On the Firing Line at Qwest

It's two Morgan Stanley analysts vs. the telecom in an unusual feud over accounting

The conference calls between Corporate America and Wall Street analysts to discuss quarterly earnings and such often have a sleepy, due-diligence tone to them, with talk of gross margins, cash flow, and the like. But on June 20, Joseph P. Nacchio, CEO of Qwest Communications International Inc., had every listener wide awake as he hammered away at Morgan Stanley Dean Witter & Co. (MWD ) for a research report that questioned Qwest's accounting practices. "I'd like people to make sure they're listening clearly," Nacchio said. "There are no accounting issues or improprieties in Qwest's financial reports. Let me repeat that. There are no accounting issues or improprieties in our reports." In explaining why he felt compelled to hold the conference call, he said, "innuendos on our integrity are not going to be tolerated, irregardless of who makes them, including what I used to believe was a reputable branded firm, Morgan Stanley."

Ouch. At a time when Wall Street analysts are drawing widespread criticism for cozying up to major corporations, the Qwest-Morgan Stanley clash has turned into a highly unusual, public, and nasty dispute. Wall Street firms tend to avoid pointed criticism of companies because they don't want to lose out on lucrative investment banking business, such as helping a company raise capital or negotiate a merger. For an individual analyst, aggressive research can be professional suicide: After Janney Montgomery Scott analyst Marvin Roffman criticized real estate mogul Donald Trump in 1990, Trump asked for his head, and the firm obliged. Still, since June, Morgan Stanley analysts Simon Flannery and Jeffrey Camp have continued to question Qwest's accounting practices in their research reports.

CREDIBILITY CRISIS. Nacchio, a brash Brooklyn-raised 52-year-old with a street brawler's attitude, has responded blow for blow. At one point, he openly scoffed at the notion that Morgan Stanley's analysts were doing the kind of independent research that analysts are supposed to do. "If I believe that, I'd have to believe in the Easter bunny," he said. "For a firm like Morgan Stanley to be taking this approach with us, while at the same time they have strong buys on companies that have large financings in front of them, would make me look twice."

These days, however, it's Nacchio's credibility that is under fire. The central argument that Flannery and Camp made was that Qwest was using accounting practices that, while legal, were so aggressive that it would be difficult for Qwest to hit future revenue and profit growth targets. A host of Wall Street firms, including Salomon Smith Barney and Credit Suisse First Boston, jumped to the company's defense. But on Sept. 10, Qwest conceded it wouldn't make its revenue and profit targets for the second half of 2001 and would show revenue growth in the "high single digits" next year, not the 12% to 15% promised. "We're proud of these analysts for uncovering an out-of-consensus view that turned out to be right," says Mayree C. Clark, Morgan Stanley's head of global research, who says the firm's research is independent of its investment banking.

The sharp-penciled analysis has helped Morgan Stanley's reputation at a critical time. The firm took a hit for its research during the Internet boom for the nonstop cheerleading of Net analyst Mary Meeker. Even some of Qwest's shareholders give the investment banking firm kudos, despite having lost money on Qwest stock. "They were the first to report on the growth issues," says Brian B. Hayward, manager of the Invesco Telecommunications Fund, which counts Qwest among its top 10 holdings. "That's the idea [of good research]." Abraham Bronchtein, a New York money manager and shareholder, wrote a letter to Nacchio arguing that Morgan Stanley had performed "an appropriate and timely service."

TAKEOVER BAIT? Nacchio, however, is conceding nothing. When he lowered his financial projections on Sept. 10, he pointedly said that the change was not due to the accounting issues raised by Flannery and Camp. Rather, he said, it was because the economy in the 14-state territory where it has local telephone operations, as a result of its acquisition of US West Inc. (Q ) last year, had suddenly slowed. Indeed, Nacchio has said that the accounting issues are irrelevant and don't have any impact on Qwest's ability to generate revenues or cash flow.

Nacchio declined to comment for this article, but at an investor conference earlier this month, he argued that Qwest will be stronger than ever once the economy recovers. "We look like the kind of company the industry is going to look like three years from now," he said. "We're on the cutting edge."

