developers Morgan Stanley had backed, had eleven telecom hotels with about 6 million square feet between them. "The demand is still there, but it's thinner," Andrew Zezas of Insignia/ESG told the New York Times in May 2001. By October, Grubb & Ellis put vacancy in telecom real estate above 30 percent in most markets.
Then the forecasts gave up. When Dell sold its Web-hosting business to Sprint in August 2001, the Journal did the arithmetic in one sentence: "Two years ago, Web-site hosting was projected to be a $17 billion annual market by 2003. Today, analysts estimate... about $9 billion."
Recall Argent's line from the summer of 2000: eighteen months was ten years in Internet time. Eighteen months later, the hosting companies found out what ten years of bad news looked like.
The tide was going out. Let's see who was swimming naked.
Exodus Continued—Ellen Hancock#
When we last left Ellen Hancock, she had just bought her biggest rival with richly valued stock. It took the market about five months to decide what that stock was worth.
In June 2001, the same week the Journal counted the empty space, Exodus shares hit $4.15. Their fifty-two-week high was $69.
The forecasts had been the asset. Now the forecasts were gone.
The departures came in a familiar order. In May, Exodus's chief financial officer, its president and its head of marketing left. In August, the company hired Goldman Sachs, Credit Suisse First Boston and Lazard as advisers, and three directors resigned. The stock was down 98 percent. Hancock still insisted "we're getting good solid business."
Hancock resigned as chairman and CEO in early September 2001. Exodus shares traded at 65 cents. The company carried about $2.9 billion of debt.Press reports at the time put Exodus's debt at about $3.5 billion. I have used the figure in Exodus's bankruptcy disclosure statement: "Indebtedness for borrowed money as of the Petition Date totaled approximately $2.9 billion." A J.P. Morgan analyst said what everyone on the Street believed: Exodus "must sell to a suitor or face bankruptcy."
There was no suitor.
Even then, the analysts split. On September 25, Andrew Schroepfer of Tier 1 Research, a former Goldman Sachs hosting analyst, predicted a prepackaged bankruptcy, with bondholders getting 20 to 25 cents on the dollar. He saw "no way they could support the number of data centers they have out there." Cary Robinson of U.S. Bancorp Piper Jaffray held the other side: "We do not currently believe Exodus will go bankrupt."
Exodus filed the next day, September 26, 2001, fifteen days after the attacks on the World Trade Center. It went into Chapter 11 in Wilmington, Delaware, with about $600 million of cash, owing about $2.9 billion across eight note issues.The disclosure statement lists five series of senior notes, originally $1.95 billion, and three issues of convertible subordinated notes with about $993 million outstanding. Press reports described six bond issues totaling $3.5 billion. On September 25, eWeek put Exodus's cash at $340 million. At midyear it ran forty-four data centers around the world. Its floor space had grown from 600,000 square feet in June 1999 to 5.6 million by the month it filed. Customers included Yahoo and eBay, and according to the Financial Times, Exodus hosted forty-six of the world's top 150 websites. The Internet still needed Exodus's buildings. It just didn't need Exodus's balance sheet.
Hancock's successor, William Krause, wrote the epitaph in the press release announcing the filing: "We sacrificed profitability in exchange for growth and market share, over-expanding in some areas in advance of demand."
Two months later, Cable & Wireless agreed to buy the best of what was left. When the sale closed on February 1, 2002, it got twenty-eight of Exodus's data centers for $560 million in cash.The press numbers were all different. The Wall Street Journal reported that Cable & Wireless would buy "the best 30 of Exodus's 56 data centers" for about $570 million in cash plus $180 million of assumed liabilities; the Financial Times said "$850m cash." I have used Exodus's disclosure statement, filed in the bankruptcy case before Chief U.S. District Judge Sue L. Robinson. It says the buyer, Cable & Wireless's CWIS unit (formerly Digital Island), signed on November 29, 2001, acquired interests in twenty-eight data centers and "paid $560 million in cash upon closing," plus about $9 million for security deposits. The sale order was entered January 22, 2002, after a two-day hearing and about ninety-seven objections, mostly from customers, landlords and equipment lessors. Nobody else wanted them. In the words of Exodus's court filing, "No other parties, however, bid on the assets." The same filing was just as blunt about the rest: "The Debtors are not reorganizing their business; they are liquidating." The senior noteholders were expected to recover 14 to 24 cents on the dollar. The subordinated noteholders would get half a cent. The stockholders got nothing.
