Verizon-MCI merger

On February 14, 2005, Verizon agreed to acquire MCI, formerly WorldCom, after SBC Communications agreed to acquire AT&T just a few weeks earlier. The MCI/Verizon merger was put on hold until March 17, 2005 for them to evaluate a rival offer from Qwest, which made an offer that was potentially worth more. MCI accepted Verizon's initial bid, although it had a lower cash value, because of their perceived financial stability in comparison to Qwest’s, but holders of 26% of MCI stock requested that they evaluate the merits of both offers before making a final decision. Qwest later lost the battle for the acquisition of MCI. On October 6, 2005, the Special Meeting of MCI Stockholders on the subject of Verizon's acquisition resulted in 64 percent of outstanding shares voting in favor of Verizon's offer. The European Union regulator approved the merger on October 7, stating that a combined company would still face strong competition in Europe. U.S. regulatory requirements were satisfied by December 29, 2005. MCI has been incorporated into Verizon with the name Verizon Business.

The Verizon-MCI merger drew the ire of many MCI Inc shareholders because the MCI Inc Board of Directors seemed to inherently favor Verizon as a merger partner. Many notable institutional investors favored the Qwest terms, including Legg Mason and Omega Advisors. Small shareholders also spoke out against the merger (see: MCIpetition.com)

ARTHUR ANDERSEN

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.  The proceeding is still pending.  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.  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.

     The court-appointed examiner in the WorldCom bankruptcy proceedings also found a number of problems with Andersen’s audit work, including: (1) failing to design and implement adequate audit procedures; (2) allowing WorldCom management to wield inappropriate influence over the audit process; (3) relying too heavily on WorldCom managers’ integrity; and (4) failing to inform the Audit Committee and WorldCom management of significant audit-related issues. Second Interim Report of Dick Thornburgh, Bankruptcy Court Examiner, In re: Worldcom, Case No. 02-15533 (AJG) at 198-212 (Bankr. S.D.N.Y. June 9, 2003). In his final report, the examiner concluded that: (1) Andersen committed professional malpractice by negligently performing WorldCom’s audit work; (2) a trier of fact would likely find Andersen negligent even though WorldCom’s senior officials deceived Andersen a number of times; (3) Andersen’s negligence compounded the injuries WorldCom suffered, because “without such negligence, WorldCom’s improper accounting could not have gone undetected

for so long;” and (4) Andersen’s negligence placed it in breach of its WorldCom contracts. Third and Final Report of Dick Thornburgh, Bankruptcy Court Examiner, In re: WorldCom, Case No. 02-15533 (AJG) at 19-29, 297-98 (S.D.N.Y. Jan. 26, 2004). See also Dennis K. Berman, Jonathan Weil, & Shawn Young, MCI Examiner Criticizes KPMG on Tax Strategy, WALL ST. J., Jan. 27, 2004, at A3. (see table 1)

The circumstances under which WorldCom’s fraud was brought to light are dishearteningly similar to Sherron Watkins’ tale. Like Ms. Watkins, Cynthia Cooper- WorldCom’s Vice President for Internal Auditing—also sought to expose and correct a massive accounting fraud. Her suspicions arose when a concerned official in the wireless division told her the accounting department had taken $400 million from his reserve account and used it to inflate WorldCom’s income. She first raised the issue with Arthur Andersen, WorldCom’s accounting firm.

Although Andersen insisted that everything was fine, she continued to press on— notwithstanding that her boss, CFO Scott Sullivan, angrily told her to back off. Concerned by Sullivan’s hostility and worried about the reliability of Andersen’s audits, Cooper and her accounting team secretly conducted an extensive review of the books, working at night and copying data to a CD to prevent it from being destroyed. Within a few months they learned that in 2001, billions of dollars in ordinary operating costs had been improperly recorded as capital expenditures, thus reporting a $662 million loss as a $2.4 billion profit.58 When Scott Sullivan discovered that Cooper’s team was auditing Andersen’s work, he asked her to suspend the review. But Cooper refused to yield.

         Instead, she went to the head of the board’s audit committee the following day. To its credit, the committee did the right thing. Within little more than a week, the audit committee convened a meeting in which all sides of the issue were fully aired. When all was said and done, the committee found Sullivan’s explanation of the unorthodox accounting practices unpersuasive and concluded that they could not be justified. The committee then told Sullivan and Controller David Myers that if they did not resign, the board would fire them the next day.

