Confessions of a Wall Street Analyst (11 page)

But it turned out that Bernie was only trying to show me that he’d done a lot of advance work. The notebook faced him, so I could see the page it was opened to but not exactly what was written on it, as it was upside down. And yes, when I say
written,
I mean
written.
The book was full of those green accountants’ spreadsheets, and the figures and notations were all handwritten. Geez, I thought. It was 1993, 14 years after I had first learned to model financial forecasts on a desktop computer, and this company’s CEO wasn’t even working with Excel spreadsheets? Either this was one sharp old-school dude or he ran one very backward company.

“For each potential acquisition,” Bernie explained, “I have a single sheet. Each sheet lists the synergies [cost savings] we think we can get in each of the first three years after we buy it. Each sheet also lists the impact on the first year’s earnings. If the impact is positive, we can do the deal anytime. If the impact lowers our earnings per share, we won’t do it.”

I was amazed, first at the utter simplicity of Bernie’s strategy, and second, at the fact that he, the CEO, was so involved in the small details of every potential acquisition. In my experience, those kinds of details were always left to the CFO, and the CEO’s job was more to guide overall strategy.

But Bernie cared about the little things. He was intimately involved in the cost-savings side of the equation as well, scrutinizing each salesperson’s weekly productivity, for example, and, as I later heard, monitoring the company’s expenses for coffee and other office supplies. As Dave McCourt, CEO of a startup telecom company called RCN and also, for a time, a board member at WorldCom, told me several years later: “Bernie manages very simply: he watches every cost item very closely and, to keep the sales force pumping, every month he fires the lowest-producing salespeople and gives bonuses to the highest producers. Believe it or not, it works extremely well.”

Certainly, the numbers in Bernie’s simple world were impressive: LDDS’s stock price had a price-to-earnings ratio that was much higher than many other companies’. That was because LDDS’s earnings were growing very fast and also because, thanks in part to Jack Grubman’s support, it had attracted the momentum crowd, investors who were willing to pay high prices for companies that grew earnings rapidly and consistently beat investor expectations. It had a higher earnings growth rate because it kept buying companies that would actually add to earnings per share in the first year, and it was beating expectations, in part because it intentionally lowballed the cost savings from each acquisition. It was a virtuous cycle, so long as there were more and more acquisitions to make.

Having tempted me with his Stone Age spreadsheets, Bernie closed the notebook, moved it off of his spotless desk, and put it back on the credenza. As Rick and I headed downstairs for our taxi, I heard the parting words I’d hear from many executives in the years to come: “Dan, I sure hope you make us a Buy!”

We didn’t. Rick initiated coverage of LDDS with an Accumulate rating, which was between a Buy and a Neutral. According to Merrill’s definitions, a stock rated Accumulate was predicted to rise between 10 and 20 percent over the next 12 months. The report set a target price of $26.50, representing 11 percent upside from LDDS’s current share price of $24. He also categorized it as “Speculative,” the worst of Merrill’s risk levels. Rick’s report was fair, I thought, but not googly-eyed with admiration. It acknowledged all of the good things going on at the company but also mentioned the risk that the growth-by-acquisition story could run out of juice. I agreed with Rick’s conclusions, but I hadn’t told him what to write. He reported to me, but he was entitled to draw his own conclusions.

Two months later, after the stock had reached Rick’s target price, he downgraded LDDS to Neutral. Using Merrill’s definitions, this meant that
he was predicting the stock would fluctuate somewhere around 10 percent above or below its current price in the next 12 months. Bernie wasn’t happy. From that day forward we would have a very testy relationship. He clearly wanted a Buy rating from us, as it would bring in a whole new cadre of potential investors—Merrill’s huge individual investor base—which might, in turn, boost LDDS’s stock and enable it to be used to buy additional companies. Rick’s rating did the opposite, since retail brokers were not about to waste their breath pitching a Neutral-rated stock with “speculative” risk to their clients. Even Accumulate-rated stocks, also called Outperform or even Buy at some firms, did not interest many professional money managers. After all, they wanted a few great stocks to put into their narrow list of stocks to own. As such, even 10–20 percent upside sometimes didn’t look so enticing, especially if it carried high risks as LDDS did.

