Hmmm... Another good column from Gretchen Morgenson and the NY Times...
nytimes.com
July 9, 2002
Despite Access, Star Analyst Missed WorldCom Trouble Signs
By GRETCHEN MORGENSON
Jack Grubman, the influential telecommunications analyst at Salomon Smith Barney, missed signs of trouble at WorldCom that some other analysts spotted. And he missed them in spite of an extraordinarily close relationship with the company's management. He was so close to the company that he attended three WorldCom board meetings, he said yesterday.
In testimony before a House committee that is investigating the company's accounting practices, Mr. Grubman defended his unwavering support for WorldCom, backing that ended just before the company divulged a $3.9 billion accounting fraud on June 25.
Though he downgraded the stock on June 21, he said that he had no previous knowledge of fraud at the company.
"WorldCom is a company I believed in wholeheartedly for a long time," Mr. Grubman said. "All my beliefs have been honestly held."
But by saying that he saw no wrong at WorldCom until just before it was engulfed, Mr. Grubman acknowledged that he missed what some other analysts identified as weaknesses in WorldCom's operations. As a result, Salomon clients who followed Mr. Grubman's advice to hold WorldCom shares as they lost nearly all their value may be able to use his competitors' viewpoints to bolster lawsuits against him and his firm, arguing that his bullish view was not reasonable, given WorldCom's declining business.
Signs of trouble compelled some of Mr. Grubman's competitors to urge investors to sell WorldCom shares and bonds well before the bottom fell out. As long as 16 months ago, when Worldcom's shares were selling for $17, Susan Kalla, a telecommunications analyst, began coverage of WorldCom at the small firm of BlueStone Capital with a sell recommendation. Ms. Kalla wrote a report on WorldCom in March 2001 that cited a slowdown in telecommunications volume and industry prices that she reasoned could only grow worse.
Saying that a cash crisis was possible at WorldCom, Ms. Kalla advised clients to steer clear of the shares and has done so since. "Prices for long distance were falling too fast," she recalled in an interview yesterday from her current job at Friedman Billings Ramsey in New York. "WorldCom no longer had a sustainable business."
Two and a half months ago, Adam Quinton, a stock analyst at Merrill Lynch and head of the firm's telecommunications research group, issued a cautionary report on WorldCom after examining the company's annual report. One reason for his caution was a surprising increase in interest expenses that WorldCom had chosen to capitalize or deduct from its revenue over a period of time rather than immediately and in one chunk.
On June 25, WorldCom said it had fired its chief financial officer after he improperly capitalized expenses and artificially increased the company's financial results. WorldCom is expected to restate its financial results to deduct these expenses from its revenue as they were incurred, diminishing its overall performance.
The increase in capitalized expenses came to attention in the company's annual report, filed in March. Mr. Quinton said the increase surprised him because it occurred in a period when WorldCom's capital expenditures had declined by 31 percent. "That was just one of a number of signs that didn't lead anybody to the fraud, but that made us wary about the numbers as they were reported," he said. "There were some aspects to the financial reporting that seemed to be aggressive, relative to their peers."
Back in November 2000, when WorldCom's shares traded at $23.75, a telecommunications analyst at Morgan Stanley downgraded WorldCom to neutral from outperform, citing deteriorating fundamentals. The analyst, Simon Flannery, remained neutral on the company throughout last year.
Then, early in 2002, the stock rallied as investors bet that a recovery in the economy would increase demand for WorldCom's services. Still, in March, Mr. Flannery gave WorldCom his firm's lowest rating.
"WorldCom's was a story of a rapidly rising growth," he said yesterday, "I guess we took a more measured view of companies being able to grow at rapid rates for a long period of time."
Glenn Reynolds, chief executive of CreditSights, an independent research firm in New York, said his firm advised clients to avoid WorldCom debt in May 2001 when the company issued $12 billion in bonds.
"Our view on WorldCom was that they had a business model that was in atrophy and they were going to be part of a consolidation theme," Mr. Reynolds said. "The market recognized there was some risk, but there is no getting around the fact that some of the leading analysts that were most closely allied with WorldCom were pounding the table on it."
More recently, John Tierney, head of credit derivatives strategy at Deutsche Bank in New York, published a note on April 12 saying that WorldCom's business model was no longer viable and that the company was headed for bankruptcy or a merger. "We anticipate that recovery values for a WorldCom bankruptcy could be quite low, less than 30 percent," Mr. Tierney wrote.
On April 17, Deutsche Bank retracted Mr. Tierney's note saying it had appeared because of an editorial mistake. Yesterday, a spokesman for the bank, which is representing creditors in a WorldCom bank loan that is in default, said that the note was retracted because it was beyond Mr. Tierney's scope to make an individual call on a company's securities. The day Mr. Tierney's note appeared, WorldCom bonds were trading around 75 cents on the dollar. They recently traded around 15 cents.
Yesterday, Mr. Grubman — answering questions posed by members of the House Financial Services Committee — confirmed that he had an unusually close relationship with WorldCom management, including his attendance at the three board meetings, where he discussed transactions WorldCom was considering. According to other analysts reached yesterday, attending board meetings is highly unusual.
Mr. Grubman also confirmed that his compensation, which has averaged $20 million a year recently, is related in part to investment banking fees generated by his firm for helping to sell WorldCom securities to the public.
Lewis D. Lowenfels, an expert in securities law at Tolins & Lowenfels in New York, said Mr. Grubman's relationship with WorldCom management and the fact that he was relentlessly upbeat on the company while some others were negative could help bolster cases brought against the firm by investors who followed his advice. "Under securities laws, an analyst has to have a reasonable basis for his opinion," Mr. Lowenfels said. "When an analyst gets too close to a company, he may lose his objectivity, and this could affect the reasonable basis for his opinion."
At the end of last year, stock analysts at four of the six large brokerage houses had buy recommendations on WorldCom. One of those was Salomon Smith Barney. The two firms recommending caution were Morgan Stanley and Credit Suisse First Boston.
Although it is impossible to predict the outcome of arbitration cases brought by investors against Mr. Grubman or his firm, Mr. Lowenfels said that if other analysts had changed their opinions from positive to negative while Mr. Grubman continued to recommend WorldCom stock, investors would be able to use these others' opinions to support their position that Mr. Grubman's opinion was not reasonable.
Mr. Grubman testified yesterday that he began to have doubts about WorldCom in March, when the Securities and Exchange Commission began an inquiry into WorldCom's accounting. In his defense, he said that other Wall Street firms had remained positive on WorldCom as long as he did. He also said that his bullish views on the company made people a lot of money for a period of time.
Mr. Grubman said if he had even a slight inkling that the operations were not as management represented them, he would have adopted a more negative approach to the stock.
The Salomon analyst was known for taking management's views and giving them a positive spin. In a February 2002 report, for example, Mr. Grubman said he thought WorldCom would generate a positive free cash flow by the second quarter of 2002, as the company had projected. "In fact," he wrote, "we believe" that the company "will actually exceed that timing by one quarter."
KJC |