Let's do the arithmetic. In February 2000, Exodus had a Market Value of more than $20 billion. Twenty-one months later, its best data centers sold for less than 3 percent of that. Global Crossing's stake of about 20 percent, the payment for GlobalCenter, went down with the common stock. As I wrote in Bandwidth, the ten-year capacity commitment became basically worthless too.
The servers kept humming through it all. The buildings were fine. The buildings were always fine. And that is the lesson the next generation of data-center investors would take to the bank, as we'll see when Equinix and Digital Realty start shopping for empty floors at pennies on the dollar.
Digex Continued—Bernie Ebbers#
When we last left Bernie Ebbers, he had beaten Exodus and Global Crossing to Digex, then paid Digex's minority shareholders $165 million in stock to make their lawsuit go away. Part of the settlement was $900 million of loans from WorldCom to Digex. Ebbers had bought himself a hosting company that needed his money to keep building.
The money ran out at the top. As I told in Bandwidth, WorldCom filed for Chapter 11 on July 21, 2002. Eleven days later, the FBI arrested its chief financial officer, Scott Sullivan, and its controller on securities fraud and conspiracy charges.The full story of WorldCom's accounting fraud and its executives' trials is told in Bandwidth. Here it matters only because Digex went down with it. Ebbers's empire, built on acquisitions paid for in stock, came apart.
Digex was a footnote to the WorldCom collapse, but a telling one. In June 2002, a few weeks before the bankruptcy, Digex cut 7 percent of its workforce. That same month, John Sidgmore, WorldCom's vice chairman, gave the Washington Post his verdict on the deal I described in the last chapter. WorldCom had "paid over $6 billion," he said, "for a company that's worth maybe $50 million."
Do the math on that. In September 2000, Digex had a Market Value of $5.3 billion, and the press had valued Exodus's bid for it at $8.5 billion. Less than two years later, WorldCom's own vice chairman valued it at less than 1 percent of either number.
Regulators, meanwhile, forced WorldCom to sell most of Intermedia's other assets, and WorldCom had trouble finding a buyer.
Ebbers had won the auction. Winning cost him more than losing would have.
Globix#
When we last left Globix, it had a Market Value of almost $1 billion and a data center going up in Manhattan.
Globix said it didn't have an empty-building problem. In June 2001, while CIBC was predicting that most of the continent's data-center space would go unused, Globix said its centers were 95 percent full.
It had a debt problem instead. In January 2002, Globix announced that it would seek bankruptcy protection. The plan would turn about $600 million of debt into $120 million of new notes plus equity. By then, Globix's Market Value had fallen to $5.87 million. Globix filed in Delaware on March 1, 2002, with the plan already agreed. The bondholders took about 85 percent of the new stock. The common shareholders kept about 1 percent. Globix emerged on April 25, eight weeks after filing.
Almost $1 billion to under $6 million. And the buildings were 95 percent full.
That is the lesson of Globix, and it's the lesson of this chapter. A full building with too much debt is a bankrupt company. The building itself was fine.Globix's preferred holders received about 14 percent of the new stock. The plan was confirmed on April 8, 2002. Globix was also negotiating to give up part of its Globix House space in London.
Data Return#
When we last left Data Return, three former Microsoft engineers had taken their two-year-old company public at a valuation of nearly $450 million, with Level 3, Compaq and Microsoft among its backers.
In November 2001, a company called Divine agreed to buy Data Return for about $31 million in stock. Data Return's shares were trading at 72 cents.
From $450 million to $31 million in two years.The $450 million is the valuation implied by Data Return's October 1999 IPO price, not its peak trading value. The market had once valued Data Return at nearly fifteen times what a buyer would pay for it.
PSINet Continued—Bill Schrader#
When we last left Bill Schrader, PSINet's name was on a football stadium and he was telling anyone who asked that PSINet was "not for sale."
As I wrote in Bandwidth, Schrader stayed an optimist to the end. At PSINet's holiday party, he told employees, "AT&T is going to go down, but PSINet will survive."Bandwidth dates this party to December 2001. That can't be right: Schrader resigned in April 2001, and PSINet filed for bankruptcy in May 2001. The party was most likely in December 2000. His board was less sure. PSINet carried about $3 billion of debt, and one director later said Schrader "was more interested in building the infrastructure than in achieving profitability with what he already had."