I think that Bernie was also insulted by the fact that I delegated the lead coverage role to Rick instead of taking it on myself. This signaled to him that I didn’t consider LDDS enough of a major company to merit my full attention. It was true: I never thought Bernie’s company would become a major player. Moreover, I had my hands full and it was Rick who knew the reseller market best and who had brought this company to my attention. Rick had earned the opportunity to cover this strange company with the weird—or was it cool?—CEO.

Even when I later took over coverage and upgraded the stock for a while, my relationship with Bernie remained strained. My employers got very little banking business and it was always a struggle to get Bernie to speak at my Global Telecom CEO Conferences. The analyst’s job, it turned out, was a lot more complicated—and personal—than simply writing reports and rating stocks.

1993–1996

The leak hurt my institutional clients, too, not to mention the individual investors, who weren’t privy to this kind of information. Or maybe it hadn’t been a leak. Maybe she misunderstood what was said in the earlier phone call. Maybe he had called after the market had closed. I really hoped so.

Fraud 101

A
S I KNEW FULL WELL BY NOW,
the Street stops for nobody. And this Tuesday in late May 1994 was no different. I had gone to the New York Eye and Ear Infirmary that morning to sit with my brother Mark, whose daughter Jennifer was having emergency eye surgery for a detached retina she got while boxing, believe it or not. I had meant to be a supportive brother and uncle, but I ended up spending the entire day oblivious to the surgery and glued to the hospital’s bank of dirty pay phones. I was listening to a surreal conference call that would cause the fortunes of one of my favorite companies, IDB Communications, to implode as quickly as if it had been punched in the face by my niece. This was my first experience with corporate accounting fraud, and it wasn’t an experience I ever wanted to repeat.

Back in early October of 1993, about the same time Rick Klugman and I were visiting LDDS, I received a phone call from a San Francisco–based Merrill investment banker urging me to take a look at a rapidly growing company called IDB Communications. IDB was a global satellite company that transmitted such events as the first Gulf War and several major rock con
certs. After an astounding string of early successes, it began to use its highly valued stock to buy up international long distance companies. By 1993 it had become the fourth-largest provider of international long distance services behind AT&T, MCI, and Sprint, with the fastest growth rates and highest profit margins in the industry. Now called IDB WorldCom, after its recent acquisition of a small company called WorldCom, the company was based in Los Angeles.

Around the same time, I received a similarly enthusiastic call about IDB from a Merrill broker in our Los Angeles office. I had made a habit of not returning retail broker calls because I saw my job as working with institutional clients only. But for some reason, I returned this one. The company seemed interesting enough to warrant a quick look, so I flew to Los Angeles a few weeks later to meet its CEO, Jeffrey Sudikoff; president, Ed Cheramy; and CFO, Rudy Wann.

Jeffrey Sudikoff was smart and, though a newcomer to telecom, had developed an impressive understanding of international telecom. He had started IDB with a $15,000 car loan and had ended up with one of the fastest growing companies in the country and a piece of the Los Angeles Kings hockey team. Ed Cheramy was a very overweight, slick, jewelry-encrusted sharpie who had previously been a partner at Price Waterhouse, one of the world’s largest and most respected accounting firms. Though loud, flashy, and hardly my type, he, too, displayed a thorough grasp of the arcane rules and economics of the international telephone regulatory system.

I did some math on the flight home and concluded that my team and I should dig deeper. It seemed like a great opportunity to get in on the ground floor of a small but rapidly growing company and to beat Jack Grubman and my other competitors to the punch by being among the first to cover the company. Plus, Merrill’s brokers adored small companies with big, albeit risky, upsides, just like the typical retail investor, who for all of his claims to the contrary, just loved the romance and the possibility of a hot stock.

I asked Megan Kulick, a 24-year-old junior analyst whom Rick and I had recently hired from Arthur Andersen, to research the international market and to work up a forecast for IDB. Assuming just small market share gains, which was conservative given that IDB was adding service to two-to-three new countries per quarter, our forecast indicated that the stock had lots of upside.

I was excited—it wasn’t every day that I had the chance to come out first on a stock—but Dick Toole, my colleague and Merrill’s longtime telecom
and utility analyst, wasn’t. He warned me he had looked at IDB a few months before my arrival, and decided to stay away. Too flashy and too fast growing for a conservative old-timer like Dick, I said to myself.

