Is Qwest Playing Accounting Games?
Red Herring columnist Christopher Byron on Qwest's "creative" accounting.
January 31, 2002
redherring.com
In light of the financial train wreck we call Enron, and the predicament in which its one-time auditor, Arthur Andersen, now finds itself, you might think that companies would want to be absolutely hospital-corners tidy when fielding inquiries about their accounting practices these days, right? Say, for example, you were to ask a company whether it pulled some of its revenue forward a month, from January 2001 to December 2000, just to dress up its year-end 2000 financials a bit. You might think the answer would be squeaky clean. You might be wrong. Consider how Denver-based Qwest Communications International handled that matter when I recently put it before the company. The issue was how Qwest has been accounting for the growth of its telephone-directories business during the last year or so, as shown in its financial statements to shareholders and the U.S. Securities and Exchange Commission.
When I first phoned Qwest's chairman and CEO, Joseph Nacchio, with some questions, my call got bucked to a public relations aide, who tried to wave it all away. But when I persisted, he said, "Look, we put out an elaborate statement about all that at the time. I'll get it for you," as if this were the most routine matter imaginable. A day went by with nothing. But then I received the following two-sentence "official" response from the company: "Qwest follows generally accepted accounting practices (GAAP) rules in how it accounts for QwestDex. We discussed our activity in a 10-K filed about March 2001."
We'll get into the particulars of my inquiries in a minute, but first let's focus on the implications of the kiss-off I received. It suggests that whatever Qwest has been doing with its accounting, it's been doing it with the seal of approval of its auditors, Arthur Andersen. And that's a problem if what insiders at Qwest have been telling me is true: that the company has apparently been pumping up its revenue and earnings in its directories business as part of a drive to prettify its financials in the face of the deepening mess in the telecommunications industry.
Let me offer a bit of context. Qwest began in the '80s as a fiber-optics subsidiary of the Southern Pacific Railroad, laying fiber along the railroad's right-of-way. The man behind the business was a chap named Philip Anschutz, who had acquired the Southern Pacific through a leveraged deal with an obscure railroad that he owned named the Denver & Rio Grande Western. In January 1997, Mr. Anschutz hired Joseph Nacchio, who had previously headed AT&T's consumer and long distance business, and six months later they took the company public in an IPO at $22 per share.
It was the start of the fiber-optics IPO boom on Wall Street: in the years following, Qwest nearly hit $200 per share (adjusted for splits). Meantime, other fiber IPOs, including Level 3 Communications and Global Crossing, also piled into the market with offerings of their own, which likewise soared out of sight.
While Qwest's stock was hot, Mr. Anschutz and Mr. Nacchio went on a shopping spree and in the summer of 1999 wound up acquiring Denver-based U.S. West, the smallest of the regional Bell operating companies, in a costly $36.5 billion hostile bid. Not long after they struck the deal, the entire telecommunications sector tanked, in March 2000, sending the stock of the combined company plunging nearly 80 percent in value, to its present price of less than $12 per share.
In the wake of the collapse, the biggest single negative in the entire company was, of course, the fiber operation, where prices of broadband services had collapsed amid the spread of stupefying overcapacity throughout the industry. This meant that the U.S. West division-with steady cash flow from telephone services and its yellow pages publishing operation-became a cornerstone of financial support for the entire company.
Here's where it gets interesting. Key sources from within the company say that as 2000 drew to a close, enormous pressure was placed on the company's yellow pages publishing executives to meet what the sources say were "completely unattainable" revenue and earnings numbers for the publishing group. To meet the targets, the sources say the publishing executives were instructed by higher-ups at the corporate level to engage in what the sources describe as a "manipulation of the directory publishing schedule."