In April 2001, PSINet reported a fourth-quarter loss of $3.2 billion and disclosed that it was in default on its lease obligations. The board asked for Schrader's resignation and got it. He lost most of his $1 billion in PSINet stock by refusing to sell. A PSINet insider described his trading discipline: "When the stock was at $30 he'd say 'I'm a seller at $75.' When it went to $60, he said 'I'm a seller at $100.'"
On May 31, 2001, PSINet filed for Chapter 11 in the U.S. Bankruptcy Court in Manhattan. The press release carried the dateline of its headquarters: Ashburn, Virginia. Its chief executive, Harry G. Hobbs, offered the diagnosis: "Our existing capital structure did not permit us to respond to the rapid changes in our markets."
By November, the Wall Street Journal reported that nobody expected a bid above $300 million for the company, against nearly $3 billion of debt. The headline put it in retail terms: "In Bankruptcy, PSINet Gets '90% Off' Tag." The Journal named Citic Pacific as the likely buyer. Jim Millstein of Lazard put it this way: "anything north of zero is taken very seriously."
North of zero turned out to be the right neighborhood. In February 2002, David Schaeffer's Cogent Communications agreed to buy PSINet's U.S. business for about $10 million, and it closed in April.The $10 million comprised $7 million for the business and $3 million the buyer had already paid for the right to do its due diligence. Cogent's own filing gives "a total cash purchase price of approximately $9.5 million" and dates the closing to April 2, 2002. The Wall Street Journal had named Citic Pacific as the likely buyer in November 2001; Cogent ended up with the U.S. business. Bandwidth describes the purchase as PSINet's assets; the Washington Post headline says its U.S. division. As I wrote in Bandwidth, Schaeffer bought several other fiber properties at distressed prices and built them into a public company worth multiple billions. Nice job, Dave!
Genuity Continued—Paul Gudonis#
When we last left Paul Gudonis, he had launched Black Rocket and asked the world whether it wanted to change.
In 2001, Genuity went shopping in France. It bought a French web hosting company, Integra, for $114 million.Bandwidth describes Integra once as "a French web hosting company" and once as "a French fiber provider." The Wall Street Journal headline called the buyer a "net-services firm" and put the price at $113.7 million. Genuity's own announcement described Integra as a European provider of managed hosting and e-business services. The French target's chairman said his company had decided "to find a big brother." Within weeks, Genuity cut its revenue outlook for the year and reduced its workforce by 12 percent.
Genuity's own big brother was supposed to be Verizon, which held an option to buy it. In July 2002, with three years left on the option, Verizon gave it up. Verizon wanted investors to know it would not be absorbing Genuity's $3 billion of debt or its $4 billion of 2001 losses. The forfeiture triggered a covenant on Genuity's debt.
Two days after Verizon's announcement, Forbes ran a story titled "Genuity Is Left on the Launching Pad." As I quoted in Bandwidth, Forbes reminded readers of the rocket and the tagline, then added: "But the '90s, alas, had just ended, and the world had already changed—and not for the better, if you were a tech investor."
Genuity's stock, already down to $2.59, fell to 29 cents. A day before Verizon's announcement, Genuity drew down $723 million on its credit line, with an unusual demand that the banks complete the transfers by noon. A spokesperson insisted the timing was "absolutely coincidental." Genuity filed for bankruptcy in November 2002.
The buyer was my old company. Level 3 agreed to pay $242 million for Genuity's assets, with adjustments in Level 3's favor. By the time the deal closed in June 2003, the price had fallen to $60 million in cash plus $77 million of prepayments to vendors. Genuity had raised $1.91 billion in its IPO three years earlier. Level 3 bought the whole thing, BBN included, for less than 5 percent of its peak valuation.
The Carriers' Buildings—Qwest and Level 3#
When we last left Joe Nacchio, Qwest had hired IBM to build twenty-eight CyberCenters, had leased 500,000 square feet in Yonkers and was waiting on PG&E for power in Sunnyvale. Qwest's Lew Wilks had called the demand curve "insatiable."
By 2001, Gartner was forecasting colocation demand growth of 2 to 5 percent a year. What happened to the CyberCenters is a gap in my sources. What happened to Qwest is not. As I told in Bandwidth, Qwest's own president warned Nacchio repeatedly in late 2000 and early 2001 about the gap between his financial targets and what the business units were projecting. Nacchio didn't change his guidance. In June 2002, Phil Anschutz flew to New York and told Nacchio he was being replaced, effective immediately. A month later, the U.S. attorney in Denver opened a criminal investigation. In December 2005, Nacchio was charged with forty-two counts of insider trading over his sale of $100.8 million of Qwest stock in 2001.