I initiated coverage of IDB on November 16, 1993, with a Buy rating, the highest on Merrill’s scale. I worked on the report with Megan, an independent-minded, hardworking woman with a great attitude and a great work ethic, and I thought it was the most comprehensive analysis we’d ever produced. Merrill’s institutional salespeople loved the report and began taking me around to the professional investors who specialized in small and medium-sized companies often overlooked by Wall Street research analysts. I was introduced to a whole new cadre of buy-siders and, I hoped,
I.I.
voters. For a while, I looked like a frigging genius: in the four months since I had recommended buying IDB, IDB shares had surged 33 percent.

There was just one little problem. The company had a great business plan, but Jeffrey Sudikoff and Ed Cheramy had no idea how to execute it. As a result, the company’s revenue growth started to slow dramatically just as the pressure to continue hitting its numbers intensified. If the company didn’t make its revenue and profit estimates, the stock would surely tank. Such was the life of a high flyer.

So what did IDB do? According to federal prosecutors, it lied to its investors and the analysts who covered it. To hide the shortfall, the company faked revenues, among other things manually backdating a customer’s order sheet so that an extra $5 million could be booked as revenue in the first quarter of 1994.
¹
In the kind of admirable accounting work that would later go out of fashion, Deloitte & Touche, IDB’s auditor, discovered the fraudulent bookings and demanded that they be reversed. But Ed Cheramy, a former audit partner himself, simply refused to make the changes and tried to intimidate the Deloitte folks into staying mum. The company brazenly reported the fake first-quarter numbers anyway, announcing “record revenues and earnings.” A few weeks later, on that May Tuesday, Deloitte resigned the account, and I heard the news when my pager vibrated as I sat at the hospital with my brother.

I bolted over to the bank of telephones and called Megan, who told me that the company was holding an investor conference call in 15 minutes. I was shocked and scared; I had had no idea that there was anything wrong at IDB, and this was my first run-in with numbers that weren’t what they appeared to be. I had no idea whom to believe, nor whether I should have
somehow been able to suss out the falsehoods. What would my clients think? Was my stodgy old friend Dick Toole right, after all?

Amazingly, on the investor conference call, Jeffrey Sudikoff and Ed Cheramy had the gall to rant about how unprofessional Deloitte was, insisting that IDB had done nothing wrong. Jeff was on the call from Germany, where he was, he declared, rustling up more international traffic deals and acquisitions. Ed was indignant, saying Deloitte had no right to question his and Jeff’s integrity. This was simply a personality clash, Ed claimed, full of piss and vinegar, not an indication that there was anything wrong with IDB’s financial performance. Next, IDB’s CFO walked through the accounting adjustments requested by Deloitte, some of which the company was making and some it simply refused to do.

I felt as if I’d been punched myself as I listened with one ear to the conference call and with the other, on another pay phone, to Megan relaying the panicked messages coming in from clients and brokers. Since I had been the most visible and was thus the most embarrassed proponent of IDB shares, I asked tons of questions on the call.

I felt like a prosecutor interrogating a defendant. I went item by item: Why did Deloitte question this? What evidence do you have to refute them? How do we know there are not other things hidden underneath all this mess? I was midsentence in my stream of questions when the elevator opened and out rolled Jennifer on a surgical cot, head completely bandaged, en route to her recovery room. I would have waved, but both of my hands were holding phones. My relieved brother sarcastically thanked me for distracting him from the surgery.

It was obvious that this stock was going to crash as soon as it opened for trading the next morning, and that the situation was more than simply an embarrassment. Merrill was also likely to be the subject of a variety of class-action suits on behalf of its retail investors who had followed my advice. Clearly, I had to get rid of that Buy rating before the market opened.

But the company was truly unanalyzable. It did not have audited financial statements because the auditor had resigned, meaning that every line item on the financial statements was up for debate. It appeared that the executives were covering up a major revenue shortfall. And the nasty and public squabble with the company’s current auditor meant that it was going to be extremely difficult to find another reputable firm willing to perform future audits.