Nacchio has a lot of work to do to restore Qwest's luster. At the beginning of this year, Qwest looked like a sure survivor in the telecom industry's increasingly brutal shakeout. It had the combination of cash-producing local assets and a cutting-edge national network that every major telecom player was shooting for. And it sported a $70 billion market cap that would have allowed it to get even bigger by, say, making a run at long-distance and wireless power Sprint Corp. (FON ) or combining with BellSouth (BLS ) in a merger of equals. Now, with its market cap down to $30 billion, Qwest could be takeover bait. The steep decline is largely because investors realize Qwest is suffering the same problems as everyone else in telecom. However, based on stock price-to-cash flow rations, there is a 10% to 20% discount relative to other Bells, largely because of concerns over accounting issues. "The market is telling you the company has a credibility problem," says Hayward.

Who are the analysts who have taken on Nacchio? Camp is a young hotshot who, at age 32, has won the top spot in Institutional Investor's prestigious ranking of equity analysts for the past two years. The Michigan native covers Internet infrastructure services--including Web hosting and high-speed Internet access--after spending four years in Hong Kong evaluating Asian telecom companies for Morgan Stanley. Flannery, a cherub-faced Irishman who arrived at Morgan Stanley from J.P. Morgan & Co. (JPM ) in 1999, covers major U.S. telecom companies. The 39-year-old made his name at J.P. Morgan sizing up Latin American telecom companies, winning the top Institutional Investor ranking in that category in 1996, 1997, and 1998. They jointly cover Qwest because the company is both a traditional telecom carrier and a provider of Internet services.

QUESTIONS. Qwest and Morgan Stanley haven't always been at odds. In 1999, Qwest helped select Morgan Stanley for the lead role in the initial public offering of KPNQwest (KQIP ), a European telecom network jointly developed by Qwest and Dutch national phone company KPN. Even at the beginning of this year, Flannery and Camp were pretty big fans of the company and of Nacchio. At the start of January, they rated Qwest's stock a "strong buy," the firm's highest rating. When the pair decided to downgrade the stock one notch to "outperform" on Jan. 25, they took pains to explain that it was because Qwest's stock had soared so high that its valuation had gotten ahead of its telecom peers.

Over the next few months, a series of events prompted Flannery and Camp to take a closer look at Qwest. In February, Qwest Chief Financial Officer Robert S. Woodruff decided to leave the company to spend more time with his family. In March, the company filed its first annual report with the Securities & Exchange Commission since the merger with US West. In April, it reported first-quarter results that were better than its peers. And through the spring, Nacchio and several other top execs were selling shares. Nacchio sold more than 4 million shares in the 12 months ended that June for a total of $183 million, according to Thomson Finance/First Call, which he said was to diversify his financial holdings. "Almost as a matter of course, we started to look through it," says Camp. "We hadn't come to any conclusions. We had some follow-up questions for the company."

To help, Flannery and Camp turned to Trevor Harris, a Columbia University professor of accounting and head of Morgan Stanley's accounting research group. Together, the trio dug up examples of where they felt Qwest was using aggressive accounting that made its financial statements look better than they would with a more conservative approach. For example, they noted that Qwest carried its investment in KPNQwest at more than $7 billion--even though KPNQwest shares had tumbled so precipitously that the market value of the stake was less than $2 billion.

"DISAPPOINTED." What's more, Qwest had made changes to its pension plans that Morgan Stanley found troubling. Last year, for instance, Qwest boosted the average return it assumed it could get on plan assets to 9.4%, from 8.8%. The result: Qwest's pension assets were figured to be growing much faster than its costs, allowing it to report income from its pension plans. Overall, the changes enabled Qwest to report income from its pension funds of $405 million in 2000. The company "has moved from having the most conservative assumptions [of the Bell companies] to among the least conservative," Flannery and Camp wrote. While each accounting item may not have been significant, Morgan Stanley felt that, in total, they suggested Qwest was straining to make its numbers. In a June 20 report, the analysts detailed their concerns and downgraded Qwest's stock, this time to "neutral."

Nacchio exploded. He called a conference call for June 20--never mind that he had held one the day before to reiterate that Qwest expected to make its financial projections for 2001. "I'm extraordinarily disappointed with what I consider unprofessional and irresponsible behavior from a major investment bank," he said.

