NYT -- Telecom, Tangled in Its Own Web.
March 24, 2002
Telecom, Tangled in Its Own Web
By GRETCHEN MORGENSON
Thanks to a star-quality cast, the Enron
(news/quote) wreck has been riveting
theater. Greedy executives concocting
transactions to inflate company earnings,
grasping Wall Street bankers eager to assist,
pliant accountants and analysts looking the
other way — Broadway's finest could not have
come up with a better script.
Yet while all eyes remain on Enron, a tragedy
of identical plot but with far more damaging
implications has been playing out on another
stage. Unlike Enron's saga, this drama is not
about a single, rogue company operating to
enrich its executives. This tale is about an
entire industry — telecommunications — that
rose to a value of $2 trillion based on dubious
promises by Wall Street and company
executives of an explosive growth in demand
for telecommunications services. When that
demand failed to materialize, the companies
were left with mountains of debt and little
revenue.
Now, securities regulators are examining
transactions among some telecom companies
— Global Crossing and Qwest
Communications (news/quote) are two — that
may have been designed to pad inadequate
revenue. Last week, Congress, too, started an
investigation of the telecom mess, looking at
how certain companies accounted for the deals
they struck with one another and whether
employees in the companies' 401(k) plans were
treated fairly.
As they dig, they may discover a trait that distinguishes this financial mess from
others: the role played by an extensive web of relationships among these
companies. Because of many deep and tangled ties, telecom companies were able
to show what looked like promising growth in the mania's initial stages. But when
demand from consumers and corporate customers of the networks failed to
emerge, the ties among the companies exacerbated their declines. When one
company failed, other failures became almost inevitable.
It is unclear whether many of these interlocking relationships served any
economic purpose. What is clear is that executives had incentives to forge them:
by creating revenue, they helped keep the stock price up.
There is no doubt that the mess is large. Since the telecom sector peaked in the
spring of 2000, some $1.4 trillion in investor wealth has evaporated, according to
one analyst. More than 15 companies have filed for bankruptcy reorganization in
the last year or so, including former highfliers like Global Crossing, which made
the fourth-largest bankruptcy filing in American history in January, as well as
360 Networks, PSINet (news/quote) and Net2000 Communications
(news/quote). Many others in the industry are teetering.
Even companies that seemed solid and well diversified have been hurt. Lucent
Technologies (news/quote) and Nortel Networks (news/quote), both generous
financiers to upstart telecom companies that bought their equipment, have had to
write off billions of dollars in bad debts associated with their customers' failures.
Almost 400,000 jobs in the telecommunications sector have vanished as well,
according to Challenger, Gray & Christmas, the job placement concern. And the
bloodletting is not slowing: telecom companies cut some 61,000 jobs in the first
two months of 2002, up 42 percent from the toll during the comparable period
last year. Adding to the injury, many of the sector's 401(k) plans — filled as they
were with company shares — are in tatters.
"The underpinnings of the emerging telecom bubble were a phenomenal
miscalculation," said David Barden, a telecommunications analyst at J. P.
Morgan. "At the time it seemed like a logical progression of history: cellular, the
Internet, the new thing. It was bold, it was risky, it was expensive. And it was
wrong."
In contrast to the implosion of Enron, which attracted front-page headlines, the
disaster in telecommunications arrived stealthily. The failures occurred in slow
motion over the last 18 months and have mostly involved smallish, lesser-known
companies. But thanks to Enron, the haves and have-nots in the drama are
depressingly familiar. Executives and shareholders lucky or prescient enough to
get out early got rich as their companies' shares rocketed. Joseph P. Nacchio,
chairman of Qwest, and Philip P. Anschutz, the co-chairman, have sold shares
worth almost $2.3 billion since 1998. And James Q. Crowe, chief executive of
Level 3 Communications (news/quote), sold $115 million worth of stock from
1999 to 2001.
