Confessions of a Wall Street Analyst (36 page)

The other thing that really amped this conference was the ever-flapping gums of Joe Nacchio. The speculation continued to swirl over whether Deutsche Telekom would bid for Qwest and whether the offer would include US West. Both Joe and Sol Trujillo, US West’s CEO, were on the agenda to speak.

Qwest had confirmed on the evening of Sunday, March 5, just a few days after the rumor had interrupted my skiing, that it was in talks with a “major telecommunications company,” which everyone believed to be Deutsche Telekom. Deutsche Telekom and its chairman, Ron Sommer, had said nothing on the record. Just a few days earlier, Sol had announced that he would retire upon closure of the Qwest merger, which was supposed to happen within the next few months. “Joe and I have different styles, different approaches,” he said in an interview with
The Denver Post.
“There’s [
sic
] some things we don’t agree on. My belief is a CEO should have his stamp on it, and a company can’t have two different stamps on it.”
⁷

All of this made for a delicious drama that would have worked on
The
Guiding Light
if only Joe and Sol had been better looking. You could almost hear the syrupy voiceover and the melodramatic music: were the two going to kiss and make up, or would the Plaza be the site of a brawl between two rich guys in suits, with other rich guys in suits betting on the action? I certainly hoped that they’d play nice, since that would push US West shares up and narrow the arb spread. This would make my mountaintop call look very good indeed.

On the other hand, all of this tension certainly heightened the intensity of the conference and pleased CSFB’s senior management immensely. They loved the tidbits of news that allowed the salespeople to go out with what are called “proprietary calls” to the buy-side clients. And they really loved having the opportunity to introduce CSFB’s top dogs—CEO Allen Wheat; head of banking, Chuck Ward; and others—to the telecom CEOs, otherwise known as potential banking clients, speaking at my conference. Next to technology, telecom was bringing in the largest banking fees to Wall Street firms, and with the Sol and Joe theatrics, our conference was the hottest show in town.

Qwest’s Joe Nacchio arrived at the conference on Thursday, although he wasn’t scheduled to speak until Friday morning. He came early just to hang out, or maybe to talk still more. During the late-afternoon cocktail hour, Joe gathered up a large group of investors as well as a bunch of journalists who had been following him around like puppies, hoping he’d give them some more information about Deutsche Telekom. He discussed—loudly—how he loved US West but felt its top managers were too resistant to change. He claimed he was not in a major fight with them, but that they needed to understand that the telecom world of the future required faster decision-making and they needed to replace old, bureaucratic habits with newer, more entrepreneurial ones. Everyone nodded vigorously. This was, after all, the mantra of the new economy.

Just then, someone noticed what Joe was drinking. “So you’re drinking German beer,” the investor said. “Does that mean a Deutsche Telekom deal is imminent? Would you like to sell to them? What’s your minimum price and is US West in or out of the deal?” It was a mouthful, but investors tend to blurt out all their questions at once, figuring they’ll never sneak in another one with so many other people angling to get a word in.

Joe just looked at his beer, smirked, and said, “Oh, sure, I have a new-found fondness for German beer. It’s really quite good, you know. It’s a lot better than that Rocky Mountain beer.” In one casual comment, he had managed to dis his original merger partner, Denver-based US West, while
kissing up to his new suitor, Deutsche Telekom. He was fueling the fire, and he knew it.

Whatever the truth, it made for great theater. Virtually every fund manager, buy-side analyst, arb, and hedge fund manager with any possible interest in telecom had hightailed it to the Plaza as soon as they realized that Joe and Sol were at the conference and squabbling with each other through the crowds of people gathered around the coffee stations. They were all hoping to pick up some shred of information that they could use to make a quick buck.

I didn’t really understand what game Joe was trying to play. It had been very reckless and even counterproductive to leak the potential Deutsche Telekom deal, in my view, because nothing had been signed and it could easily be called off. His implication that US West either would be left behind or would need to accept a lower price shocked US West shareholders, leading them to put enormous pressure on Sol Trujillo not to accept any change in the deal terms.

