The victory couldn’t help but feel hollow. When I came home and told Paula the news, she congratulated me, but it didn’t take long for her to ask, “So what’s going to keep you going now?” It was a good question. The twin towers were down, the markets were down, much of the telecom industry was down, the reputation of analysts was down, and even Jack Grubman was on the way down. Every part of my professional world was unraveling, from the companies I followed to the firms I worked for.
MR. REINGOLD,” the voice mail message began, “I saw your report today about WorldCom.” I didn’t know who he was, but his voice had an ominous tone.
“Mr. Reingold, you are making the stock go down with lies about the company. I know how you Wall Street firms work. You guys short the stock and then go out there with your negative reports and force the stock down.” By now, he was starting to breathe heavily, growing more and more agitated. “I’m going to take you and your firm to court, Mr. Reingold,” he screamed. “I am not going away. You guys and all the others like you will pay! See you in court!” He hung up.
The first time this man called me was in the middle of 2000, after my first downgrade of WorldCom’s stock and after I had begun to regularly reduce my earnings estimates for the company. Every sell-side analyst on the Street got calls from such people on occasion, and as the stock market began to teeter and tumble, there were understandably many more of them. By October 2002, when the market hit its bottom, the Dow Jones industrial average had lost 38 percent from its high, while the NASDAQ composite index had tumbled a horrifying 78 percent. Some estimates put the total value of stock market losses at about $8 trillion.
Yet today, after analysts have been excoriated—and rightfully so—for remaining relentlessly sunny as the clouds on the Street began to build, there’s a part of the story that is rarely understood. That’s the unslakable thirst of investors—whether pros, individuals, or that new breed, day traders—for bullish commentary, as if such commentary could make “the value of these stocks…perpetually rise,” in Jack Grubman’s words of 1999. My irate caller’s rant came from the misplaced belief that analysts had the magic wand to reverse a stock’s decline, simply by saying it wasn’t so. He saw us as all-powerful, when we turned out to be anything but. In a panic-driven market, no one person or group could halt an avalanche. The true believers couldn’t, and wouldn’t, accept this reality.
A few months later, in late 2000, the same man called again and left even more threatening messages, full of venom. I was unnerved, so I forwarded the message to CSFB’s legal and security departments. The folks in security actually hired a private detective to find out more, and after a little bit of digging, they discovered that he was an attorney in a Boston suburb with a history of class-action lawsuits against Wall Street. That made me relax a little bit. At least, he seemed to use legal means to fight his battles and wasn’t, I figured, some wacko who was going to blow me away one morning as I walked into the office.
But what was most disturbing—and eye-opening—was that he seemed utterly convinced that we at CSFB were artificially forcing down WorldCom’s shares. The great irony, of course, is that WorldCom’s problems were only beginning. While he was apoplectic that WorldCom’s stock had fallen from a high of $64 to $15, the company was essentially bankrupt already. I’m sure he now wishes I’d been more negative on the stock at the time, not less. I certainly wish I had.
There had been countless press stories romanticizing the stock market and the brilliant minds behind it, and now, as the indices began to sink into an unforgiving quicksand, the pendulum swung to the other extreme. First came the dot-com debacle. Pets.com was one of the first newly public American companies to go under, in November of 2000, with hundreds of others soon to follow. A bitterly funny Web site, Fuckedcompany.com, sprang up to spread the latest gossip about each failed dot-com and the number of layoffs associated with it. In a split second, the market psychology on these new companies switched from “anything is possible” to “nothing is real.” There were still jokes, but the tone changed from giddy silliness to gallows humor.
I watched all this through the eyes of a bystander, or so I thought. As the dot-com meteorites quickly disappeared into a black hole, it still seemed relatively easy to believe that what was going on there was a South Sea Trading Company–style bubble bursting, while what was happening in telecom was simply a classic shakeout. People were not going to stop talking on the phone, obviously. And businesses were not going to stop sending information and data from one place to another via the Internet either, though the traffic wasn’t as much as prophesized.
Sure, the Telecom Act of 1996 was doing significant harm to the incumbent long-distance companies, and sure, the bull market had funneled too much cheap money to the startups, but the Baby Bells still seemed to be on solid ground and Qwest had the advantage of owning a real phone company in US West. Even Global Crossing’s business came mostly from overseas, where competition wasn’t as intense.
What an incredible piece of self-delusion. No one had realized it, but our sector was headed for a collapse that would make the dot-com crash look like a fender bender.
As 2001 dawned, some disturbing events began to hit much closer to home. The first telecom group to lose favor was the startup local telephone companies that had sprung up to meet the new telecom needs of the dot-coms. Companies such as ICG, Winstar, Metromedia Fiber Network, McLeodUSA, and XO Communications, which provided local phone and data service in competition with the Baby Bells, began to buckle under the weight of their enormous debt, which they had easily raised from investors who believed they would fill a massive unmet need for communications services.
Mark Kastan and I both thought that the winners among them would be the ones that built real networks and were not dependent upon the Baby Bells to connect to customers. But it turned out that building local infrastructure—that last mile to the home—is extremely expensive and takes a very, very long time. And although the startup local carriers were more than flush with cash thanks to the generous stock and bond markets, the money came so easily that they wasted a lot of it on fancy headquarters and massive advertising programs and neglected their buildouts.
Ultimately, the dot-com collapse had a domino effect on the local carriers: when the dot-coms’ capital dried up, they cut back their expansion plans and canceled orders for communications lines. The Bells, with their healthier finances and well-diversified customer base, weren’t affected nearly as much.
The local-carrier collapse hit Jack the hardest, because he continued to strongly recommend almost every one that did its banking with Salomon—which was most of them—even as the stocks began to tumble. The first to file for bankruptcy was ICG, in November 2000, followed, five months later, by Winstar Communications, a company that had been a top pick of Jack’s and of Mark Kastan’s. Although Mark was more selective in his recommendations than Jack, all of us were slow to see what poor competitors a lot of these companies were and how quickly the funding would dry up. But as the year went on, it was Jack’s reputation that took more and more of a hit. He’d always claimed to be in the co-pilot’s seat with these companies. So why didn’t he know they were about to crash, his critics asked?
Yet as strange as it may sound given the speed with which the market fell apart, the whole thing was pretty anticlimactic. The year 2001, for me, was a lot like being stuck in a ship taking on water. There was no single event that told everyone that it was over. Instead, we experienced a slow-motion decline that at first seemed strange and later seemed somehow normal. The Dow had peaked in early 2000, but fallen and risen several times since then, creating a sense that this might still be a short-term correction rather than a major bear market. And the true believers of the Internet kept on talking. Although fewer people were listening, those believers provided a final lifeline for the investors who hadn’t yet realized that a major chunk of their life savings might have disappeared.
With no real idea how long all of this would last, most of the Street analysts just dug in and stuck to their investment theses. For me, that meant I continued to talk up the Bells and Qwest and to talk down WorldCom, the company most exposed to the downward trends in long distance. I remained restricted on AT&T and couldn’t talk or write about it. I think that my jubilation over the first part of my longtime arguments having come true—the incumbent long-distance companies were in big trouble—may have kept me from fully understanding just how all-encompassing the global glut of telecommunications services would be. I still believed that there would be survivors in this industry, and that one of them would be Global Crossing, which I was recommending with a Buy, or “2,” rating.
For Jack, sticking to the program meant continuing to pound the table for his favorites—WorldCom, Global, Qwest, and virtually every local startup—and to steer investors away from the Baby Bells even though he now had Buy, or “1,” ratings on SBC and Verizon, two of the three Baby Bells. The remarkable thing about Jack was that the worse things got, the louder he talked, as if he could make it so simply because he said so. It wasn’t actually an unreasonable point of view, given that until now most people seemed to think he really did make the world turn.