In the manipulation, yellow pages directories that had previously been published in January of every year were pulled forward and published a few weeks earlier, in December. As a result, the associated revenue could be declared in 2000, thereby allowing the company to meet a 10 percent revenue growth target for its publishing segment. This seems eerily similar to the so-called channel-stuffing ploy used by Sunbeam-another of Arthur Andersen's erstwhile clients-which met its revenue growth targets by shipping merchandise to distributors months before the distributors needed the goods.
The sources say this phone-book version of channel stuffing began with the Colorado Springs directory, and later was broadened to include other directories, adding $30 million to the segment's revenue for 2000. One of the sources involved in the process says this $30 million, while not a large number in the overall scheme of things, nonetheless played a key role in helping the publishing segment meet its unrealistically high 10 percent growth target, and thereby helped Qwest as a whole meet Wall Street's expectations.
Qwest's annual financial statement for 2000, audited by Arthur Andersen, explains the growth in year-over-year revenue for the publishing segment as being due, among other things, to "an increase in the number of directories published." But the sources say the "increase" derived simply from publishing some 2001 directories a few weeks earlier than normal, and that this is what is meant by the word increase-not more directories, just the same number of directories being published a few weeks earlier to create more reportable revenue.
An unaudited quarterly statement by the company, covering the subsequent three-month period, from January through March 2001, shows, predictably enough, that revenue from the publishing segment was down in the first quarter from the same period in the year before. The vague reason given was a "change in the mix of directories published in the three months ended March 31, 2001." Well, duh! A more forthright explanation would have been this: "Our revenue in the first quarter declined because we published various directories in the fourth quarter of last year to make those numbers look better."
Meanwhile, the company appears to have embarked on yet another ploy to dress up its publishing numbers. The sources say this involved a process known as "extending the lives of directories." Instead of publishing a 12-month directory, the company decided to treat its annual directories as if they were to be used by the public for 13 months and began billing advertisers 8 percent more than the year before. The sources say the company's salespeople were told not to tell advertisers unless they asked.
The sources say that by August 2001, seven directories, including the ones for Portland, Oregon, and Denver, had been switched to a "13-month" schedule, creating a 5.1 percent year-over-year increase in revenue in the second quarter. The only explanation appears in a single sentence in the company's June 30 quarterly financial filing to the SEC, on Form 10-Q, which states murkily that the revenue gain came largely from "a change in the length and mix of directories published."
By the summer, other aspects of Qwest's financials began to set off alarm bells at Morgan Stanley, where a three-person team of analysts published reports questioning the company's accounting practices. In one instance, the analysts noted that revenue gains for the company seemed to be coming increasingly from one-time sales, including the sale of long-term leases of its broadband capacity to other carriers. In another, they questioned the company's use of write-offs. Qwest's CEO, Mr. Nacchio, attacked the analysts for not understanding the basics of accounting.
Meanwhile, the top two men at Qwest-Mr. Nacchio and Mr. Anschutz-had sprung into a cloudburst of insider selling. Mr. Nacchio sold or registered to sell $181 million's worth of his stock in 2001, and Mr. Anschutz sold or registered to sell $408 million. Most of these sales came at two and three times the stock's current price, and many involved deep in-the-money options.
The fact that Qwest was apparently all too willing to fog the true picture of its yellow pages business while the men at the top began cashing in their chips should be warning enough to any investor that other problems still may lurk in this company's accounts.
In fact, at least in the case of the directories revenue, the problems still seem to be there, complete with those artful explanations about the "mix and length" of the directories being published, all the way through the company's latest financial filings, for the period ended September 30, 2001. On January 29, the company reported a loss of $0.31 per share for fourth quarter 2001. Read the company's full-year 10-K when it comes out in March-we'll see what the explanation is for the publishing segment. When it turns out that the auditing firm for those accounts is the same paper-shredding crowd that blessed the disaster at Enron, well, what else is there to say but beware.
Christopher Byron is a syndicated radio commentator and writer living in Connecticut. He also writes a weekly column for the New York Post and for MSNBC.com. Write to contrarian@redherring.com. |