In my view, it would have made a lot more sense for Joe to quietly approach Sol and his board and discuss Deutsche Telekom’s offer, explaining that if US West gave up a little on the amount Qwest had offered to pay for it, Deutsche Telekom could pay a big enough price to make shareholders of both companies better off. This seemed like an obvious approach, but Joe apparently couldn’t keep his ego—or his mouth—under control. The share prices of Qwest and US West reflected the commotion, gyrating up and down with every interview and whispered—or shouted—conversation. Whichever paging transmitter was closest to the Plaza must have been in overdrive as buy-siders sent buy or sell orders back to their firms’ trading desks and their traders sent back the latest gossip they’d heard.

None of this banter showed up on the webcast of the conference that was available to day traders, the general public, and even retail brokers. This was the “professionals only” part of the insider game, but even the pros had no idea what was really going on: they were being manipulated by Joe, who himself may not have had a handle on what was about to happen.

Indeed, by the time he spoke to the crowds the next morning, his flirtation with a foreign suitor had come to an embarrassing end. The night before, March 9, Deutsche Telekom got cold feet. It rescinded its offer—if there ever had been one—and ended the talks. “Last night,” Joe announced, somehow seeming totally unfazed, “Qwest announced that it was informed by a major telecom company with whom it has been engaged in discussions
that it has withdrawn from discussions to acquire Qwest and US West based on positions taken by US West.”
⁸
That day, Qwest’s shares fell 12 percent on the news. US West fell as well, dropping 8 percent.

Ironically, that same day, the FCC gave its blessing to the Qwest–US West merger, and both sides tried their best to put a happy face on the sad debacle. “I know I’m in the middle of a merger. I know the reasons for doing the merger are true,” Joe Nacchio said in a poor attempt at trying to move forward. “You gotta operate with what you have.”
⁹
“In a conference call with reporters later that day, Joe claimed that while he and Sol Trujillo had “different views,” the relationship remained “professional and cordial.”

From what I’d seen, “professional” and “cordial” had only that day become part of Joe’s vocabulary. Deutsche Telekom went on to buy Voice-Stream, now T-Mobile, the next year, and Qwest and US West consummated their marriage four months after the conference, just as the stock market began its radical shift downward.

My mountaintop call turned out to be the right one: the arb spread quickly narrowed, making anyone who took my advice a very healthy 38 percent profit in just four months. Those people would have bought US West shares at $72 per share on March 2 and sold them at $87 per share on June 30, the last day before the merger was completed and US West shares stopped trading. They also would have sold Qwest shares at $60 that same day and bought them back at $50 on June 30—making money on both sides of the trade. It was probably the best short-term call of my career. It was also my last good one.

The Beginning of the End

“WorldCom is the poster child for buying real things with fake money.” That was a quote from a telecom consultant, Mark Bruneau of Renaissance Strategy Worldwide, in a
Fortune
article that ran April 17, 2000, called “Bernie’s Big Gamble.”
¹⁰
True as this had been so far, WorldCom’s amazing streak of acquisitions was about to come to a screeching halt—thanks not to any problems with investors, who wanted the company to buy the world if it could, but to the people companies don’t think about when they’re small and nimble—the regulators.

By June, we were hearing rumors that the U.S. Department of Justice’s Antitrust Division was carefully looking at WorldCom’s offer for Sprint and
raising a lot of serious questions. I guess it made sense: the merger would concentrate much of the world’s long-distance and Internet traffic, and unlike the participants in many of the earlier deals, these were very similar companies with similar coverage, so overall competition could be reduced. With the antitrust issues looming, I decided that it was time to think about downgrading WorldCom shares from my Strong Buy, or “1,” rating. At this point, the vast majority of analysts had the same rating on the stock.

Ehud, Ido, and I sat down and tried to figure out the implications of WorldCom either abandoning Sprint and instead acquiring a wireless company, or buying Sprint but getting rid of a lot of its long distance business to satisfy antitrust concerns. An analyst named Scott Cleland, who ran an investment advisory service focused on federal government decisions, had recently predicted that the deal would not get U.S. antitrust approval. My Washington contacts saw this as entirely plausible as well, so I decided to work up some models reflecting several scenarios. They all came up with target prices for the stock that were lower than our current targets but still higher than WorldCom’s current price. Yet the risks meant that a Strong Buy, or “1,” rating was no longer justified.