"Unlike the Internet, which was brand new, telecom had an aura of an established
and understood technology," said Paul Elliott, an analyst at Thomson Financial.
"This, in part, set the stage for this massive transfer of wealth to the new
telecom barons, not only from gullible investors, but banks and lenders who
presumably should have known better."
Workers and shareholders who did not get out were left without chairs when the
music stopped. In the 401(k) at Qwest, for example, almost 40 percent of the
assets were in Qwest stock at the end of 2000, the most recent filings available.
Since then, the shares have lost almost 80 percent of their value. At Global
Crossing, 29 percent of 401(k) assets were in the company's stock as of the end
of that year.
The telecom turmoil isn't over. Two years after the bubble popped, many
companies in the industry are still operating on the edge, even more heavily
encumbered with debt as a portion of their capitalization than they were when
their stocks were flying high. Many now have little equity value but still carry
onerous levels of debt.
As a result, in recent months, Qwest, WorldCom (news/quote), Sprint and
AT&T (news/quote) have sharply reduced their operations, staffs and earnings
forecasts. Smaller companies like XO Communications (news/quote) and Level 3
Communications are struggling to restructure the terms of their debt obligations
to stave off bankruptcy. Just last week, Metromedia Fiber Networks warned that
it might file for bankruptcy soon.
REGULATORS, meanwhile, are focusing their investigations on how telecom
companies accounted for certain transactions in which competitors swapped
capacity on their networks. At issue is whether companies artificially inflated
their earnings by striking deals that had no economic value but that appeared to
produce immediate revenues to both parties.
At the center of this debacle stand the usual Wall Street enablers. Investment
bankers raised money from investors for far more telecom networks than were
economically feasible. Brokerage-firm analysts, eager to help their employers win
ever more securities offerings, drummed up investor interest in untested
companies.
Because these companies had neither revenue nor earnings, telecom analysts
devised new rationales, new metrics, to justify the purchase of already
overpriced stocks — just as they did with Internet shares.
The most popular method was to value the companies based on the money they
had put into their networks — money from investors, not money that the
company had earned. Susan Kalla, a telecom analyst at Friedman Billings &
Ramsey in New York, recalled when telecom shares were promoted by big
brokerage firms as good values because they traded at prices that represented
four or even five times what they had invested in plant and equipment.
That argument, she said, "presumed that every penny that every company
invested would produce the same rate of return."
"They really thought that if you put in the latest, fastest thing, that was enough to
drive the business," she added. "It was crazy."
But for all its similarities to other debacles, the one in telecom is remarkable in a
particular way: the hundreds of interlocking relationships — all financial —
among the industry participants that perpetuated the spread of the collapse. As
Mr. Barden of J. P. Morgan explained: "It turns out that the amount of revenues
generated inside the telecommunication industry by other telecom participants
was such a large percentage of the total that a small number of bankruptcies
fueled a larger number of bankruptcies and the entire emerging structure started
to collapse."
Noting early on how intertwined the fortunes of telecom companies were, Mr.
Barden published an extensive research report last April called "The Matrix." In it
he identified 184 relationships among 49 telecom companies. The ties fell into
four categories: commercial, which included deals like leasing capacity on one
company's network by another; strategic, which involved investments in
competitors; equity, which referred to the purchases of shares in another
company; and vendor financing, in which one company provided funds so that
another could buy its products.
At the time of the report, each company in Mr. Barden's telecom matrix had ties
to an average of four others in the industry. But some had far more. Metromedia
Fiber Networks, for example, had sold fiber to 21 companies, making it an
important dealer of the commodity. But because most of these deals were
long-term leases, Metromedia's fate was inextricably tied to the health of these
companies. Five of them have filed for bankruptcy, and others are in danger of
failure. So it is not surprising that Metromedia recently warned that a bankruptcy
filing of its own might be near.