Robin Szeliga, Qwest's new chief financial officer, then rebutted the Morgan Stanley report point by point. She conceded that Qwest would write down the value of its stake in KPNQwest, but said it would be $4.8 billion because that was the value suggested by an independent appraiser. On the pension plan, she said the assumed return figure was simply average for the telecom industry. Qwest's stock sank 4% that day, but after several other analysts issued reports critical of the Morgan Stanley research, it recovered to its previous level of $31 a share by the end of June. Even when Qwest said in July that it would write down its stake in KPNQwest to $1.3 billion, the stock held up.

It was another story after the next Morgan Stanley report. In August, Morgan Stanley dug into Qwest's second-quarter financial statements and found that the company had more than doubled sales of indefeasible rights of use (IRUs), which are slices of capacity on its network. The increase was so large that it had a big impact on the company's overall sales: Qwest's revenue growth in the second quarter was 12.2% with the capacity sales, but 7.5% without them.

Morgan Stanley said the trend was troubling for two reasons: First, Qwest could only sell so much capacity because its network is finite. Second, the demand for IRUs was drying up as telecom players ran into financial trouble. Nacchio appeared on CNBC (GE ) arguing that he would never run out of optical capacity, but investors grew nervous. "[The steep increase in IRU sales] was what was most worrisome to us," says Invesco's Hayward. Qwest shares dropped 5% the day the report came out, to $22.10.

By the time Qwest lowered its financial projections on Sept. 10, there was an air of inevitability to it. Virtually all the major telecom companies were missing their earnings targets. Many upstarts had filed for bankruptcy. And Morgan Stanley's reports had primed investors that Qwest could disappoint. Even while explaining how the economic slowdown had hit Qwest, Nacchio remained upbeat. "In the short term, we have to be conservative, reflecting a slowing economy," he said. "I am still very bullish about this industry. I really like our position. I like our assets."

UNUSUAL DEAL. In a sense, it was a chance for Nacchio to wipe the slate clean, to start over and let investors forget about the accounting issues raised by Morgan Stanley. That didn't happen. Two weeks later, another accounting issue came up--and this one didn't start with Flannery and Camp.

In late September, several investors heard second-hand that a small telecom startup called Calpoint LLC had cut an unusual deal with Qwest. Under the agreement, Calpoint would develop communications services based on new optical technology, and Qwest would market those services to its own customers. As part of the deal, Qwest would buy telecom gear, mostly from optical player Ciena Corp. (CIEN ), and then resell it to Calpoint. When investors called Qwest to get more details, they found out that Qwest was planning to book as much as $300 million in revenues from the deal--even though selling equipment is hardly Qwest's business. One portfolio manager, who cannot speak on the record because of his firm's press policies, was incredulous. "Maybe [Nacchio] does need stuff like this to make his numbers," he said. "What else is he doing that we don't know about?" During the last week of September, Qwest's stock slid to $16.70.

The following Monday, Oct. 1, Nacchio hastily arranged another conference call to explain the Calpoint deal. He said the agreement was designed to minimize Qwest's expenses by having another company make capital investments and that Qwest was buying the equipment for Calpoint because Qwest could get bigger discounts than a tiny upstart. And he backed down from counting the Calpoint deal as general revenues, saying he would break out any revenues received from the arrangement. "It will not be used to confuse our gross margins, our net margins, our revenues," he said.

These days, Nacchio seems to have lost some of his fight. At a Goldman, Sachs & Co. (GS ) conference on Oct. 3, he sounded almost despondent as he spoke to institutional investors. "Anything I tell you, you're not going to believe anyhow," he said. "We're obviously under a cloud. You all think we lie, cheat, and steal." Still, he vowed to pull Qwest out of its current troubles. "We'll let the numbers speak for themselves on Oct. 31," when the company reports third-quarter results.

Even though they've won the respect of many investors, Flannery and Camp aren't celebrating. They know that Morgan Stanley's relationship with Qwest is badly damaged. Both say they would like to repair it. "Their input is critical to what we're doing," says Camp. Making tough calls on Wall Street has never been easy.

By Peter Elstrom

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