Inside the Telecom Crash: Bankruptcies,
Fallacies and Scandals
A Closer Look at the WorldCom Case
Dr. Fotios Harmantzis
Assist. Professor, Stevens Institute of Technology
Director, Real Options Group (ROG)
Head, PerfEcTNet Research Group
http://www.stevens.edu/perfectnet
http://www.rogroup.org
PerfEcTNet Research Group
15th Biennial International Telecommunications Conference 2004
Outlook of Presentation
• Introduction: Defaults in US
• Telcos in Distress
• The WorldCom Case
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The Scandal
Chapter 11 Process
Plan of Re-organization
Emergence form Bankruptcy
• Credit Models for Telcos
• Telcos the Road of “Recovery”
• Ending Remarks/Thoughts
PerfEcTNet Research Group
Introduction
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Telcom crash many times bigger than the dotcom one
Astronomic growth figures
Misleading accounting practices
Telecom investors lost some $2 trillion, as stocks tumbled 95% or
more form their heights.
• Half of million workers lost their jobs & CEOS ousted the last three
years
• Worldcom biggest case of accounting fraud in the US history
($11bn as of March 2004)
• Even without WorldCom, the default rate of the economy would
remain as high as 9.27%, and the contribution of the defaulted
communications firms would be as high as $40.28bn
2002 Defaults
Total
Communications
Default Rate (per
$)
Par Value Defaults
12.8%
6.65%
$96.89bn
$50.38bn
Issues
344
88
Firms
112
26
Recovery Rate
25%
16%
2002 Bankruptcies
Total
Communications
No of Fillings
112
31
Pre-petition
Liabilities
$337.5bn
$120.6bn
In year 2002, the communications sector led the way in:
• Defaults (52% of total), about the same as in 2001
• Number of defaulted firms (23%)
• Bankruptcies (36% of total)
2002: Largest Telecom Bankruptcies
Company
Bankruptcy Date
Liabilities
WorldCom
Adelphia
Global Crossing
NTL
7/21/2002
6/25/2002
1/28/2002
5/8/2002
$45.9bn
$17.3bn
$14.6bn
$14.1bn
Williams Comm.
4/22/2002
$7.1bn
XO Comm.
6/17/2002
$5.8bn
Historical Default Rates in U.S.
High Yield Bond Market - Historical Default
Rates in the U.S.
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
01
99
97
95
93
91
89
87
85
83
81
79
77
75
73
71
0.0%
Companies Defaulted
Number of Companies Defaulted, 1983-2002
180
160
140
120
100
Comm (117)
80
Total (897)
60
40
20
01
99
97
95
93
91
89
87
85
83
0
Recovery Rates in Telecom
Recovery Rates in Telecom by Year
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
98
99
00
01
02
Causes of the Crash
Easier to see where the sector went wrong in retrospect
• Between 1998 and 2001, the transmission capacity increased 500-fold, due to
the amount of fiber-optic cable laid out in the ground plus the advances in the
fiber optics technology. But over the same period, demand merely quadrupled
• Astronomic Traffic Growth projections
• Internet growth mania, “Internet Time” buzz.
• Players tried to go Global
• Some argue that problems started with the 1996 Telecommunications Act, letting
long distance companies and Bells compete in each other's markets.
• Heavy borrowing
• People ignored that industries such as telecommunications are characterized by
fixed costs and low marginal costs, which is likely to yield aggressive pricing as
long as customers see competitive firm’s offerings as near-commodities, e.g.,
long-haul service.
• Role of Wall Street analysts, the quality of their research and their bias in
recommendations contributed to the collapse (Jack B. Grubman)
WorldCom: Unique Case
• “Fallen Angel” within a month (May 2002): From A- to BBB (Baa)
and then Ba.
• The largest bankruptcy/Chapter 11 filing in the corporate history
of United States ($45.98bn in liabilities). Company expected to
emerge from bankruptcy in the spring of 2004 (within less than two
years from filing date).
• The company defaulted within just two months of the decline to
“junk” status.
• The largest corporate accounting scandal in the United States,
estimated at $11bn as of March 2004.
• Company the nation’s second-largest long-distance phone
company, after AT&T Corp.
• Company one of the biggest stock-market stars in the past decade;
Investors lost more than $180bn;
• Ultimately, almost 20,000 employers lost their jobs (current
workforce of about 55,000 employees).
What Went Wrong
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Insatiable appetite for acquisitions: Under Bernard J. Ebbers, WorldCom raced to make
more than 70 acquisitions in two decades. Among the biggest, were MFS
Communications (the deal made WorldCom a major Internet player), and MCI, the second
–largest telecommunications company in the U.S. after AT&T.
The traffic growth myth: WorldCom executives kept referring to the myth of 100-day
doubling of growth.
Enormous Debt: They were having an incredibly devaluated asset next to $30bn debt
that looms large.
Grubman’s recommendations: He did not downgrade “STONG BUY’ to “NEUTRAL” until
April 22, 2002, when the stock had dropped about 90% from its peak, to $4.
