Confessions of a Wall Street Analyst (42 page)

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.”

“How Do You Know This?”

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!”