The 2001 CSFB Global Telecom CEO Conference took place in March, as always, but the tone was decidedly less exultant than it had been the prior year. Many months earlier, we had decided to move from the Plaza to the Grand Hyatt to better accommodate the crowds, but they were long gone. The NASDAQ had dropped a shocking 59 percent in the past year alone, taking along with it most of the telecom startups. We had 25 percent fewer people than the year before, but it was still a good turnout considering the huge snowstorm that hit New York on the first day. There was a lot of talking going on, but not a whole lot of deal making. The telecom world was coming to terms with the fact that not everyone was going to be a winner—and that, in fact, many were going to be big, big losers.
In the meantime, we had a show to put on. We didn’t exactly party like it was 1999, but we didn’t go into mourning either. In fact, our budget for the conference had been bumped up by almost 40 percent, to $2.3 million. Our attendees still expected a good show, and we obliged. We considered a lot of big names for our special entertainment, people like Sting and Seinfeld.
The going rate for these guys was as inflated as the stock of the executives they were performing for. Sting, for example, charged between $600,000 and $1.1 million, plus six first-class and nine coach round-trip plane tickets, 14 hotel rooms, ground transportation, and production. Seinfeld required a $550,000 fee, along with private aircraft or two first-class round-trip airfares, one hotel suite, and one single room. Not only would these guys bust my budget, they just seemed too ostentatious given what was happening in the markets.
We ultimately chose Harry Connick, Jr., at a “bargain” cost of $375,000 plus two first-class and 18 coach-class round-trip airfares, two suites, and 18 rooms, along with ground transportation and production costs. I thought he summed up the mood I was striving for—serious and classy. Instead of MP3 players, we gave out Motorola walkie-talkies. It was still absurd—just not quite as absurd as it had been the year before.
We had to walk an odd tightrope in this image-is-everything environment. To come off as cheap would imply that CSFB was suffering, and my bosses didn’t want to project that. On the other hand, too much bling would mean we were oblivious to what was going on in the world and in the market, and that, too, would come off poorly. Our marquee speakers were Ivan Seidenberg of Verizon, Qwest’s Joe Nacchio, and Duane Ackerman, CEO of BellSouth. AT&T, WorldCom, and Sprint executives were nowhere to be found. The idea of being pelted with questions from 1,000 angry investors probably wasn’t that appealing to them.
In contrast, Global’s president, David Walsh, substituting for CEO Tom Casey, and Joe Nacchio were just as ebullient as could be. Joe exulted over the strong demand Qwest had seen in January, while Walsh confirmed the first quarter’s positive outlook.
Perhaps because I was no longer recommending his stock, or perhaps because his stock was in free fall (having plummeted from $41 to $16 over the last year), Bernie Ebbers didn’t speak at this year’s event. Yet WorldCom was unquestionably the main topic of discussion in the hallways, as it had been everywhere I’d gone for the past few months. On January 22, 2001, Fortune published a piece, “Can Bernie Bounce Back?” that described him as down but not out and suggested that the company might make a good takeover candidate.1
I didn’t know if anyone was truly thinking about buying WorldCom, but I thought it would be an incredibly stupid move to do so. My January report had reiterated my Hold rating, with the stock at $22.75, and said: “We remain on the sidelines on WCOM.”
By the time of the conference, however, takeover rumors involving WorldCom were rife, particularly one that suggested that SBC might buy WorldCom. A reporter from Bloomberg News later that day asked me if I thought Bernie would sell the company for $35 a share, even though he supposedly had been looking for $50.
“In a New York minute,” I said offhandedly.
“Who could afford WorldCom?” he asked.
“That’s the problem,” I responded, explaining that a buyer faced a slumping long-distance business, demoralized employees, and a long regulatory review.2 If that was Bernie’s way out of the fix he was in, he was in big trouble.
It should be obvious by now just how unevenly information travels on Wall Street. Of course, the individual investor gets the least information and gets it last. But even within my world, the playing field is not level for institutional investors that aren’t as big or as powerful or don’t have as many votes in the I.I. survey as others, or for those who simply are not able to attend a particular small-group meeting. There are the official rules and then there is the way things really are.
A perfect example took place on June 14, 2001, when I sponsored a private meeting with Global Crossing executives for a small group of seventeen carefully selected clients. As it turned out, a lot of hedge fund guys came to this particular meeting, from such big names as SAC, Pequot, Galleon, and Chilton. Some of them were short Global stock and were loaded for bear, hoping to hear some bad news that would drive the stock down. They wouldn’t be disappointed.
The meeting took place at 88 Pine Street, Global Crossing’s New York headquarters. It was a very modern space, with lots of black and silver and a sleek new-economy feel to it. The schedule called for an executive from every major sales category of the company to make an informal presentation and take questions from us. But as we got ready for the 2:00 PM meeting to start, I was surprised to see Global Crossing’s fourth CEO in three years, Tom Casey, a former banker at Merrill and lawyer to telecom companies, stride into the room with Global’s president, David Walsh, by his side. Tom hadn’t been on the agenda.
The turnover at the top of Global had been worrisome—the stock traded down every time one of the CEOs left—but at the same time, understandable: each of them was paid such an outrageous amount of money in salary and stock options (Bob Annunziata left with $16 million for 11 months of work) that no one was surprised when they headed off to the beach after a year or so.
Yet later it was learned that Tom Casey’s predecessor, the previous CEO, Leo Hindery, convinced that Global Crossing’s business was not as strong as everyone believed, had written a devastating memo to Chairman Gary Winnick at the time of his departure nine months earlier, although this wouldn’t be discovered by investigators until the following year. Leo predicted the company would fail unless it made major strategic changes. “Like the resplendently colored salmon going up river to spawn, at the end of our journey our niche too is going to die rather than live and prosper,” he wrote. “…The stock market can be fooled, but not forever, and it is fundamentally insightful and always unforgiving of being mislead [sic]….Without looking like we’re shaking our bootie all over the world, [we should] sell ourselves quickly to whichever of the six possible acquirers offers our shareholders the highest value.”3
But the booty shaking apparently hadn’t attracted anyone, so here was Casey, standing all alone, his booty still. He wanted to chat with the group before the sales presentations began, so I introduced him quickly and he got right down to business. Casey asked what he said was a “hypothetical” question: “What would you guys think,” he said, “if we stopped selling IRUs and instead sold capacity only via shorter-term leases?”
IRUs, otherwise known as indefeasible rights of use, were long-term rights to use Global’s fiber-optic network—its main asset.*
Tom Casey’s “hypothetical question” immediately raised eyebrows in the room. Most of my seventeen clients had their BlackBerries and, boy, did a lot of thumbs suddenly get a workout. Just about everyone in the room understood in a split second what I did—that Global must really be having problems selling IRUs—and this meant big trouble for the stock. Tom Casey hadn’t said the company was definitely changing its policy, nor had he warned that its forecasts were in jeopardy, but his hypothetical question caused everyone to ask their own question, which was some variant of the following: why would he even consider voluntarily halting the IRU gravy train unless customers were jumping off it?
I immediately asked for more. How would they make this transition, and why would they consider it? Others asked Tom if he was seeing tougher price competition or slower demand, and whether, if Global made this move, it would be a temporary or permanent decision. His answers didn’t satisfy anybody. Everyone who worked for a hedge fund, and therefore was able to sell stock short, instantly sent a note back to their trading desks: “SHORT GX!” In the course of one hour, from 2:00 to 3:00 PM, Global Crossing’s stock dropped 17 percent, from $10.50 to $8.66, on heavy volume, proving once again the insider’s advantage the big guys had over the little guys. Other than those of us in Global Crossing’s conference room, no one knew why the stock was falling—not individual investors, not institutional investors, not even those watching CNBC and other financial news shows.