In 1998 and 1999, during the early days of the telecom gold rush, such
relationships were crucial for start-up companies; they knew that networks were
expensive to build and that investors who financed them would have only so
much patience before they began to demand returns. Rapid growth in revenue
was therefore necessary, Mr. Barden explained, and the quickest route to it was
through sharing of the networks that were being laid.
For example, in a 10-year deal worth $500 million and signed in 2000, Exodus
Communications (news/quote) agreed to send half of its traffic to a network
owned by Global Crossing. Conversely, Global Crossing owned $1.9 billion of
Exodus shares that it had received from the sale of a subsidiary, Global Center, to
Exodus.
The Exodus network did not attract enough traffic, however, and the company
filed for bankruptcy last October. The loss of the Exodus deal contributed to
Global Crossing's problems, which came to a head in January.
In another pact, dating to December 1998, Winstar Communications agreed to
pay Williams Communications $640 million over seven years to use one of its
networks, while Williams was to pay $400 million over four years to Winstar for
some wireless capacity. After Winstar declared bankruptcy last April, Williams
Communications estimated that it would lose $70 million in revenue that it had
already booked from April 2000 through last December. Struggling under $5.2
billion in debt, Williams warned last month that it might file for bankruptcy soon.
In November 2000, Level 3 Communications sold fiber infrastructure worth
$250 million to Mc- LeodUSA. McLeod also owns fibers on Level 3's network,
thanks to its acquisition of Splitrock Communications in 1999. McLeod filed for
Chapter 11 bankruptcy protection in January, and Level 3 said recently that its
declining revenue might violate terms of a bank covenant this year. That could
ultimately force the company into technical default on some of its debt.
And just last week, Velocita, a private company led by Robert Annunziata, a
former chief executive of Global Crossing, appeared to be in danger of defaulting
on its debt. The company's plan to build a 20,000-mile telecom network was
financed by, among others, Cisco Systems (news/quote), which invested $200
million in the company and lent it an additional $285 million to help buy Cisco
equipment.
While tying up with other companies in the industry helped all the players initially,
the relationships also meant that most companies were offering the same services
to potential customers. They could not differentiate themselves, and that can spell
death when a field is crowded with competitors.
As the accounting for some transactions is being questioned, these relationships
are causing additional problems for telecommunications companies. Two weeks
ago, Qwest announced that it had been contacted by the Securities and Exchange
Commission regarding its accounting treatment of long-term contracts it had
struck to sell capacity on its high-speed voice and data networks to Global
Crossing, whose accounting is also under investigation. Both companies say their
accounting methods are proper.
Such swaps continued to be struck across the industry as recently as last year,
long after the bubble began to lose air. Ms. Kalla estimates that telecom
companies made swaps worth $2.5 billion in 2001. It is not yet clear how many
of those swaps lacked a real business purpose. But some analysts wonder if
these interlocking relationships were intended to overstate the true economic
value of the businesses. Given that the companies were not generating nearly
enough revenue to keep investors happy last year, there was certainly incentive to
inflate results.
ULTIMATELY, it became clear that increased demand for telecom services from
consumers or corporate customers was not going to build. So the revenue pool
wound up fairly static — yet it had to be shared by many, many more hopefuls.
"Every one of these companies assumed they were going to be the success
story," Mr. Barden said. "So every one of them bulked up with every fiber optic
cable they could get their hands on, every switch, every salesperson. All these
companies built for success, and most of them, given the economic size of the
market, were doomed to failure. Because at the end of the day, the dollars
coming into the system were just not growing fast enough."
Bad as things have been in telecom, the worst may not be over. Ms. Kalla says
that while the regional Bell operating companies are well-positioned, business will
become grimmer for long-distance carriers. "If the capital markets close down in
a business that is hugely capital intensive, then there is enormous turmoil until
they can get costs in line with revenues," she said.
James Challenger, the outplacement authority, said: "Many of these companies
have been through multiple rounds of layoffs, yet the industry is leading the way
in 2002. This suggests that the excesses of the late 90's have yet to be purged."
Copyright 2002 The New York Times Company |