I downgraded the stock to Neutral before the market opened the next morning. I told the Merrill sales force there was no way to know what IDB’s true numbers were in the past, let alone to forecast its future. I said the stock was going to get crushed, perhaps cut in half, and that from that price, it would likely trade sideways for quite a long time—hence the Neutral rating. It was too late to put a Sell on it; the stock would react to the news before anyone heard my report. And to argue it was oversold and therefore deserving of an Accumulate or Buy rating would have been irresponsible, since there was no way to know what the company’s real financial situation was.

Merrill’s lawyers had worked all night reviewing my written report to ensure I didn’t create even bigger problems for them. They told me to read the report verbatim at the 7:30
AM
Merrill morning meeting and not to veer from the script. As soon as IDB shares opened for trading later that morning, they lost almost half of their value.

Sudikoff and Cheramy were indicted on a litany of fraud charges, along with insider trading. I was subsequently interviewed several times by the U.S. Attorney’s Office in Los Angeles. Yet despite what seemed to be clear evidence of extensive fraud at IDB, in a settlement with government prosecutors Sudikoff pleaded guilty to only three charges, including insider trading. In December, 1999, Sudikoff was sentenced to a year in jail and a fine of $3 million, though he allegedly made $4.6 million of profits on his IDB stock sales.
²
He admitted to selling IDB shares through an offshore account when things were falling apart, but before the public knew. Cheramy pleaded guilty to only one charge of securities fraud. His sentence: three years probation, 500 hours of community service, and fines of $250,000, although he, too, sold millions of dollars worth of IDB stock before the accounting issues reached the public. Additional fraud charges—that carried much stiffer penalties—were inexplicably dropped by the government.
³

For me, the whole experience was a very serious reminder that management can’t always be trusted, that some executives think they are above the law, and that I needed to be more vigilant. Ironically, I also learned another lesson, one that would serve me very poorly later on: accounting firms can be trusted to stand up for the investor and resign when a client insists on using improper accounting. Deloitte had lived up to the auditing profession’s principles and maintained its independence. Subconsciously, I suppose, I thereafter relied more on audited statements than before. Although it would take another six or seven years for me to realize this, it was exactly the wrong lesson to learn.

The one company that benefited from the collapse of IDB was LDDS, which snapped up the broken company’s assets for a song. LDDS got something else from IDB WorldCom, too: a new name. Liking the sound of WorldCom, Ebbers and company absorbed it as their own. Its new name was LDDS WorldCom. They didn’t seem to mind the fact that it had a whiff of scandal about it.

Tone and Notice

It was around this time that the pressure on analysts to do extra little things that might help out a banking relationship began to build. In mid-1994, I got a call from Matt Bowman, the Merrill banker covering MCI. Matt was also a neighbor of ours, and our kids played on the same soccer team. We got along great. Matt was a vice chairman at the firm and an outstanding investment banker, one who orchestrated so many of Merrill’s own M&A deals that “Danny Boy” Tully called him “my investment banker.”

With a touch of embarrassment in his voice, Matt told me that Doug Maine, MCI’s CFO, had called him. Maine was serving on a committee set up by the American Electronics Association to oppose the expensing of stock options on a company’s income statement. The Financial Accounting Standards Board (FASB) had come out in favor of expensing the options. But later, under enormous pressure from Congress, which had been lobbied to death by technology companies and startups in particular—which saw the stock option as the ideal way to compensate employees—it backed down from its earlier opinion.

So why did Doug Maine call? It turned out that he wanted me, as a “respected analyst,” to testify before Congress—and tell them that I thought it was a mistake to expense options. “MCI’s an important client, Dan,” Matt said, “and the entire tech industry’s really concerned about this issue.” The thing was, I had never thought much about stock-option accounting before and it was quite possible my conclusions wouldn’t be the same as Doug’s.

“Hmmm, Matt,” I said, trying to wriggle out of it, “I guess I should be flattered that he thought of me, but I’m not really very comfortable in such a lobbying role. I’m not even an accountant. And once I study the issue, who’s to say that I’ll come out in support of Doug’s position?”

Matt’s response was extremely professional. He clearly was not surprised by my answer, and didn’t complain about it, even though he knew
he’d have to go back to Doug with a big no. I’d just made his job—and perhaps mine—more difficult. “All right,” he said, “I’ll tell Doug you’re not comfortable doing that.” I never heard another word about it.