At 5:00 PM, Tom Casey and Global’s IR director, Ken Simril, moved uptown to another private buy-sider meeting, this one a dinner hosted by Jack Grubman. I rushed back to the office and prepared a report with my team that would cut our forecasts for Global Crossing. It seemed obvious that the buying power was shifting to the customer and thus future revenues would be lower. I left at about 10:00 PM and Ido and Ehud stayed at the office to make changes to the final draft. By the time I got home an hour later, the report was ready to go. Ehud asked if he could run the report by Ken Simril, the IR guy, figuring we’d get more detailed feedback if Ken had to react to something concrete and in writing. I said fine. At around midnight, Ehud and Ido called back to say that Ken had awakened Global’s CFO, Dan Cohrs, at the St. Regis Hotel and that he would soon be calling us to talk about it.
As tired as I was, I was happy about this. Cohrs knew the forecasts cold and thus we’d at least get a sense of whether our numbers were lower or higher than theirs. Either way, we’d be smarter after the call. At about 1:00 AM, my home phone rang again. On the line were Ehud and Ido, a very sleepy and annoyed Dan Cohrs, and an equally sleepy but not-yet-annoyed me. The CFO didn’t waste any time.
“Dan, do you have to publish this?” he asked in a raspy voice. “I don’t see why you have to or why you would want to. It was a private meeting, Tom’s comments weren’t official, in fact they were hypothetical, and we are not changing our guidance at all. We said similar things at Jack’s dinner and Jack had no problem. He will be reiterating his numbers tomorrow morning.”
Well, hooray for him, I thought. Had Jack not realized what Tom Casey was saying, or Casey toned down his comments for the dinner, realizing how much they had scared the earlier audience? I had no idea, but I did know that I didn’t appreciate Cohrs’s attempt to goad me into backing off. Anyone who thought I was going to follow Grubman’s lead was smoking some very strong stuff.
“I understand your points and I appreciate them,” I said, as I had now learned to at least pretend to be listening before I delivered the news people didn’t want to hear. “However, I already had some concerns about my forecasts that were amplified by the discussions today.”
Cohrs cut me off. “But, Dan, this creates a big FD [Regulation Fair Disclosure] problem for me. It forces me to make a filing with the SEC tomorrow saying that we have changed our guidance.” I didn’t know if he meant this or not, but, if he did, he was admitting that the company had given material information to one group that it hadn’t shared with everyone—exactly what Reg FD prohibited.
“Hold it right there,” I said. “I don’t know if you have changed guidance or not. But I do know that I’m more concerned about your revenue outlook, and I need to lower my forecasts as a result. These are my forecasts, my points of view, and my concerns. I’m not saying you lowered guidance. We are simply lowering our forecasts. I apologize if this puts you in a corner, but I just have to do it.”
Cohrs, quite pissed, signed off. It was now 1:30 AM and we were all exhausted. The next morning, Ehud spoke on my behalf at CSFB’s morning meeting, informing the salespeople that we were lowering our forecast for Global’s 2001 revenues by 8 percent. Our report was published a few minutes later. Cohrs opted not to make a filing with the SEC.
Also that morning, a report from Jack, titled “Global Crossing: True Feedback [emphasis added] from Management Meeting” appeared. “Contrary to comments by a competitor,” he wrote, referring to me, “GX management did not alter prev. published financial guidance…. GX did not say it was changing [its] business model to a leased vs IRU business. Pressure on stock overdone. Reiterate buy.”
We were onto something, but I still didn’t downgrade the stock from its Buy, or “2,” rating, because Global was now at $8.66 a share—significantly below my new and lower target price of $14. I concluded it was simply too cheap to bail out now.
A few weeks later, I received a message from Gary Winnick, Global Crossing’s chairman. I called back and his secretary hooked me into his cell phone, as he was en route to investment banker Herb Allen’s exclusive annual powwow of business movers and shakers held every year in Sun Valley, a fact he wasted no time announcing. Although Gary’s tone was polite, his words were biting.
“I heard you are predicting a revenue miss in the second quarter,” he said. “I just want you to know that you will be proven wrong.”
I suppose those were intended to be fighting words, a threat in the sense that I would be embarrassed for lowering my forecasts. But, with a positive rating still on the stock, I was actually hoping he would be proven right. And, given that the quarter was already over, I figured he—if anyone—should know. Better to be wrong on the forecast but right on the stock, I figured.
Just around the time of Gary Winnick’s phone call, The Wall Street Journal ran a story, “Overbuilt Web: How the Fiber Barons Plunged the Nation into a Telecom Glut.”4 It argued that the race to build out capacity had more to do with the dueling egos of Level 3’s Jim Crowe and Qwest’s Joe Nacchio than the need for more fiber. Still, Qwest came out as the winner in the piece, mainly because it was well-diversified with its ownership of US West. It was clear that the biggest losers were incumbent long-distance companies such as WorldCom and AT&T, which were in full meltdown. Despite the fiber glut, companies like Global and Qwest were still signing up corporate and government customers for high-speed data and Internet services and hitting their numbers.
Not everyone, however, believed that. Simon Flannery, Morgan Stanley’s fairly new telecom analyst, had also been recommending Qwest with an Outperform or “2” rating, Morgan Stanley’s equivalent of CSFB’s Buy. A serious Irishman with a decent reputation, I didn’t know him too well, but had seen some of his reports and they were excellent. On June 20, 2001, he published a report, co-written with two other Morgan Stanley analysts, lowering his rating on Qwest to Hold based on a bunch of arcane accounting concerns.
I studied the report carefully and reviewed each of its arguments. While I believed there were some interesting technical points about the accounting, I also thought these items would not affect future revenues or cash flow, the two elements that most affected my Strong Buy rating. The report also questioned whether Qwest’s current rate of revenue growth was sustainable, without showing any real evidence to the contrary. I concluded it was just Flannery’s hunch. My analysis of Qwest’s recent financial reports showed the opposite.
At a time when most analysts were still bullish on Qwest, Simon’s report hit the Street with a bang. And good old Joe Nacchio, as you might imagine, was apoplectic—and determined to make this guy pay. Later that same day, Joe held a conference call to respond to Simon’s report. I couldn’t remember any other company ever holding a conference call specifically to refute an analyst’s report. I thought it would be an interesting call, and I was right.
“I’d like people to make sure they’re listening clearly,” Joe said. “There are no accounting issues or improprieties in Qwest’s financial reports. Let me repeat that. There are no accounting issues or improprieties in our reports. Innuendoes [sic] on our integrity are not going to be tolerated,” Joe raged, “irregardless [sic] of who makes them, including what I used to think was a reputable, branded firm like Morgan Stanley. This report is laced with innuendoes that are unsupported and are a direct attack on our intelligence and our integrity. I’m extraordinarily disappointed with what I consider unprofessional and irresponsible behavior from a major investment bank.”5
Joe didn’t stop there. To an audience of over 1,000 fund managers and analysts, he said he had called Phil Purcell, Morgan Stanley’s CEO, and reamed him out. Then he declared that Morgan Stanley would no longer be considered for Qwest’s investment banking assignments and cast aspersions on the firm’s motivations.
