Confessions of a Wall Street Analyst (18 page)

Did a summer intern prepare these numbers? It seemed nuts to all of us. We also noticed that Jack’s valuation model had an extremely high assumption for an arcane but important input called a terminal multiple. His was 13, much higher than our more conventional assumption of 8.5. If we plugged our assumptions on those two items into their model, Salomon’s model fell to $1.88 billion—very close to our valuation. The bankers called Qwest’s CFO, Robert Woodruff, and walked him through the adjustments, explaining that all three of us (Merrill, Qwest, and Salomon) had almost the same number. Hopefully, we’d avoid some of the conflict that had ruined our meet-and-greet back in January.

Silly me. Joe Nacchio and his team were fixated on Salomon’s number, regardless of its methodological flaws, and consumed with maximizing the value of the IPO. So the word came down: Joe Nacchio wanted to talk to me directly and immediately. Here we go again, I thought. There was just one problem with his intimidation strategy: I wasn’t going to be around to listen to it. After all, it was spring—
I.I.
campaigning season—and even Joe Nacchio wasn’t going to keep me from visiting my clients.

I had just had dinner with the telecom analyst at Franklin Funds in San Mateo, California, and had hopped a flight to Portland, Oregon. As I checked in to the Heathman Hotel there at about 11:30
PM
, the clerk handed me 20 pages of faxes. The first six pages were charts comparing the various Qwest valuations, followed by four pages of Mark’s and Megan’s analyses, then six pages of news clips and stock prices and four pages of copied phone-message slips, one of which was from Mark Vander Ploeg, a Merrill banker. It confirmed that a conference call had been set up with Joe and his CFO, Robert Woodruff, for the next morning, Thursday, April 3, at 9:30 New York time, which meant 6:30
AM
in Portland.

As brutal as that sounds, the timing was intended to accommodate my schedule, which included a breakfast presentation to Portland money managers at 7:30
AM
, a 9:00
AM
meeting with Columbia Management, an 11:00
AM
flight to Seattle for a lunch meeting, a meeting with Bank of America at 2:00
PM
, and finally a six-hour flight home, arriving after midnight. Hell of a day indeed—especially now that I would have the pleasure of beginning the day by getting reamed out by the biggest loudmouth in the telecom business. I tried in vain to get some sleep. This one was going to be a doozy.

I got up at 5:00
AM
, checked my voice mails, and skimmed
The Wall Street Journal.
Then I showered and reviewed the valuation charts that Megan had prepared. I knew we weren’t going to be bullied; we would only make a change if it turned out that we had overlooked something in the modeling. Then I dialed in to the conference call. Megan and Joe were already waiting.

Nacchio’s voice boomed through the receiver: “Dan, you’re on the call, right?”

“Yep, I’m here, Joe,” I said, stifling a yawn.

Nacchio didn’t waste any time. “I don’t understand why you are so much lower than Jack,” he bellowed. Geez, I thought to myself, it’s 6:30 in the morning and I’m already getting that “Why can’t you be like Jack” crap? I cleared my throat to be sure my reasonable self emerged, instead of the cranky one who just wanted to put the blankets back over my head.

“Joe,” I said, “I don’t know if you have seen the latest comparison sheet, but it looks like we are all circling around $1.8–1.9 billion when we apply common assumptions. Jack—or his banking folks—have been using some pretty aggressive and, frankly, indefensible assumptions.”

One of the bankers then offered to walk Joe through the models, but he wouldn’t have it. He was stuck on Salomon’s valuation. Joe either didn’t understand the methodology or didn’t want to hear about it. He simply wanted the highest number possible, and once he got it from one bank, he wanted it from all of the banks. “Dan, I don’t understand why you would be lower than the other analysts,” he whined. “We’re gonna beat all these numbers, you know.”

After listening to him drone on for a while, my slow burn picked up speed. Plus I needed to get to my breakfast on time. “Look, Joe,” I snapped, “we can debate this all day and all night and you can tell me I’m too conservative and I should be more like Jack. But the truth is, none of us is going to price this deal. The market is going to price it, and that means that Fidelity, Capital Group, Alliance, and a few others are the ones you should be lobbying.” In other words, it didn’t ultimately matter a whit what Joe, Jack, or I thought the IPO would be worth. It mattered only what the market was willing to pay for it—and that was something that had become highly unpredictable in this bull market.

One of the bankers jumped in, trying to smooth over the rough edges I’d just created. “If the portfolio managers think we’ve undervalued your shares, Joe,” he said, “they will place larger orders and we’ll raise the IPO price
to clear the market. So it may not really matter if we all agree on an exact price.”