Credit Risk Assessment: Altman’s Z-Score Model

Failing firms exhibit ratios and financial trends that are very different from those of companies that are financially sound.  In this section we are discussing a simple credit model and test its predictability in the case of several troubled telecom firms.

The five-factor Z-Score model was developed by Dr. Edward I. Altman, Professor of Finance at New York University’s Stern School of Business.  It was first published in 1968 and refined into several variations later on. We tested Altman’s scoring model in several troubled telecom companies, using data available from Bloomberg.  The results, presented at the Appendix B, confirm the prediction capabilities of the model.  For example, WorldCom’s Z-scores, starting back in 2000, were signaling a possible future distress situation for WorldCom, placing the company in the grey zone.

The Z-Score is the sum of five weighted ratios:

Z = 1.2(X1) + 1.4(X2) + 3.3(X3) +0.6(X4) +0.999(X5)

Where,

X1, Working Capital/Total Assets

This is a measure of firm’s net liquid assets relative to its total capitalization.  Working capital is defined as the difference between current assets and current liabilities. A distressed company should focus on reducing its total assets to increase the ratio, e.g., by disposing fixed assets to generate cash.  Working capital increases because of the conversion of longterm assets into current assets or decreased liabilities. This is the not very important variable for the model.

X2, Retained Earnings/Total Assets

The retained earnings is the total amount of reinvested earnings and/or losses of a firm over its entire life.  It is directly associated with returns and growth.  It is the most exciting ratio. The age of the firm is implicitly considered in this ratio as well. To increase retained earnings, a company must be profitable, either through operations or the sell-off of assets or divisions or the forgiveness of debt.

X3, EBIT/Total Assets

This is a measure of the productivity of the firm’s assets, independent of any tax or leverage factor.  This ratio appears to be particularly appropriate for studies dealing with corporate failure.  It is the most important variable (most heavily weighted Z-Score factor), because a firm’s long-term existence is based upon the earning power of its assets. To increase EBIT it is usually vital that a company decrease costs.

X4, Market Value of Equity/Book Value of Total Liabilities

This ratio shows how much the firm’s assets can deliver in value (as measured by market value of equity plus debt) before its liabilities exceed its assets, and it becomes solvent. This ratio adds a market value dimension that other failure studies did not consider.

X5, Sales/Total Assets

The capital-turnover ratio is a standard financial ratio illustrating the sales generating ability of the firm’s assets.  It is one measure of management’s capacity to deal with competitive conditions. The assets should be deployed in profit-generating activities for the company to segue into the future.  This is the least important variable.

The five indicators provide insight into various aspects of a company’s finances and market value. The lower the Z-Score is, the greater the odds are of failure. 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.

No model predicts precisely when failure is likely, but Z-Score has indicated that failure is likely up to two years before a company declares bankruptcy.  The most important changes in the ratios occur between the third and second years prior to bankruptcy.

One of the primary uses of the Z-Score model is to assign a bond rating equivalent to each score.  This enables the analyst to assess the default probability of an applicant by observing the historical experience of each bond rating.  It has also been applied to private companies, non-manufacturing firms and emerging market companies.

The model is useful beyond forecasting possible bankruptcy. It can assist management in devising a plan of action to bring about a successful turnaround.  Following a plan that improves the Z-Score helps validate the turnaround plan by providing management with a tool it can understand, buy into, and follow.  Obviously, executing the strategy is more difficult than the theory behind the Z-Score.

Safeguards in Ball/Altman Plan

   In order to protect against inappropriate governmental interference in private sector decisions, Ball and Altman propose that the trust fund private equity investments be done through a system with safeguards that are similar to those found in the Federal Retirement Thrift Investment Board and the CPPIB. For example, Ball and Altman would limit investments to a very broad index fund (such as the Wilshire 5000) that reflects virtually the entire American economy.  

In addition, they propose that the investments be directed “by a board structured to ensure its impartiality and autonomy.” Specifically, they propose the creation of an independent agency, like the Federal Reserve Board, that would have long and staggered terms. This agency would be charged with “selecting the index fund, selecting the portfolio managers by bid from among experienced managers of index funds, and monitoring and reporting to the trustees and public on Social Security’s investments.” Their proposal would prohibit Social Security from voting any stock or influencing the policies or practices of any company whose stock is held by the index.