“For a firm like Morgan Stanley to be taking this approach with us, while at the same time they have Strong Buys on companies that have large financings in front of them, would make me look twice,” he shouted. Thereafter, Simon was banned from visiting the company or talking to its executives. He also was blocked from asking questions on Qwest’s investor calls.6
I was hardly surprised to hear this, given what I’d experienced with Nacchio. But I couldn’t believe how far he had gone. Intimidation in private was the norm for Joe, but to go public with it not only was outrageously unprofessional but also managed to unify the entire investment community against him. Though many of us disagreed with Simon’s conclusions, we all supported his right to his opinion. One friend of mine on the buy-side, who owned lots of Qwest shares, even circulated a letter, to be sent to Nacchio, imploring him to let Wall Street analysts do their jobs. I gladly signed it.
I was torn about what this meant for the stock. On one hand, I had never been a fan of Joe’s, and this act certainly seemed like that of a CEO who had lost control. On the other hand, I disagreed with Simon’s conclusions. Qwest, now trading at $30, was so cheap that it would be silly for investors to sell out now. I felt that the stock had fallen too far on the news, and that investors would be wise to take advantage of this temporary dip to load up on the shares. It reminded me of the irrational arb spread between Qwest and US West share prices when I was skiing in Vail.
It’s worth mentioning here that liking a stock and liking a company are not the same thing. There are very few stocks that are not worth buying at some price. Investing is a relative game, and smart investors look for mispriced or misunderstood stocks. Often, the most underpriced stocks are those of companies or managements that have stumbled. Qwest seemed to fit the bill: it looked as if it had been beaten up more because of Joe’s big mouth and some insignificant accounting issues than for fundamental business reasons. I felt that this would correct itself over time, as long as Qwest continued to grow its revenues and operating cash flows as it had for the last few quarters.
Although the fiber glut was becoming more and more apparent, Qwest had something the Level 3s of the world didn’t—a true blue, nuts-and-bolts local phone company in the form of US West. To me, a longtime fan of the Baby Bell stocks, this was a huge plus and a substantial hedge against the long distance market. So rather than downgrade the stock, I decided to hold firm. I reiterated my Strong Buy, or “1,” rating and countered the Morgan Stanley arguments in a conference call that I hosted for buy-side clients. It would prove to be a horrible decision.
Life as an analyst had always been busy, but suddenly our job seemed a lot more like that of Bill Murray in Groundhog Day than anything else: hear bad news, absorb it, lower estimates or ratings, try to quickly interpret it for clients, wash, rinse, repeat. Gone were the deals and the road shows plugging IPOs for the most part, since falling stocks meant most companies had a terrible time raising capital. This meant a lot more time for research and a lot less traveling. It was the one benefit of the downturn.
Yet just when I should have been using my extra time to really dig into the numbers behind all the companies I covered, I simply slowed down. I don’t know if I was burned-out or depressed or preoccupied by the carnage around me, but I didn’t go the extra yard that might have helped me uncover the numerous frauds. The timing was perfect. I had a great staff with the skills and brains to do it, and a lighter schedule. I should have focused more on the IRU business, which might have led me to uncover the growing number of swaps that were being used to boost revenue numbers. I didn’t.
As the market continued to tank, the press, formerly fawning lapdogs, turned into attack dogs. And what these dogs dug up put everyone in my world on the defensive. The media’s story line went like this: every little guy got ripped off, while every big executive or Wall Street insider walked away, pockets bulging with ill-gotten gains. But it was not quite as simple as that. Greed is a very democratic emotion. There were some little guys who picked up their chips and walked away at the right time, just as there were others who bet everything on the pass line and came up craps. There were big shots who truly believed that their companies were changing the world, and others who used their insider connections and information to take advantage of a bubble.
No longer big swinging dicks, geniuses, or industry power brokers, suddenly everyone on Wall Street bore the scent of scandal. The biggest fingers pointed at analysts, who had been lionized as “power brokers” on the way up and now were being made into buffoons on the way down. The guru days were clearly over. What had become celebrity was beginning to become notoriety, and even those of us who had tried to stay on the straight and narrow were beginning to be looked at with scorn. We were crooks, manipulators, swindlers, or—best case—incompetents who never saw it coming.
In some kind of weird karmic boomerang, the biggest winners in the bubble economy quickly became the biggest losers. First to fall had been the Internet analysts, the most famous of whom were Henry Blodget of Merrill Lynch and Mary Meeker of Morgan Stanley. In March of 2001, Henry Blodget’s role as analyst-cum-banker was highlighted in a series of articles in The Wall Street Journal, and subsequently an investor brought a suit against him, claiming Blodget had recommended stocks that he thought were dogs. Merrill would settle the suit a few months later for $400,000, unleashing a tidal wave of similar lawsuits. In May 2001, Fortune ran a cover story, “Can We Ever Trust Wall Street Again?” featuring a very unflattering, sinister-looking picture of Mary Meeker.7 I didn’t know either of them very well. But I thought the accusations were still far from hitting the bull’s-eye. After all, Merrill hadn’t really been all that successful in the technology banking sphere, and neither of these analysts seemed to have used their insider information and connections to vault themselves to power the way many thought Grubman had.
But Jack quickly became the third Musketeer in this very public hanging. WorldCom’s continuing disappointments weren’t helping, nor were the seemingly monthly death knells of the startup carriers he’d recommended for so long. Most frustrating for many investors was Jack’s refusal to admit he’d been wrong. The anger went beyond the press to his own clients and brokers, who suddenly chomped on the hand that had fed them. If he had such great inside connections to these companies, they wanted to know, how could he not have known that they were in trouble? I was sure that finally, Jack’s dealings were on the verge of being exposed, and I looked forward to that moment.
Suddenly, the regulators and the politicians woke up from their decade-long hibernation with hearty appetites. The damage was already done, but that didn’t stop anyone from sounding as if they’d suddenly discovered that the earth did, in fact, revolve around the sun. Led by Louisiana Republican Richard Baker, the House of Representatives announced it would hold hearings on the topic of conflicted research. Arthur Levitt, the chairman of the SEC, had resigned in early 2001. His temporary replacement, acting Chairwoman Laura Unger, announced in June an investigation into conflicts of interest on Wall Street, focusing particularly on analysts’ own holdings of stocks they may have recommended. At the end of June, the SEC finally issued an alert to investors identifying what it called “key issues that could compromise the objectivity of the research.”8 There were also rumors that the New York State attorney general, Eliot Spitzer, was launching his own investigation into conflicted research.
In the meantime, the finger-pointing was beginning to affect senior executives at the banks as well. One of the first to take the fall was Allen Wheat, the CEO of CSFB. In December of 2000, The Wall Street Journal had reported that the SEC and the U.S. Attorney’s Office in Manhattan were investigating the way in which investment banks were doling out IPO shares. The allegations were that CSFB, and possibly other banks, were involved in a kind of kickback scheme, in which some institutions and hedge funds would receive large allocations of shares in hot technology IPOs if they agreed to pay higher-than-normal commissions.
I had heard nothing about the investigation and knew only what I’d read in the papers, but CSFB had opened its own probe into the events—centering on Frank Quattrone’s institutional sales group—and by June, three brokers from Quattrone’s San Francisco office had been fired. A few weeks later, on July 12, 2001, in a weekend coup, Wheat was unceremoniously canned by his Credit Suisse bosses in Zurich. His replacement was none other than “Mack the Knife,” John Mack.
John had resigned from Morgan Stanley earlier in 2001 after Morgan Stanley merged with Dean Witter and he lost the battle with Phil Purcell for the top job. The intracompany battle would keep raging for many years after Mack left, and would culminate in a virtual civil war between Dean Witter and Morgan Stanley factions that led to Purcell’s resignation and Mack’s reinstatement in 2005.