When we last left Level 3, we had gone from nothing to 4 million square feet in thirty facilities in two years, and our own Jimmy Byrd had warned that too many data centers were coming online at the same time.
Byrd was right. I'd like to tell you we all saw it coming. The record shows that one of us did, out loud, in the Wall Street Journal.
Global Crossing Continued—Gary Winnick and Leo Hindery#
When we last left Leo Hindery, he was "a broken man" handing GlobalCenter to Ellen Hancock in exchange for about 17 percent of Exodus.
Hindery didn't stay to watch. He resigned as Global Crossing's CEO on October 12, 2000, two weeks after the Exodus deal was signed. By the time the deal closed in January 2001, Global Crossing's stake, by then estimated at about 20 percent of Exodus, was worth $1.8 billion. By the end of 2001, as we saw, it was basically worthless.
Global Crossing followed its stake down. As I told in Bandwidth, the company filed for Chapter 11 in January 2002. Singapore Technologies Telemedia eventually agreed to buy 61.5 percent of the reorganized company for $250 million, which valued all of Global Crossing at $600 million. A couple of years earlier, it had been worth $50 billion. Gary Winnick, meanwhile, had managed to extract $734 million for himself.
Global Crossing had been the anchor tenant of Terremark's new Miami building, taking about 250,000 of its 700,000 square feet.
AboveNet Continued—Steve Garofalo and Bill LaPerch#
When we last left Metromedia Fiber Network, it had paid $1.76 billion for the original AboveNet, a hosting and exchange company in San Jose, and announced a vast expansion into Europe.
Bandwidth readers know how this one ends. But the data-center part of the story deserves its own telling here.
In 2001, MFN faced an existential problem. Nearly every distressed fiber provider was its customer, and those customers made up most of its $2 billion revenue backlog. As they failed, MFN's funding failed with them. A Citicorp credit commitment turned out to be conditional. A class action was filed against Steve Garofalo, the CEO who had founded the company. The stock fell below $1 a share. In April 2002, MFN's auditor, KPMG, said it couldn't review the company's quarterly numbers because its internal controls were so poor. That same month, Verizon and Genuity terminated their fiber agreements with MFN.
MFN filed for bankruptcy in May 2002. It emerged in September 2003 under a new name: AboveNet, borrowed from the San Jose hosting company it had bought four years earlier. Its estimated enterprise value was $230 million to $330 million. At the peak of the boom, it had been worth $10 billion.
Selling the Floors
The bankruptcy turned MFN's data centers into cash. While it was still in Chapter 11, the company sold real estate in Northern Virginia's data-center market for a combined $63 million, a steep discount to what the properties were worth.
Then Bill LaPerch took over. LaPerch was a West Point graduate and former army captain who had come up through NYNEX and MCI as an operations executive. He joined MFN to run operations after WorldCom absorbed MCI, and he became CEO of the reorganized AboveNet, its fifth in three years. He sold multiple data-center assets. In December 2004, Equinix bought AboveNet's data center in San Jose. In October 2006, Digital Realty bought more AboveNet centers.
LaPerch used the proceeds to build fiber to as many data centers as he could reach. He explained the strategy in a 2010 interview I quoted in Bandwidth: "we know that a significant amount of business is going to be focused around the data center infrastructure. So, we establish a fiber ring that hits the key carrier hotels and data centers." He no longer wanted to own the buildings. He wanted to connect them. As I wrote in Bandwidth, his ten-year execution of that strategy was extraordinarily successful. Zayo bought AboveNet in 2012.
But look at who was buying. The two companies that bought AboveNet's data centers, Equinix and Digital Realty, are the two central characters of the next chapter.
September 11—Danny Lewin#
On the morning of September 11, 2001, Danny Lewin was aboard American Airlines Flight 11. He was thirty-one years old.
Two years earlier, Akamai's IPO had produced the fourth-biggest first-day gain in history. Lewin had grown up in Jerusalem after being born in Denver, served as a captain in an elite Israeli military unit, studied at the Technion and worked for IBM in Haifa. At MIT, he and his professor, Tom Leighton, had worked out how to push the Web's content to the edge of the network. With Jonathan Seelig, they founded Akamai in 1998.
Lewin died aboard Flight 11.