Recommendation

   I believe that the Ball/Altman proposal to invest a portion of the Social Security trust fund in private equities is far superior to proposals to invest Social Security assets in the equities market through individual accounts. First, private accounts entail much higher administrative costs than do investments through a single fundSecond, I believe that the risks and rewards of equity investments should be shared widely rather than borne on an individual by individual basis. Finally, as I discussed at length in my 2005 contribution to this Review, I believe that individual accounts raise a host of other problems.

Thus, if any of Social Security’s assets are to be invested in the equities market, I believe that the investment should be done through the trust fund rather than through individual accounts.

Whether any portion of the Social Security trust fund should be invested in private equities is a more difficult question. I believe that the proposal has distinct advantages. It offers the opportunity for higher returns, and ensures that those higher returns (and risks) would be shared widely. Nevertheless, it raises significant corporate governance issues. While past experience with state and local government pension plans shows how substantial the risks may be, past experience with the Federal Thrift Savings Plan  and the Canadian Pension Plan suggests that the risk of inappropriate interference in the private markets can be overcome. Accordingly, I believe the proposal merits serious consideration.

The American Social Security system faces a long-term funding deficit, and reform of the system appears inevitable. Robert Ball has proposed, and Nancy Altman has endorsed, a three part plan that would bring the Social Security system into close actuarial balance. Although the plan is not costless, it merits serious consideration. There is simply no costless solution to Social Security’s long-term funding deficit, and the benefits of the Ball/Altman plan (the most significant of which is bringing the Social Security system within close actuarial balance) outweigh its costs.

Sector on the Road of Recovery

The last couple of years, the biggest phone companies in the US try to position themselves better than the others in the industry for the economic turnaround, when it comes.

In 2003, telecoms continued to reduce their debt loads and capital expenditure substantially, whittling down ruinous overcapacity .  Before the market turned around early in 2003, the sector traded on a wide spread than the rest of the market, against the official lending rates, since credit investors required a sizeable risk premium for buying the telecoms companies’ debt.  By the end of 2003, the difference had narrowed significantly. With Internet traffic rising briskly, the industry glut will slowly be eaten away.  As demand starts picking up, telcos hoped to boost profits and resist pressures to cut prices.  However, competition between the large long-stance carriers in the US and the regional phone companies intensified across the states.  Bundling of services, e.g., local and long-distance, become common practice in order to fight against declining revenues.

Unfortunately, some optimistic signs in 2003 were not enough to make a full recovery to the depleted industry .  Some argue that a “jobless recovery” is not feasible for the sector.  In the U.S., telecom executives say they have been paralyzed by regulatory confusion, and unless politicians get out of the evolving legislation, the recovery will not happen any time soon.It is also widely believed that in the next few years we will evidence a new fever of mergers-and-acquisitions, with long-distance companies such as AT&T Corp., the largest long-distance carrier in the US based in Bedminster, N.J., which is a now a shadow of the Ma Bell that once controlled virtually all phone services in the U.S., and MCI as prime targets for the more financially healthy regional Bell companies. Experts believe that the industry needs to be consolidated. 

Indeed, talks regarding the consolidation frenzy kept going during 2003 . In the face of declining business (15 straight quarters of declining revenue), Wall Street’s view about AT&T, is that the firm will eventually get acquired.  BellSouth Corp., the Atlanta based company which serves most on the Southeast, had been in sporadic deal discussions with AT&T since 2001.  On late October 2003, BellSouth walked away from merger talks with AT&T (BellSouth executives were uncomfortable with the premium built into the $24-a-share price, people said).  The other possible matches for AT&T, Verizon Communications Inc. and SBS Communications Inc., do not seem interested at this point, say people familiar with the companies.  Analysts believe that BellSouth might need to get bigger to keep up with SBC and Verizon, its larger rivals.  Buying AT&T or MCI would be the fastest and easier way for a Baby Bell to get into the market for providing telecom services to businesses, which is notoriously difficult to break into. Like AT&T, MCI is presumed to be an acquisition target, though no buyers are expected to make a move until it is out of bankruptcy protection and has audited books.

Year 2004 started with more optimistic signals.   Early January, Verizon Wireless, a joint venture of Verizon Communications Inc. and Vodafone Group PLC of the UK, America’s largest wireless carrier, announced that it will invest $1bn in the next two years to deploy a high-speed wireless Internet data network nationwide . After three years of sharp declining in capital spending in the industry, people hope to see more investments by telecom companies in growth areas.