With Mack’s reputation for cutting costs, it was clear that there would be many changes and probably a lot of layoffs. Many expected Mack to reduce the power of Frank Quattrone’s technology group. Poor Wheat, I thought. What a naïve guy. He had delegated too much and paid the price. But I was happy to see John Mack again. It had been six years since he tried to entice me back to Morgan Stanley. I hoped he’d clean up the place fast and work to get the regulators off the firm’s back.
But the first thing John Mack did gave all of us in research a little bit of pause. Right around the time that he took over, Mark Kastan downgraded McLeodUSA, a startup local carrier that was buckling under the weight of the enormous debt it had taken on. Mark didn’t tell the CSFB bankers or anyone at McLeod before doing so, of course. It turned out that the top guys at Forstmann Little, a giant buyout firm that had invested $600 million in McLeod, were furious about not being alerted and complained to John Mack.
So within weeks of getting there, Mack’s research department promulgated a new and very scary rule: all analysts had to give advance notice to both the relevant banker and the company when they were planning a downgrade. I supposed the idea was to give the banker a chance to call the CEO and soften the blow, but Mack’s rule put even more fear into the hearts of CSFB’s analysts. It seemed to give the bankers and company management yet another opportunity to pressure us either by giving the banker and company one last chance to argue with the analyst or by discouraging downgrades altogether. I found Mack’s move particularly strange at a time when the SEC and Congress were finally bringing the symbiosis between bankers and analysts under the microscope.
Changes were underway at other banks as well, but in the other direction. On July 10, Merrill prohibited its analysts from owning or buying shares in companies they cover. The previous month, it had started disclosing on the front page of its research reports whether the firm had or might have investment banking relationships with the companies its analysts were covering. (The former had always been disclosed in fine print at the end of its reports; the latter was a new disclosure.)
I figured this move couldn’t hurt, but it didn’t address the crux of the research-banking conflict, which in my view was that some analysts were writing opinions they didn’t believe, and some were using over-the-Wall information improperly. I had always avoided trading in stocks that I covered anyway, because I knew that occasionally I would go over the Wall and receive nonpublic information. What if, a day before an acquisition was announced, I unwittingly bought shares of the acquiree? It would look as if I was profiting from advance knowledge.
You would think that by this time Jack might have toned it down a bit. But just like the feisty boxer he claimed to be, when pushed into a corner Jack didn’t cover up but instead came out swinging even harder, trying to remind people that he still ruled the roost and knew more about what was going on than anyone else. He loudly and frequently repeated his bullish views on his long list of favorite stocks, as if they were neglected children who needed his unconditional love in order to grow. Earlier that year, he had come out with a report he titled “Grubman’s State of the Union: Does He Ever Stop Talking?,” a massive tome on the telecom industry whose title might have seemed merely arrogant in his glory days but now sounded completely detached from reality.
In Jack’s conference call to discuss the report, held on March 15, 2001, he had first made sure to point out that there were over 500 people listening in. “Over the next 12 to 18 months,” Jack concluded, “which seems like an eternity…you will probably look back on some of the prices today and say gee, I wish I had loaded up…[on startup telecom stocks].” Jack was increasingly on the defensive, and since it was I.I. voting season, I didn’t mind a bit. I wasn’t looking too hot either, with my disastrous Strong Buy, or “1,” rating on Qwest and a Buy, or “2,” on Global Crossing, but I was getting accolades from clients for my cautious call on WorldCom and my long-held view that incumbent long-distance stocks were losers and the Baby Bells were winners. With the local startup collapse, the Bells were looking even better, since they would likely face less competition and lose less market share.
On July 24, about 30 cable and telecom sell-side analysts showed up at the Four Seasons Hotel in New York for a private dinner hosted by AT&T. About two weeks earlier, Comcast, the large Philadelphia-based cable television company, had made a $44.5 billion bid for the cable TV properties that AT&T had acquired with much fanfare over the previous few years, and we were there to hear more.
One very large conference table was set up for dinner. Each of us was assigned a seat next to a specific AT&T executive. I sat next to Mike Armstrong, AT&T’s CEO, while Jack sat across from us, next to Armstrong’s CFO, Chuck Noski. Although Armstrong had already said publicly that Comcast’s bid was too low, many investors and telecom specialists believed that it was a good offer and that AT&T was simply bluffing and would ultimately accept it. I remained restricted on AT&T shares because CSFB was the banker for its three-way split-up. So, unlike most of the analysts in the room, I couldn’t make predictions or issue an opinion.
After Armstrong and Noski had finished their prepared comments, it was time for Q&A, and Jack was one of the first to speak up. He brought up the Comcast bid. “You know, uh, frankly,” the eternal know-it-all blustered, “when I was talking with one of your board members the other day, it was clear you have no intention of accepting the current Comcast bid.”
The room hushed. We all swallowed whatever we had in our mouths (dessert, I think), and my jaw grew slack. Had someone slipped a mickey into my mousse? Had Jack Grubman just publicly declared that an AT&T board member, perhaps his boss, Citigroup’s CEO, Sandy Weill (that’s who immediately came to mind), was telling him what was going on inside AT&T’s board meetings?
“Did he really say that?” I whispered to the analyst next to me, shocked at Jack’s recklessness. “Amazing what that guy gets away with,” he responded.
AT&T’s board had already announced that it wasn’t interested in Comcast’s initial bid, so the information wasn’t officially insider information. But what Jack was doing—not in front of clients this time, but in front of competitors and executives, the oddest of all audiences, since this didn’t help him win business or impress investors—was announcing that he was privy to what was supposed to be the most private forum a company could have. Jack was saying he knew something only the board could know—that it was not bluffing and that it had no intention of accepting that bid even if Comcast refused to up its offer. He was also insinuating that his source would tell him what was happening as the negotiations with Comcast—or any other bidder—unfolded.
If Jack had indeed had this conversation, it was dangerous, since he risked getting his source in big trouble for leaking confidential board deliberations, and it was stupid. But he simply couldn’t help himself, I guessed. His seemingly pathological need to impress got in the way of his instinct for self-preservation. I turned to see what Armstrong was doing, but he had turned his face away and sat silent as a stone. In the end, Comcast did up its bid and AT&T took it.
Qwest and Global: The Swapstakes
In the beginning of August, Gary Winnick broke his promise: Global Crossing missed its second-quarter 2001 numbers. With the stock now at $7 per share, I immediately downgraded the stock from Buy to Hold, or from “2” to “3,” certain, finally, that this company was in big trouble.
It was apparent that Gary had no clue how bad things were, even very late in the quarter. That was almost as troubling as the disappointing numbers, because it meant he was either incompetent or completely out of the loop. Neither explanation was very comforting.
Even more disturbing was the fact that the company was using what it called “reciprocal purchase agreements” to generate more than one-fifth of its revenues. These agreements, also referred to commonly as “swaps,” were the ultimate addiction of many of the companies that flamed out so spectacularly in 2001 and 2002. Basically, a swap was an agreement by two companies to purchase goods or services from each other at the same time, inflating both companies’ revenues without any true economic purpose being fulfilled. In the case of Global Crossing or Qwest, the company would sell another phone company the right to use its fiber, as these companies did with the IRUs, and at the same time purchase the rights to use some of the other phone company’s capacity. If done for legitimate business reasons and at market rates, there was nothing wrong with a swap. But if done to create the illusion of business that didn’t really exist or if priced at above-market levels, swaps were inappropriate at best and illegal at worst. Either way, if not disclosed to investors, they were very misleading because they suggested that revenues were higher and growing faster than they really were.