The New York Times ran his obituary two days later under the plainest of headlines: "Daniel Lewin, Technology Executive, 31."
The attacks changed the data-center business in ways that took years to play out. The first change showed up within weeks. Banks wanted backup data centers. In October 2001, the Wall Street Journal reported that a vacant 200,000-square-foot building in New Jersey had drawn a bidding war. Ron Vidal, a senior vice president at Level 3, explained the new thinking in eight words: "We don't want it all in one building."
The hosting companies had spent the boom selling concentration: put everything in our building, and we'll keep it safe. After September 11, customers wanted their computers in more than one place. It was the logic Akamai had been selling all along.
Pennies on the Dollar#
By 2003, the hosting Gold Rush had turned into a clearance sale.
Cable & Wireless bought twenty-eight of Exodus's data centers for $560 million in cash, and it had already paid $340 million for Digital Island. Cogent paid about $10 million for PSINet's U.S. business. Divine paid $31 million for Data Return. Level 3 paid $137 million for all of Genuity. ST Telemedia paid $250 million for control of Global Crossing. AboveNet sold its Northern Virginia data centers for $63 million.
In April 2002, Tier 1 Research tried to count the wreckage. Hosting companies around the world operated more than eight hundred Internet data centers, with over 40 million gross square feet between them. Less than half of that space was even in operation. Of the space that was open, 31 percent was in use. A year earlier, CIBC had estimated that only 22 percent of North America's space would be used or sold. Tier 1's count was hardly more cheerful.
Even the buyers weren't sure what they had. When Cable & Wireless bought Exodus's centers, a Gartner analyst offered a backhanded endorsement: "We think Web hosting is a valuable business... but it's one that's better for the large telecom operators." Many of the large telecom operators, of course, were the ones going bankrupt.
The buildings told a different story. Customers didn't leave them. Switching hosting providers could cost a customer 20 percent of a year's hosting bill, the Journal reported. When Cable & Wireless took over Exodus's best centers, the customer list it inherited included Microsoft and Cisco. The racks, the generators, the cross-connects and the customers all stayed put. Only the names on the deeds changed.
A buyer with cash and patience could pick up those buildings for a fraction of what it cost to build them. Nobody put it better than the Equinix executive who explained his company's purchase of AboveNet's San Jose building: "We're paying pennies on the dollar for the San Jose building's assets. If we had to go out today and build a building from scratch like this, we would have to deploy $80 million in capital."
The starkest example surfaced in 2004. In 2000, Exodus had built twin 150,000-square-foot buildings at 2045 and 2055 Lafayette Street in Santa Clara. The property, a later prospectus said, "was built specifically for Exodus." Its new owners estimated that Exodus had invested "approximately $150 million in the electrical systems" alone. In May 2004, GI Partners, the fund that would soon take Digital Realty public, bought both buildings for $60 million.
The same patience was at work in Ashburn. Two developers, Lammot du Pont and Hossein Fateh, had bought land there in September 2000 and put up two data-center shells in 2001. A colocation provider leased them from mid-2001 through late 2003. Then one of them sat empty until 2005. In their own later account, du Pont and Fateh "began acquiring data centers that were distressed assets between 2000 and 2003." We'll meet them again.
What should we take from all this? In Bandwidth, the myth was that Internet traffic doubled every three months. Andrew Odlyzko debunked it in 1998. As he and K. G. Coffman later showed, the doubling had been real in 1995 and 1996. By 1997, traffic had slowed to roughly doubling once a year. The myth was a true number that outlived its time. The hosting business had its own version of that myth. In 1998, Forrester said hosting would grow eighty-fold in five years. In 1999, forecasters said $17 billion by 2003. In 2000, analysts said $35 billion by 2005. By August 2001, the estimate for 2003 was about $9 billion. And a month later, in the press release announcing its bankruptcy, Exodus was still quoting IDC's forecast that hosting demand "will reach $24.8 billion by 2004, up from $7 billion in 2001." The buildings went up on the forecasts. The bankruptcies came when the forecasts came down.
The demand was real. It just wasn't as big, or as fast, as the forecasts said. Keep that distinction in mind when we get to the AI forecasts at the end of this book.
By the end of 2003, the worst of the Bust was behind the data-center business. The empty floors were still empty, but the prices had finally caught up with reality. Now came the part of the cycle that rewards the patient: the time when buyers with cash walk through the wreckage and pick up hard assets for next to nada. The table was set, once again, for the phoenix.