The prospects of some telcos are also looking up.   For example, Qwest Communications International Inc., the Denver-based local and long-distance carrier, was in the verge of bankruptcy mid-2002, due to excessive debt and accounting scandals.  The company saw its shares drop from a high of $66 in 2000 to just over $1 in 2002.  In a recent interview , Richard C. Notebaert, chairman and chief executive office who took over in June 2002, explains how is getting Qwest’s financials back on track, fostering change in the organization, looking at the right economic models (cost structure, pricing, new products and services, efficient operations), and focusing on sound marketing practices and key wholesale partnerships.

Analyzing the signals for the markets, both risky, volatile stocks and junk bonds soared in 2003.  Large stock investors are buying up MCI-like stocks and bonds, hoping to get in on the ground floor.  Historically low interest rates and accommodative credit markets, makes this the perfect environment for investors investing in troubled companies to score big gains. According to J.P.

Morgan Chase, overall, stocks of formerly bankrupt companies have beaten the S&P 500 stock index by 85 percent point in their first 12 months out of bankruptcy since 1988 .  Although some investors believe that investing in formerly bankrupt equities has been a successful investment strategy, there are risks as well, e.g., low liquidity, coverage by analyst, etc.  Sentiment improved early this year also due to underperformance of the sector, a stock rally that sent the Dow Jones Telecommunications Index to its highest level in nearly a year, as well as credit rating upgrading . However, there is also skepticism if recent run-up in telecom stocks might not be sustainable.

Yet, those events and short-term factors come amid conflicting signals abut whether the telecom industry is clearly on the mend.  From the U.S. to Europe to Asia, telecom carriers are locked in price wars that continue to depress profit margins, stealing market share from one another.  On January 2004, America’s two top long-distance carriers, AT&T Corp. and MCI, said that revenue would fall yet again this year by about 10 percent . As profits in core businesses such as phone lines continue to decline, competition intensifies and new technologies arrive, AT&T chairman and chief executive David Dorman marked a strategic departure for the company, by deciding to match discounts on business calling offered by competitors such as MCI, Sprint Corp., the regional bells and others  . With the business unit bringing in almost three-quarters of AT&T’s revenue, skeptics think that Mr. Dorman’s plan holds enormous risks for AT&T.  With MCI hung on to more customers than anyone expected (partly by using price breaks) and the Bells, which have deep pockets and existing relationships with most customers, becoming aggressive, AT&T is dragged into this telecom price war with a multitude of players.   On the other side, supporters argue that AT&T has the financial strength, technical know-how and cost-cutting prowess to win in this war. After slashing costs for year and years to stay competitive with WorldCom that artificially boosted its performance, now they think that have the opportunity to compete on both price and merit.  Yet, Mr. Dorman seems to acknowledge that AT&T and the telecom industry are stuck in a period of decline, foresees more layoffs, thinking that this is a long-term transition for the industry .

Ending Remarks

Although it is difficult to say how far off we are from a full recovery of the sector, early signs of 2004 make us believe that the worst is behind.  Also, as the economy picks up, it is probably safe to argue that the historic decline in the telecommunications industry has reached a bottom, although many challenges remain.  Investors and analysts for example, cite the recovery economy, the fact that the industry has trailed so badly for so long that is overdue for a rebound. And they say that the battered sector could be ripe for deal-making, which could boost share prices.  

Some specialists have long advocated that the sooner all the superfluous telecom companies collapse, the sooner the industry can return to health.  One main issue is the inability of entities in the telecom sector to obtain financing.  A general criticism directed at many in the industry is that they waited far too long before admitting to their lenders that their revenue streams were not going to meet their projections.

 That created credibility problems with their lenders.  Lenders that enabled the number of entities in the telecom industry to expand rapidly are now carrying a significant amount of non-performing loans.   For the ones that filed for Chapter 11, most have simply emerged from court protection with less debt, hoped to be acquired by bargain hunters or exploit low-interest rates to issue more debt. WorldCom’s rapid reorganization clearly underlines the speed and efficiency of the US bankruptcy process.  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.  In the US, competition in the telecom industry is increasing rapidly, as Bell’s phone-line monopolies are gone.  Phone service has become a commodity, and people think that you have to have that mindset in order to compete.  Appropriate pricing models have to be used in this new era of telecom services.