For example, Qwest might purchase an IRU from Global Crossing giving it the right to use the latter’s New York to Houston fiber-optic line, while Global purchased rights to use Qwest’s Los Angeles to Seattle line. The two companies might agree to pay each other $100 million. It was reasonable to think each company was filling in geographic holes, but you couldn’t really be sure. Each would then book the $100 million received as revenues in “year one,” while spreading out the $100 million paid over the 20 or so years it expected to use that fiber-optic line.
The net effect: each company had juiced its revenues by $100 million and its operating cash flow by some large fraction of that. Both companies could therefore proclaim a lot of new business and meet their revenue goals even though it wasn’t clear if this was a real transaction or just a mutual backscratching exercise. Most companies didn’t report the results in enough detail to know for sure. Some, including Qwest, didn’t even tell us they were doing swaps at all.
Global Crossing, to its credit, had first mentioned its swaps in May of 2001 when it reported its first-quarter results. But the mention was buried in one vague sentence in a long press release full of self-congratulatory quotes from Global Crossing executives. As far as I know, no one—including me—took any note of it, which isn’t surprising considering the company had exceeded most analysts’ expectations for revenues and cash flow. And the market didn’t notice either: Global’s stock rose 30 cents to $14.10 the day after the swaps were reported.
By the second quarter, however, it became clear that swaps were making up a good deal of Global’s revenue growth. It wasn’t certain there was anything wrong with the accounting—Andersen, Global’s accountant, had apparently okayed the approach—but it seemed odd to me and many of my clients that so much of its new revenue was coming from these seeming quid pro quos. Swaps became the topic de jour; we all began to ask every company we covered how much of its revenues, if any, came from swaps and how it was accounting for them. It wasn’t until near the end of the year that Qwest publicly disclosed its swap revenues.
On August 6, a few days after Global missed its numbers, Gary Winnick called me again. I called back and was patched through to him at his new home in Beverly Hills, where I could hear the sounds of hammers and power saws. Gary’s new home was not just any old new home: this palace, formerly owned by Conrad Hilton, had at least a dozen bedrooms and a dozen bathrooms. Gary had paid some $60 million for the Bel Air estate, making it, at the time, the largest sum ever paid for a private home.
Global Crossing, although it had never made a dime in profit, had just two years before boasted a market capitalization greater than that of General Motors. And Gary Winnick, unlike some of his competitors, had sold a portion of his shares while the stock was still high, netting an astonishing take of over $700 million. Now the stock was trading at $6.28 per share. Either he was a damn smart investor, understanding that his new company’s shares were propelled by an unsustainable bull market, or he knew something the rest of the world didn’t about Global’s problems.
To be polite, I asked him how the renovations were going. “Good,” he said. “It’s a big project [and indeed it was, costing something like another $30 million], but it’s coming along nicely.” Pleasantries over, Gary got down to business. He acknowledged that he’d been wrong when he assured me second-quarter revenues would come in on target.
“Dan, I know we didn’t make the numbers,” he said. “You know, I have been leaving Tom [Casey] alone and thought he could handle it. But I’m gonna get back involved now, as I want to make sure we get back on track.”
“Oh, okay,” I said, not sure what else to say.
“Gotta go,” Gary said, over the din of pounding hammers and static from the cordless phone. “Someone’s at the door.”
Get back involved? From my perspective, he’d always been part of day-to-day management, or if he hadn’t been, why hadn’t he? Yes, he was the nonexecutive chairman of the company, but he was also its founder and had billions still riding on it. I thanked Gary for the call. At least he was man enough to acknowledge how wrong—or misleading—he’d been. I didn’t know which it was, but neither was good. No top executive had ever given me assurances that were missed so widely. And no top executive had ever admitted to me he was not sufficiently involved in his business.
On September 10, 2001, Qwest reduced its earnings guidance for the first time. Joe Nacchio was finally admitting that Qwest wasn’t necessarily going to be the ultimate Survivor and was not immune to the problems affecting everyone in our industry. He refused, however, to admit that there was anything funny going on with the numbers.
“There is no accounting issue,” Joe said in a conference call that day. “Let me say this one hundred percent clear.” Referring to Morgan Stanley, he continued, “There is one house on Wall Street that doesn’t understand…. We follow the rules.”
Qwest’s guide-down was big, and bad, news. But just as I was trying to decide whether this signified the end of this company’s run as a growth stock, the terror attacks of September 11 made this huge shift in the telecom business seem irrelevant and unimportant.
On that Tuesday, Paula and I were in Italy, partway through a bicycling trip in Parma. I had been trying to call in to my voice mail as we pedaled along (this time I’d brought a cell phone), but AT&T’s international circuits were constantly busy. We walked into the lobby of our hotel, sore from biking 30 miles, and saw a group of people huddled around the television. We assumed it was a soccer match from the emotional intensity of the crowd. But it wasn’t.
We glimpsed the screen with the pictures of the falling towers and stopped in shock, unable to move or speak. It was the most terrifying image I have ever seen in my life. We held each other, horrified, thinking of all the people we knew—and didn’t—that might not have made it out alive. We frantically tried to call home to check on friends and family, but we couldn’t get a circuit to the States. Fortunately, the hotel concierge let us use her computer, and using e-mail, we learned that our kids, our kids’ friends’ parents, and our niece and her boyfriend, who lived just a little bit north of Ground Zero, were okay. CSFB’s offices, located in lower Midtown, were not at Ground Zero but were not too far from the carnage.
I finally managed to get through to my office and spoke to everyone on my team, urging them all to just go home to be with their families. But many thousands of people, some of whom were family members of people I worked with, were not okay. After years of nonstop work, I realized in a split second—as, I’m sure, most people did—that our obsessions with work and careers were meaningless in the face of such tragedy. All of these years of analyzing, picking stocks, competing: did any of it really matter?
On Wall Street, the attacks simply froze every assumption and every thought process in its tracks. They may also have halted many of the investigations into these companies or individuals in their tracks, partly because the SEC’s Wall Street investigation office—with all of its documentation and casework, including that Grubman file that had ostensibly been started years earlier—was located in one of the World Trade Center buildings. Its findings simply dissolved into dust like everything else.
Yet Wall Street, animal that it is, never grinds to a halt for too long. So even though it wasn’t known when the markets would reopen, we were told to be ready to make a call on our sector and stocks. Would they be helped or hurt by what had just happened?
On Monday, September 18, when the markets finally reopened, Paula and I were still in Europe, since we couldn’t get a flight home. We were driving from Milan to Paris, since Paris had far more U.S.-bound flights. I used my cell phone to call in some comments about how phone companies, particularly Baby Bells, do well in uncertain times and tend to be countercyclical, but I was deflated and depressed, as was everyone. It all seemed so pointless. Whether or not WorldCom or any other company made its numbers seemed so irrelevant.
In reality, the tragedy of September 11 provided convenient cover for many of the struggling telcos—as well as many other companies. The uncertainty it brought on froze the purchase and expansion plans of many of them. If M&A had been drying up before, it was now as parched as a desert. Any earnings disappointments or misfires that came up could now be laid at the feet of the global disruption rather than any flaw in a company’s business model or execution.
Right in this midst of the chaos, the news I’d been waiting to hear for so long finally arrived. After four long years, I had finally regained the number one position in the Institutional Investor ranking of research analysts in the wireline telecom category, because my picks, the Baby Bells, had held up relatively well compared to WorldCom and some of Jack’s other favorites. Jack was second, though still tops in the startup local carrier sector, not that there were many companies left in it.