CEO’s lobbying in Washington: Ebbers donated generously to politicians in Washington,
hoping to secure favorable legislation that would enable him to keep up his pace of
acquisitions. The collapse of the Sprint deal represented a fatal blow to WorldCom.
CEO’s Loans: Mr. Ebbers ended up owing WorldCom some $400m, before he was ousted
in April 2002.
Accounting irregularities: According to investigators, “Everything they could do they did.
But by the end of 2000, they had run of tricks: Bad debt was manipulated. Tax was
manipulated. “Merger magic” accounting was used.”
The Accounting Scandal
• Enron was all about complex partnerships and accounting
for special purpose entities. But what WorldCom did
wrong is something fundamental: The firm had taken line
costs and wrongly booked them as capital expenditures
• WorldCom’s misrepresentation of these expenses led to
an artificial inflation of EBITDA
• This transfer of obvious expenses into capital
expenditures is absolutely fraudulent, and not in
accordance with generally accepted accounting principles
(GAAP).
Investigation and Litigation
• On June 26, 2002, the SEC commenced a civil injunctive action
against WorldCom, alleging violations of the antifraud and other
provisions of the federal securities laws.
• Besides the SEC, WorldCom faces scrutiny from the Justice
Department and the House Energy & Commerce Committee.
• Also, the company faces fraud charges brought by several
shareholder lawsuits.
• Finger pointing: WorldCom blames auditor Arthur Andersen for not
uncovering the irregularities. Andersen blames the former CFO
Scott D. Sullivan. Sullivan claims that Ebbers did know about the
money shifted into the capital expenses accounts. Ebbers states
he has done nothing fraudulent. John Sidgmore blames the former
management for the company’s problems.
• Bondholders, who bought more that $41.1bn in WorldCom debt in
May 2002, are suing underwriters Citigroup and J.P. Morgan for
lack of due diligence. Both banks say their underwriting was
proper.
Chapter 11 Process
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Chapter 11 provides a financially beleaguered company a method to keep
operating its business under protection from its creditors while developing a plan
for resolving its financial problems. It is under Chapter 7 of the U.S. Bankruptcy
Code, that the assets of the debtor are liquidated and proceeds are distributed to
creditors.
Is Chapter 11 is a privilege not a right in the United States?.
On July 21, 2002, the “petition date”, WorldCom filed, voluntary, for Chapter 11
protection with the U.S. Bankruptcy Court, listing $45.98bn in liabilities. The filing
aimed to help WorldCom secure financing, easing a cash crunch that staggered
the company, after anxious vendors began demanding immediate payment.
While under Chapter 11, the company functions as a "debtor in possession" and
an Official Committee of Unsecured Creditors ("Creditors Committee") is
established.
Employees get paid, operations in the U.S. and outside the U.S. continue without
interruption, and WorldCom retains possession of assets.
Typically a company that declares bankruptcy will lose credibility and many large
corporate and government clients, that typically do not do business with
companies in Chapter 11.
If Chapter 11 is not successful, the next step is shutting down and liquidating
assets.
Capellas’ 100 Day Plan
• Sidgmore, who took over for ousted Bernie Ebbers in April, had
since led the company through one bad news announcement after
the other. Job cuts, selling of assets, frustrated workforce painted a
picture of a distressed and then bankrupt company.
• On November 15, 2002, WorldCom announced Michael D.
Capellas as chairman and CEO, effective December 2, 2002.
• According to him, throughout those 100 days, the company would
launch new products appealing to both businesses and consumers,
converging the company’s voice and data networks. With a targeted
action plan and disciplined execution, Capellas expected new sales
emphasizing new products. Capellas also emphasized the
company's commitment to corporate integrity and rebuilding trust in
the marketplace, with employees, and with the public.
Plan of Reorganization
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The firm filed its proposed Plan of Reorganization, delivering on the company's
"fast track" Chapter 11 reorganization schedule.
Company announced the appointment of Robert T. Blakely as its new CFO,
Brand name change to MCI
Relocation of its corporate headquarters to Ashburn, VA.
Management continues to run daily operations but significant business decisions
must be approved by the court.
Plan included a three-year business plan outlining the future plans for WorldCom
Most creditors agreed to accept shares or bonds worth 36 cents for every dollar
originally owed
Plan describes a company which hardly differs from the one Ebbers created, in
terms of its operations and the scope of its ambitions. Continue to serve large
corporations worldwide and US residential customers.
General optimism in the management reflected in the company’s growth
projections. Plan valued the company at around $12bn, inclusive of $3.5bn$4.5bn of net debt. This is much less than WorldCom’s value at the peak of the
market, and far below the $41bn debt load that forced the company into
bankruptcy.
Emergence of Bankruptcy: 2002
• The question in July of 2002 was whether WorldCom
would emerge from Chapter 11, survive and become
profitable again.
• In summer 2002, Wall Street seemed to think that AT&T
might benefit the most from WorldCom’s trouble.