There is significant overcapacity in the long-haul network; the bulk of the networks built during the telecom bubble are still operating, keeping excess capacity in the marketplace.  Network traffic engineers argue that, although it is not possible to measure traffic exactly, the evidence of exponential growth is there; the question is what is the rate of that exponential. 

However, while traffic is growing, there is no sign of willingness to dramatically increase spending, to make the business plans of the bubble years a reality. If we argue that the growth is there, then companies need to develop new business models in order to come up with new source of revenue.

Academics and researchers emphasize that firms should continue to invest and foster innovation, e.g., spectrum allocation and usage, auctions, etc.  They also encourage the government to support this effort.

 Financial analysts urge firms to focus on profit and investors to understand the markets and realize that we live in a market economy.  Given the state of the U.S. economy the last years and the ongoing exercise of balance sheet repair at most major U.S. corporations, it behooves us to familiarize ourselves with financial distress prediction models, the bankruptcy process, and the high yield bond and leveraged loan market. Credit risk models are getting more attention from practitioners and regulators, and can signal unpleasant situations for investors and executives at early stages.

If long-distance and local calling get reunited in one business, the “all-distance” telecom, that will transform the industry, leading to consolidations and producing stability to the sector. 

Executives forcefully argue that the sector needs to consolidate, just as the defense industry did in the post cold war era.  But any merger of a regional operator and long-distance group would bring against regulatory hurdles once again (proposed merger between WorldCom and Sprint on October 1999).  Currently, in the US, there is still evolving legislation and regulatory confusion.  Political leadership in Washington is crucial and responsible for good public policy for the next years.

There is no doubt that the telecommunications industry is vital for the U.S. economy, traditional source of innovation, and a contributor to Homeland Security.  Let us hope that this time all parties involved will recognize and acknowledge the losses and pain, move on, and make the telecom industry a great engine of growth again.  We think that this is a longterm transition for most companies, and the involved parties seem not to rush this time.

Acknowledgements

I consider myself fortunate to be able to attend finance classes at two of the most worldrenowned business schools, Stern’s and Rotman’s Finance Departments, at New York University and University of Toronto respectively.  I am thankful to the faculty, and most particularly for this piece of research to Prof. Edward Altman, instructor of the elective course ‘Bankruptcy and Reorganization’ at the Stern School of Business.  Prof. Altman started teaching ‘Bankruptcy and Reorganization’ in 1975.  Since 1990, he has directed the research effort in Fixed Income and Credit Markets at the NYU Solomon Center. 

           He has an international reputation as an expert on corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis and is probably most well known for his development of the Altman Z-score.

In addition, I would like to thank discussants and participants of the “Remedies for Telecom Recovery” workshop in Columbia University on October 3, 2003, at New York City, organized by the Columbia Institute for Tele-Information (CITI), a Sloan Foundation Center on the Telecommunications Industry.  Many thanks to Credit Suisse First Boston (CSFB)’s team on Telecommunications, Media & Entertainment High Grade Credit Research, especially Robert Schiffman, Managing Director and Group Head of North America and Latin America.  Dr. Audrey Curtis, executive in residence and director of Telecommunications Management programs at Stevens Institute of Technology.  With 27 years of experience in both Lucent and AT&T, her comments and private conversations about the evolution of the US telecom industry, were valuable and insightful.  At last, but not least, the students in my graduate course on Economics of Networks at Stevens Institute of Technology, School of Technology Management.  Of course, I am fully responsible for any errors or omis

Conclusion

The time has come for a retrenchment from Sarbanes-Oxley .The legislation’s most outspoken sponsor, Representative Michael Oxley, has taken the position that “it is unlikely that Congress will revisit it.” By contrast, the SEC’s Advisory Committee on Small Companies has taken a refreshing and proactive stance, recommending elimination of SOX section 404 attestation procedures for smallecorporations, among other things. Perhaps the Committee, or the American Bar Association, or both, could take the lead, sending the message that more is not necessarily better.

Other countries have come to the conclusion that, even among public companies, tiers of disclosure and other requirements may be more appropriate than “one size fits all The United States should evolve, and authoritative bodies should advocate, a two or even three tiered system not only of disclosure but of SOX as well. Such a system would constitute the rootstalk for a generation of renewed entrepreneurship and capital formation in the United States.