“But wait,” said Joe, “there’s more sizzle coming than the $1.8 billion reflects! We are soon going to announce an investment in Mexico, an expansion into the southeastern U.S., and three or four new executives. All of these should increase the value of the company.” Sizzle? I had no idea what “sizzle” meant in a financial context and still don’t. Joe, however, was a salesman at heart, and a salesman lives for sizzle. I excused myself, as it was time for my breakfast presentation. Nothing had been resolved.

Joe didn’t get me to change my estimates, but as it turned out, he was more right than I could ever have imagined. After a three-week road show—the traveling circus in which Qwest’s top executives traveled around the world, visiting institutional investors in 10 cities in the U.S. and five in Europe, to try to sell the stock—it went public on June 24, 1997, at $22.

Jack’s $2.2 billion and our $1.8 billion estimates looked laughable after the first day of trading, when the stock closed at $28, valuing the company at an unbelievable $2.8 billion. We had all dramatically underestimated some things that didn’t figure in to our models at all: the market’s appetite for new economy telecom startups and the degree to which an association with the Internet—a big part of Qwest’s road show—would propel valuations. Yet Jack, even though he had blown up his numbers with an air pump, was still closer to reality than I was. It killed me. Ultimately, Qwest would peak at $66, three years later. It didn’t matter how meticulous our research was in an environment like this, I realized. The only way to get close to this new reality would be to add a line to our valuation model and label it “adjustment for ‘irrational exuberance.’”

JULY 1997 –JANUARY 1999

Our once-sleepy industry was suddenly looking like
Barbarians at the Gate
all over again, with breathtaking hostile takeover offers fueled by a stock market that was making anything possible. In four short years, a tiny upstart company run by a former gym teacher had catapulted itself into the same league as old Ma Bell. WorldCom symbolized how the telecommunications industry had transformed itself from a snooze-inducing swampland to the glamour girl of the Street.

The Case of the Secret Document

Q
WEST
’
S INCREDIBLE STOCK MARKET DEBUT
signaled a new phase in the telecommunications world. Now, momentum began to have more impact than the good old-fashioned analysis I loved to do. It was worrisome. Were my methods outdated, or was the market beginning to act irrationally? I didn’t know. In addition, the frenzied pace of anticipating and analyzing every deal to come down the information superhighway had worn me out.

So in July of 1997, Paula and I went to Italy for a long-awaited vacation. We headed to JFK as soon as our kids boarded their bus to summer camp, looking forward to eight days of wine, pasta, and—most important—serenity along the shores of Lake Como. From there, we planned a drive to Venice. It was already pouring when we arrived at the Grand Hotel Villa Serbelloni in Bellagio, formerly the country home of an aristocratic Milanese family, with a breathtaking position on the promontory jutting halfway out into the lake. And it kept pouring for three days straight. We spent most of our time sitting in the hotel lobby reading, and, at dinnertime, sprinting, umbrellas in hand, to various restaurants near the hotel.

We decided to pack up and head south. Our plan was simple: drive until we saw sunlight and cloudless skies, which happened as we entered Tuscany. With no reservations and not much in the way of guidebooks, we found a hotel in Siena and spent a day touring there, learning about the special horse race called the Palio di Siena that happened in the main square once a year. We then drove south to Montepulciano, a beautiful walled city on a hilltop.

I did call my voice mail once a day, but there wasn’t much happening, and for once in my Wall Street career, I felt completely relaxed. Eventually, we stopped at an
agriturismo,
a bed-and-breakfast on a farm. This seemed like the perfect place to unwind for a few quiet, sunny days. The guest rooms had no phones, which I figured would be a welcome change for me. I could always use the phone in the farmer’s living room, which doubled as a guest bar, to check my voice mail.

The serenity lasted for about 36 hours. We had spent a day and a half playing tennis, swimming, and hiking when I checked my messages. One, marked as urgent, was from Megan reporting that MCI had just announced it was having a conference call for analysts and investors at 4:00
PM
EST, which would be 10:00
PM
in Italy. It was now 9:50
PM
. I instinctively knew that this meant trouble for MCI. Why else would a company hastily set up a conference call just a week before it was slated to release its second-quarter earnings? As I had learned many years earlier at MCI, good news can await the earnings release, but the stock market had to be softened up for bad news. I wondered if it could have something to do with British Telecom’s (BT’s) deal to buy the company.

That transatlantic deal, which had been announced with great fanfare the previous November, was a $21 billion transaction, one
The Wall Street Journal
called “colossal.”
¹
If completed in the next few months, as widely expected, it would be the largest foreign takeover of an American company in history and the telecom industry’s first cross-border merger. MCI shareholders would receive a whopping $36 per share, a 40 percent premium, making my Neutral rating look dead wrong. My relaxed state evaporated into the starry Tuscan night.