In May 2001, when clients had voted, what they knew was that the incumbent long-distance companies, especially WorldCom, Jack’s favorite, had crashed, while the Baby Bells were looking like the survivors, to use Joe Nacchio’s word. Jack had done such a great job of being identified with WorldCom’s success that he was now twinned with its failure. He began to look like the Wizard of Oz—a lonely, powerless man behind a flimsy curtain—rather than the all-powerful, all-knowing, larger-than-life magician so many believed he had been.
In a normal year, I would have been thrilled, proud, victorious. Now, in the context of a terrifying new world and a dying industry, it didn’t feel like much of a victory. I had achieved the professional goal I’d worked toward for many years. Sure, the number one ranking on the Institutional Investor magazine poll made my team and me feel happy, relieved, even vindicated, but there wasn’t any partying or cheering.
Our team was evolving, too; Ehud—who I had hoped would soon take over the bulk of my coverage of stocks—left to work at a hedge fund. And Ido, Julia, and Connie understood that one of my primary motivations for keeping going for so long—to beat my chief rival—was no longer there. I’m sure they wondered whether I would quit soon.
For me, the victory couldn’t help but feel hollow. When I arrived home and told Paula the news, she congratulated me, but it didn’t take long for her to ask, “So what’s going to keep you going now?” It was a good question. The twin towers were down, the markets were down, much of the telecom industry was down, the reputation of analysts was down, and even Jack Grubman was on the way down. Every part of my professional world was unraveling, from the companies I followed to the firms I worked for. I still felt good about the way I’d done my job, but I didn’t feel good about doing it in an environment like this one. As we talked, it was clear that I’d lost my passion for the business.
There was one moment of personal satisfaction, however, and it happened in late September, when Institutional Investor scheduled a photo shoot for all the top-ranked analysts at a studio on the far west side of Manhattan. I walked in to see about 50 analysts, most of whom I didn’t know. Someone called my name and I looked up to see an old colleague from Merrill.
Standing next to him was Jack, who was still ranked first in the local startup category, although I had recaptured what was called the telecom or “wireline” slot. When he saw me, his jaw dropped and his face went gray. Even with the dramatic fall of WorldCom’s stock, his reversals on AT&T, and the virtual demise of most of his favorite startup local phone companies, it seemed it had never crossed his mind that he wasn’t still the king of the telecom hill. Until that moment, he clearly had no idea that he had lost in the wireline category. Doing what I thought was the right thing, I stuck out my hand to “congratulate” him. He muttered something incomprehensible and turned away, clearly mortified that not only had he been unseated, he’d had to learn about it in front of all his peers.
Outed: Qwest’s Accounting Gimmicks
Almost immediately, more bad news set in. On September 27, the next-to-last trading day of the quarter, I got a phone call from Rob Gensler, my client at T. Rowe Price, a large mutual fund company. Rob headed up T. Rowe’s Telecom/Media fund and also served as T. Rowe’s in-house telecom analyst. He was the most aggressive person I ever encountered on the buy-side. He had a memory and quickness with numbers that was unbelievable, and he was better at wheedling information out of people than anyone else in the business.
Rob had quite a colorful résumé: he had both worked at Salomon’s infamous arbitrage desk for several years and taught in the Peace Corps in Botswana. He lived in Baltimore and traveled virtually nonstop all over the world to visit companies. He relentlessly worked the phones to keep up on what company executives were saying and influential analysts were thinking. He also tried to influence sell-side analysts’ opinions, because that might help his picks do better.
Calls with Rob were usually long ones, full of energetic debate. Generally we had covered every company in the industry by the time we were through, and I always felt that I’d learned more from him than he from me. So when I got his message around noon, I didn’t call back right away, because I knew it would require some quality time. Instead, I called back after the markets had closed. Qwest shares had fallen precipitously, about 15 percent, that afternoon, so I fully expected this would be a key discussion point with Rob. And it was.
“Dan, I’ve already told six of your competitors this,” Rob started off. Damn, I should have called back earlier.
“It looks like Qwest is doing some funky deals to gin up revenues for the quarter. They are selling equipment at big markups to a company called Calpoint [he said ‘Calpoint,’ but I thought I heard ‘Calport’] that, in turn, is going to establish an Internet and data transport company. Calpoint needs to raise $600 million to buy the equipment, and Qwest is guaranteeing its debt. It’s a joke and it looks like it is being used to bulk up third-quarter revenues.”
It turned out that Calpoint had circulated some financial documents to the unit of T. Rowe Price that invested in bonds and other debt instruments. Apparently, this Calpoint company—which neither Rob nor I had ever heard of—was trying to borrow money from large investment firms, hedge funds, and pools of private money. Only a select group of professional money managers hear about these kinds of investments, referred to as private placements.
Rob was basically saying that Calpoint was “buying” Qwest’s equipment, which Qwest could then book as revenues, in return for Qwest’s guaranteeing its debt. In other words, Calpoint was essentially a shell company, backed by Qwest. Sure, it was promising to buy equipment from Qwest, but those purchases would be funded with borrowings backed by…Qwest! Oh, shit, I thought, Joe Nacchio wouldn’t manufacture revenues that wouldn’t exist without the shell company, would he?
“Rob,” I said nervously, “I can’t believe that Joe would book this stuff as regular recurring revenues. That would be preposterous. This sounds like it is simply a financing transaction like the ones we used to do at MCI back in the 1980s. We never even considered booking the proceeds as revenues. There’s no way Qwest could put that over on their accountants!”
“I’ve called Lee Wolfe [Qwest’s IR guy] for the past three days,” Rob said, “and told him I need to know how this is going to be accounted for. But he hasn’t called back. Why don’t you call him or even try Joe and see what you can get?”
I agreed, then hung up and left a voice mail for Lee. “I need to talk to you and Joe immediately,” I said. “This Calport [sic] thing, or whatever it is called, is spooking many of your holders. I need to have a coherent answer on how it will be accounted for.”
At around 10:30 that night, Lee and Joe called me at home. Joe, effusive as ever, told me that no decisions had been made yet on the accounting for Calpoint and that it would be a few days until they had fully determined which deals were complete and thus booked in the third quarter and which weren’t. That scared me, so I asked him a more basic question: “How do you feel about making your revenue target for the quarter?”
“Oh, we’re gonna be right on target,” he said, selling as always. “We just can’t comment on a deal-specific basis yet. At the end of any quarter, there are all kinds of balls in the air, and I can’t tell you which ones will land in this quarter and which ones in the next.”
It seemed to me that Joe wanted the flexibility to book the Calpoint revenues in the current quarter if some other deals didn’t come through. He also wanted to be able to hold it over until the fourth quarter in case it was needed to cover any shortfall then. Like a broken record, he kept coming back to that message: “We are on target. We have no reason to alter any guidance we have given in the past. The third quarter looks real good.”
It was late, I was exhausted as usual, and I was getting frustrated.
“Look, Joe, I think it is important that you fully disclose this deal and that, if it is what I think it is, you make sure to identify it separately from your regular revenues. At least that way, investors will be able to deduct it from their revenue models, as I plan to do. If you don’t call it out separately, investors will think the worst, which is that perhaps you have other undisclosed nonrecurring revenues too.” I had no idea how close I was to catching on to Qwest’s game of boosting revenues with swaps and one-time equipment sales.
Joe hemmed and hawed, but promised nothing. As worried as I was, I didn’t consider a downgrade, primarily because the stock had already dropped 15 percent on this news and I had no idea how Calpoint was going to be booked. This might turn out to be a false alarm. If Qwest did do the right thing or if these concerns turned out to be exaggerated, its shares would surely rebound and it would have been exactly the wrong time to downgrade. In retrospect, to my detriment and the detriment of anyone who followed my advice, I had focused too much on the cheapness of the stock and not enough on trying to figure out whether or not Qwest was playing fast and loose with the numbers.