• Despite gloomy predictions, the widely predicted exodus
of customers does not appear to have materialized.
• Chapter 11 is often used in the United States by
companies that have fundamentally strong businesses
and loyal customer base to restructure their financial
position and debts to strategically strengthen their
businesses. WorldCom clearly falls into this category and
was always recognized in the enterprise space.
Emergence of Bankruptcy: 2003
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Re-routing issue: In the summer of 2003, the company had to face an
orchestrated campaign by its rivals. MCI’s competitors, lobbied regulators
and the government to break up the company or force it to pay a huge
fine. Ultimately, they wanted to push for an indictment against the
company – the corporate equivalent of a death penalty.
Towards the end of the summer of 2003, Drew Edmondson, Oklahoma’s
state attorney-general, filed criminal charges against WorldCom and six
former executives, including Ebbers.
In the positive side, fighting out of bankruptcy protection, MCI struck a
deal with two groups of creditors previously opposed to its plans.
Besides the $750m fine, a record, that MCI agreed to pay to the SEC,
rivals saw it as further evidence that the government was letting the
company get away with fraud.
General sentiment that the company has not been punished enough.
Criticism against the bankruptcy law came back.
Emergence of Bankruptcy: 2004
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Report came out by Mr. Richard Thornburgh, a court-appointed examiner in the WorldCom
case, criticizing KPMG of helping the firm avoiding paying “hundreds of millions of dollars”
is state taxes. On top of that, the report offered new insights into WorldCom’s questionable
relationships with accounting firms, e.g., Anderson and KPMG
Company announced it expected revenues for 2004 to decline as much as 12 percent , but
it planned cost cuts. Having eliminated 15,000 jobs since 2002, the company will likely
make several waves of layoffs during the year.
Restatements for 2000-03 were the largest and most complex ever undertaken.
After trying for two years to build a case against Bernard Ebbers, the federal government
finally charged him in early 2004, with securities fraud, conspiracy to commit securities
fraud and making false filings to regulators. Prosecutors received unanticipated
cooperation from Mr. Sullivan (plead guilty)
Despite the obstacles, MCI is putting the largest bankruptcy behind
The widely expected exodus of customers from WorldCom never materialized.
Stock started Nasdaq Stock Market during spring 2004.
MCI will emerge from bankruptcy having shed $36bn in debts, with more than $5bn in
cash and only $5.5bn in debt, putting it in a stronger financial position than many of its
competitors.
Capellas has exceeded most expectations up to this point.
15th Biennial International Telecommunications Conference 2004
Altman’s Z-Score Model (1969)
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X1, Working Capital/Total Assets
X2, Retained Earnings/Total Assets
X3, EBIT/Total Assets
X4, Market Value of Equity/Book Value of Total Liabilities
X5, Sales/Total Assets
Z = 1.2(X1) + 1.4(X2) + 3.3(X3) +0.6(X4) +0.999(X5)
For publicly owned companies, a value of 2.99 or higher indicates
bankruptcy is not likely (“safe zone”), scores below 1.80 indicate
bankruptcy is possible (“distress zone”), while scores between 1.81
and 2.99 belong to the “grey zone”, i.e., a company may survive if
corrective actions are taken.
PerfEcTNet Research Group
WorldCom’s Z-Scores
Z-Scores: WorldCom
6
5.37
5
4.07
4
3.76
3.73
3.04
3
2
3.02 2.79
2.47
1.86
2.23
1.66
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15th Biennial International Telecommunications Conference 2004
Telcos the Road of “Recovery”
• Some optimistic signs, e.g., reduced debt, soaring stock
prices, in 2003 were not enough to make a full recovery
• M&As: Long-distance companies (AT&T, MCI) prime
targets for more financially healthy regional Bell companies
• Prospects of some telecoms (e.g., Qwest) are looking up this
year.
• Is investing in formerly bankrupt firms a successful
strategies?
• Competition in US intensifies (price wars?), cost-cutting
PerfEcTNet Research Group
Ending Remarks/Thoughts
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Early signs of 2004 make us believe that the worst is behind
Difficult to say how far off we are form a full recovery
Difficulties with financing; credibility issues with lenders
Bankruptcy is surely not an enjoyable experience, but it provided resolution.
New technologies, e.g. telephony over the Internet as an information service,
allow new players to aggressively enter the market.
Increased Competition, New Technologies
While traffic is growing, there is significant overcapacity in the long-haul network
Firms should continue to invest and foster innovation
Executives forcefully argue that the sector needs to consolidate, just as the
defense industry did in the post cold war era
Leadership in Washington is crucial: , there is still evolving legislation and
regulatory confusion
We think that this is a long-term transition for most companies, and the involved
parties seem not to rush this time
15th Biennial International Telecommunications Conference 2004
Thank You
Dr. Fotios Harmantzis
fharmant@stevens.edu
http://www.stevens.edu/perfectnet
http://www.rogroup.com
PerfEcTNet Research Group