I ran back to our room to find Paula. I told her I had to deal with some MCI nonsense and would be in the bar. Quickly returning to the farmer’s house, I tried to explain to him, using futile hand gestures, since I spoke no Italian, how sorry I was, but there were some big doings back in the States and I needed to use his phone for a while. He and his wife stared at me
blankly. Using my AT&T calling card, I settled into a creaky wooden chair in the farmer’s living room, with my pen and notebook ready, and dialed in to the conference call.

As I heard Doug Maine, MCI’s CFO, being introduced, the farmer’s wife turned down the living room lights, a signal that the bar was closing and it was time to go to sleep. But there was no way I was going to miss this call. The farmer came into the room and stared at me, first confused, then perturbed, as I proceeded to spend the next 45 minutes listening without saying a word and feverishly jotting notes in my notebook. I doubt he had ever seen anyone spend 45 minutes on a phone without speaking a single word. Was this some newfangled kind of American telepathy?

What Doug had to say was not good. He said that the challenges of entering the U.S. local market, a $2 billion, 20-city initiative MCI had announced in 1994, were proving to be far more difficult and expensive than anticipated. The punch line: MCI would earn in the range of $1.20 per share next year, instead of the $2.00 most of us had estimated. With one exception, this 40 percent cut in expected earnings was by far the largest cut I had seen in my 14 years in the telecom industry. I was shocked.

After Doug finished, the moderator announced that the lines were open for questions. I had plenty and I was anxious to get started. Someone had to get to the bottom of what was going on, and I figured it might as well be me. Not that that was an easy task. On calls like these, with upward of 1,000 listeners (analysts, institutional money managers, journalists, and others), those of us who were lucky enough to be allowed a question had to speak fast and get our follow-ups in before they moved on to another caller.

“Doug, it’s Dan Reingold. I have a question.” I had finally spoken, and my yawning farmer was visibly relieved.

“Jack, go ahead with your question,” Doug said. Jack had a tendency to spout off for a while and give his spin on what we had just heard, leaving everyone on the call wondering what his question was. His spin blamed the evil Baby Bells, not MCI. Of course, Jack had a Buy rating on MCI and had looked very astute when the BT-MCI deal had been announced eight months earlier. Meanwhile, I had looked pretty bad with a Neutral rating on MCI. Unlike Jack, I had argued that the best partners for BT would be the Bells or the new startups, not an incumbent long-distance company like MCI.

“Next questioner please,” the moderator announced once Doug was finished responding to Jack’s non-question.

“It’s Dan Reingold, I have a question,” I blurted again as quickly as I could.

“Go ahead, Blake,” said Doug. Blake Bath was the telecom analyst at Lehman Brothers and a former junior financial guy who worked for me at MCI for a few months before I left for Wall Street.

Damn, I thought to myself, I wonder if the overseas delay is causing me to be drowned out by the other questioners’ voices or if Doug simply doesn’t want to give me a chance.

Blake’s question was also innocuous, perhaps intentionally. Like Jack, he, too, was a bull on MCI shares and I suppose they saw no point in making Doug and MCI look any worse than they already did. Or perhaps he was simply as stunned as I was.

When the monitor asked for questions again, I yelled, “Reingold, question, can I ask a question please?”

“Dan, it is hard to hear you, but go ahead with your question,” Doug finally said.

“Thanks Doug,” I responded. “I actually have several questions. First, you’re cutting your forecast by 80 cents, or 40 percent. Can you split that between your long distance business and your local initiatives?” Doug seemed to be trying to spin us to believe that the entire problem was in the local business. But I knew that MCI’s stock price was far more sensitive to its long distance outlook, as long distance produced 100 percent of its earnings and cash flow.

The farmer, who had been staring impatiently at me all this time, sighed again, mollified. At least this weird American understood that the purpose of a telephone was to talk as well as to listen. He was probably terrified that I would stick him with an enormous bill for this call.

Doug’s answer was a study in obfuscation, designed to give the appearance of answering the question without actually doing so. I remembered his approach well from my days at MCI. I needed to know more, but hell would freeze over before they’d let me ask another question. Fortunately, there were a lot of BT shareholders on the call, and they kept hammering Doug on MCI’s outlook, but without eliciting much added information.

It was obvious to everyone on the call that both BT’s and MCI’s shares would be hit hard in the morning, since MCI’s disastrous earnings outlook translated into a noticeable earnings hit for BT as well. BT’s management suddenly looked like a bunch of bozos for believing that a struggling MCI would be its savior.