I assume Rob Gensler and his colleagues at T. Rowe Price avoided a big loss by selling their Qwest shares before he called the analysts. Qwest shares dropped nearly 20 percent, from $19.40 to $15.60, in just five days. There was nothing illegal about this: Gensler was being rewarded for being astute and for reading all the documents available to him—in this case, the private but entirely legal Calpoint prospectus. If he’d been at a hedge fund, he would have been able to go one step further, not only selling his Qwest shares but shorting them, too, for a much larger profit.
This time, the group that was most in the dark was the Street analysts. There was no way we would have seen that Calpoint private-placement prospectus—since it was confidential and distributed only to a small group of potential investors—without connections on the buy-side like Rob. Even the pros got knocked out of this insider game sometimes. We still knew more than the little guys did. But often it wasn’t enough.
Thirty days later, on October 31, 2001, Qwest reported its third-quarter results very early in the morning and held its usual conference call for the investment community. The press release crossed the wires and the results were very disappointing. Revenues were flat, almost $100 million shy of my forecast, and operating cash flow had fallen more than 5 percent over the same period. Even the US West side of the company looked bad, with local revenues up only 1 percent, significantly below my 5 percent forecast and worse than the other Baby Bells.
I got the information while I was uptown at Columbia University, where I had agreed to speak to a business school class. I was shocked. Just as had Gary Winnick, Joe had been wrong, or lied, or something. I urgently needed to lower my forecasts, target price, and, I decided, my rating too. I had been very wrong about Qwest shares. Its torch suddenly seemed to be flickering.
So, as the 9:00 AM Qwest conference call was approaching, I called Ido and Julia, who hooked me into CSFB’s squawk box system. I stoically told CSFB salespeople around the globe that there were too many uncertainties lining up and that I simply could not recommend the stock as a Strong Buy anymore. I downgraded the stock to a Buy, or “2,” rating, down one notch.
Looking back, I can see my decision to drop Qwest’s rating only one level was a huge mistake: much too little, much too late. Qwest shares would fall 24 percent or $4.05, to $12.95 per share, by the end of trading that day, down from an all-time high of $64 and $48.62 a year ago. I had prided myself on my hard-nosed analysis, but that perspective had caused me to miss the forest once again. Part of me saw trouble; the other part of me, the value investor, saw a company that still had a lot of valuable assets and was cheap as hell. My gut told me one thing and my brain another. I went with my brain. It was a low point in my career.
As soon as I hung up, Ido and Julia pointed out that I’d just violated John Mack’s new rule that analysts were supposed to inform the bankers as well as the company before they issued a downgrade. I guess I’d blocked out the rule because I didn’t like it. So as I signed on for the Qwest conference call, I hurriedly left a voice mail message for Lee Wolfe at Qwest informing him of the downgrade, as well as for the CSFB banker assigned to the company. But the Qwest call was already beginning, so there was no way Lee could have heard the message before the call began.
Joe Nacchio and Robin Szeliga, the CFO, were the speakers. Joe spun the story as always. He admitted that the economic effects of the September 11 terror attacks were hurting Qwest’s performance, but proclaimed that everything else was moving along nicely. After their opening remarks, they opened the call to questions. I was the second questioner, and politely asked Robin if she could tell me what the profit margins were on the Calpoint deal.
Despite my warnings, they had indeed included Calpoint in their financials. They had, however, fully broken out its revenue impact, so analysts like me who didn’t want to count it as recurring revenue had enough information to remove it from their models. I also wanted to deduct it from the quarter’s reported cash flow, and to do so, I needed to know how much profit came from Calpoint or any other swaps. The margin number would solve that puzzle and I assumed it was on the tips of Joe’s and Robin’s tongues, since they had to know this would be a big topic on the call.
Instead, they stonewalled.
“You know, I don’t have that in front of me,” Robin said.
Joe butted in, making it clear to Robin that he didn’t want her to say more: “Call us after the call. We’ll dig up whatever numbers you’re looking for.”
I tried again. “Let me go back to this margin question,” I said. “I mean, you know the margin. I know it fluctuates with contract and with customer and quarter to quarter, but I’d like to understand what it was a year ago and what it is now.”
“Dan, call us after the call,” Joe said, irritated. “We don’t know that answer right now. We’re not trying to not tell you. We’re trying to give you the accurate information.”
I was getting more and more frustrated. I was harried, having missed some of the opening remarks while making those Mack-rule calls, and I fretted that I had missed some key information. My BlackBerry wasn’t getting a signal at Columbia, either, so I was cut off from whatever stories were hitting the newswires, including how much Qwest shares were falling.
Robin tried to speak again, but was quickly cut off by Joe. “If you want to know about that specific contract,” she managed to say, “we’ll dig up the numbers and we’ll tell you what it was.”
After a bit more of this, I had had it. The low-key, analytical guy I knew so well disappeared. I lost control.
“What are we hiding here?” I yelled.
“We’re hiding nothing here, Dan,” Joe replied after a brief pause, his voice dripping with condescension. “Let me answer,” he snapped at Robin, who had just begun to speak. “Dan, we have local equipment sales like every other [Baby Bell]. The margins are the same. We will tell you what they are when we go back and look at that third-quarter sale. We don’t know that right at this moment. There’s nothing being hidden. If you want to write a note about it so everyone else knows, that’s fine. Call us after the call.”
Knowing that was all he was going to say, I moved on to another question. That day, Qwest’s trading volume surged to seven times the previous day’s level. The sell-off continued the next day, with Qwest falling another 95 cents.
Julia and Ido told me afterward that they were amazed. Yes, I had had some rough Q&As over the years, but it had never gone this far. At first, I was embarrassed and thought those listening to the call would think I’d been unprofessional. But it turned out to be the opposite. Even people who didn’t know about the downgrade suddenly knew that one of Qwest’s major supporters was challenging Nacchio, and they applauded the move.
I thought back to Simon Flannery’s report. His accounting points had been a bit off, but his instincts about revenue shortfalls had been spot-on. Qwest’s revenues and revenue growth rate, just as we later learned about so many other telecom companies, were inflated by swaps and one-time equipment sales that, in reality, were nothing other than schemes to cover up revenue shortfalls. Qwest was playing fast and loose with the accounting rules and inflating its revenues and cash flow in ways that were misleading and unsustainable.
The next day, I got a call from the senior CSFB banker handling Qwest. He said he’d been speaking to someone at Qwest who had been in the room with Joe Nacchio during the conference call, and he related what he thought was a pretty funny behind-the-scenes story. During the conference call, when I asked them what they were hiding, one of the executives in the room reportedly whispered (with the microphones on mute, of course), “What an asshole!”
Joe, who was still unaware that I’d downgraded the stock, smiled. “Yes,” he quipped, “but he’s our asshole.”
Not anymore, I wasn’t.
* With a 20-year IRU, for example, Global would sell to a telecom company such as Deutsche Telekom or to a corporation such as Exxon-Mobil the right to use a certain amount of its capacity for 20 years. The payment by DT or Exxon-Mobil would be made up front at a discount. Global Crossing, Qwest, and many other telecom companies sold a lot of IRUs, and it made their numbers look terrific as well. In certain circumstances, if a customer paid 100% up front, a company could book the entire payment as revenue in the first year instead of having to spread it out evenly over 20 years. With the explosion in demand for communications, pricing had been fantastic for IRUs and customers were happy to pay up front for them. But as demand began to slow, it wasn’t certain that customers would still pay in advance rather than stretching out payments into cheaper multiyear leases. If prices were falling, why buy 20 years of capacity today, at today’s rates, if you could buy it cheaper later?