So early in the morning of June 27, with WorldCom shares at $37.50, I lowered my WorldCom rating to Buy, the second-highest rating in CSFB’s four-point system, pointing out that if regulators rejected the Sprint deal, WorldCom would still need to acquire a wireless business and it was becoming more difficult to grow via acquisition. Our report was titled “WorldCom: There Must Be Some Way Out of Here—But All Lead to Lower Target Prices.” Its conclusion: “We believe the WorldCom/Sprint merger cannot proceed as originally proposed…. We are lowering our rating on WorldCom shares to buy from strong buy because all realistic scenarios yield significantly lower target prices….”
¹¹

I’m sorry I ever ran those alternative scenarios. I was far too mired in my detailed models to truly grasp the looming disaster. They beautifully quantified different share prices in different situations but did not show how WorldCom had been using a series of ever-larger acquisitions to hide a slowing core business. The company was already beginning to spiral out of control. Though I wasn’t mesmerized by the hype that had attracted many others to this stock, if I had been less analytic and more intuitive, as I had been in Tuscany and Vail, I might have better understood WorldCom’s addiction to acquisitions and, perhaps, aggressive accounting methods to fuel
its continued growth. My lower rating was still too bullish. It did not capture what lay ahead for WorldCom and its investors.

Just as our 22-page report, finished at 2:30 that morning, was hitting the wires, Attorney General Janet Reno and Antitrust Division head Joel Klein announced that the government was filing suit to halt the merger. “This merger threatens to undermine the competitive gains achieved since the [Justice] Department challenged AT&T’s monopoly of the telecommunications industry 25 years ago,” Reno said. The merged company would control 30 percent of the market for long distance services between the United States and other countries and a combined 51 percent of Internet traffic, the government said.
¹²
Faced with that pressure, WorldCom and Sprint announced later that day that they would withdraw the merger application and reconsider it after divesting certain assets. For all intents and purposes, the deal was doomed.

For me, the news came a day too early. If it had happened a day after my warning and downgrade, my clients could have saved serious money. But having it come out simultaneously meant that my call was useless to investors, as WorldCom and Sprint shares moved instantly on the news of the merger’s cancellation. Sprint shares dropped 2 percent while shares of WorldCom gained almost 6 percent, rising $2.06 to $39.69. The following day, WorldCom topped $42 per share, while Sprint fell another $5.63 to $52. Indeed, hope sprang eternal when it came to WorldCom’s stock. Within three weeks, WorldCom shares had risen even further, hitting $47 per share and making my downgrade look pretty bad.

I
N PREPARATION
for WorldCom’s second-quarter earnings results, we did everything that we could do in advance to get a written report out quickly. That meant setting up a pre-written template of a short report, which we called Quick Notes, that we would rush out as soon as we got the numbers and assessed whether we needed to change our forecast or rating. Our goal was to get a Quick Note out within an hour or two of a company’s press release, but it was always tricky. Even after we’d done our bit, we had to get compliance to approve it, which took at least 30 minutes and sometimes over an hour.

At 8:16 on Thursday morning, July 27, 2000, WorldCom’s second-quarter earnings hit the wires. Ehud, Ido, and I scurried to scan the press re
lease for any telling words, then crunch the numbers, and get the Quick Note together before Bernie and Scott held an investor conference call at 10:00
AM
. We quickly realized that WorldCom’s earnings were a penny shy of our forecast, and that revenues had grown only 13.3 percent, below our 14.0 percent forecast, with the shortfall coming almost entirely from Internet revenues.

One of the reasons investors had such unyielding faith in Bernie and Scott was that they delivered time after time. Before this stretch of disappointments, WorldCom had had an incredible record of meeting or beating expectations. Yet this was the second quarter in a row that they hadn’t hit the numbers. I was concerned, but these dribs and drabs of bad news still seemed to be just that. Still, I had to react: the markets would be opening at 9:30
AM
, which meant clients and salespeople would need time before then to get their orders ready. So I summarized the shortfall, lowered my revenue growth forecast for 2000 to 13.5 percent from 14.0 percent, and recalculated the target price, figuring I’d done the best I could in the time allotted. The changes were not enough to justify a further rating reduction, in my view.