After several more questions from British investors, Doug finally admitted that somewhere around 20 to 30 cents per share, or one-third of the shortfall, would come from trouble in the long distance division. It seemed like a disclosure of minor importance, but it would turn out to be a major victory for me. To me, Doug’s statement clearly contained a key piece of information, but it would somehow be ignored by virtually everyone on the U.S. side of the Atlantic Ocean—the arbitrage community, many portfolio managers, and most of my sell-side competitors.

By the time the call ended, it was 11:30
PM
in rural Italy and 5:30 in New York. My poor farmer, who doubtless had to rise very early in the morning, was still yawning. But I was as wired as if I’d just downed 12 espressos. Here I was in the middle of one of the most beautiful, serene places in the world, and all I could think about was that I was cut off from the information I needed most.

What was going to happen to this deal, I wondered to myself. And how was I going to write this up and talk to my team? I had no cell phone, no wireline phone once the farmer kicked me out of his living room, no fax machine, no nothing. I was afraid to hang up and give the farmer an opening, so I just hit ##, got the AT&T USA Direct redial service, and called my voice mail, which was already full of messages from reporters, buy-siders, arbitrageurs, and Merrill’s traders wanting to know what I thought of MCI’s announcement.

I forwarded my messages to Megan and Mark, asking them to return the calls once we figured out our stance. Then I left a seven-minute message for them outlining my thoughts. My message to Mark and Megan went something like this: “MCI’s announcement, shocking to some, makes starkly evident what we have been arguing for two years now: it is going to be extremely expensive and time-consuming for the incumbent long-distance companies to add local service. And, at the same time, pressures in the long distance business will only get worse when the Baby Bells start competing with them.” As soon as I’d finished, I started another voice mail, continuing my thoughts. By the time I finished this one (14 minutes had now elapsed), I’d received several new messages from Megan and Mark responding to my first one. We were playing voice mail tag.

Mark and Megan argued that this was a disaster for MCI and that they thought the company was hiding an even worse long distance problem under the cover of problems in the local market. I agreed. The whole thing jibed with my belief that the incumbent long-distance players like AT&T,
MCI, and Sprint were likely to suffer from intense price cutting in the long distance market even
before
the Bells entered the market. There were big implications for virtually every telecom stock, and Doug’s comments were giving me the perfect opportunity to reiterate my point of view.

Paula and I had planned to drive to the medieval walled city of Lucca the next day, with numerous stops along the way. Since I didn’t have a cell phone and I hoped to salvage a little bit of the vacation, I asked Megan and Mark to write up the report and to speak the following day on my behalf at Merrill’s internal “squawk box” morning meeting for the sales force and brokers. I also asked them to speak for me on the conference call for institutional investors that was being set up.

It was now half past midnight. I went back to our room, where Paula, who’d been asleep for a while, woke up just long enough to ask what was going on. I whispered, “Those jerks at MCI have really, I mean really, messed up this time!”

The next morning, we began our drive to Lucca. We drove as quickly as possible, but Italy’s roads can be slow and there are lots of interesting towns along the way, including Pisa, where we did the obligatory photo op pretending we were holding up the famous Leaning Tower of Pisa. We continued driving as trading of MCI shares was about to begin in New York. BT shares had already been trading for several hours in London. I assumed both would be down significantly on the MCI news, but I had no way of knowing. I had stupidly not rented a European cell phone and I had no way to receive faxes or e-mails.

As we drove along those winding Tuscan roads, I wondered whether the BT-MCI deal would hold up at all. From my rural perch, I didn’t know how investors in the U.S. were reacting, or what BT’s executives were saying. Was this news a surprise to BT too? If so, were they considering backing out of the deal entirely or trying to renegotiate its terms? Or had BT been fully aware of MCI’s problems? Was BT still committed to the deal at its original price?

We arrived at the hotel at 4:15
PM
to a pile of faxes, including a long list of phone messages, the MCI press release, Mark and Megan’s report, and the announcement that the conference call I was ostensibly hosting for institutional clients was set for 10:00
AM
New York time, which meant it had started 15 minutes earlier. We rushed to the room.

For these calls, I would usually have prepared an outline and had time to study it a bit. But this time I was just going to wing it. I hurriedly dialed in to
the Merrill conference call, where hundreds of my clients were waiting to get some answers. I had to explain to the skeptical operator that I was indeed one of the speakers, and heard Megan handing off to Chris McFadden, Merrill’s London-based analyst covering European telecom companies, including BT. Chris had a Neutral rating on BT shares, largely because he, too, was concerned about the future of MCI.