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Inside the Telecom Crash: Bankruptcies, Fallacies and Scandals A Closer Look at the WorldCom Case Dr. Fotios Harmantzis Assist. Professor, Stevens Institute.

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Presentation on theme: "Inside the Telecom Crash: Bankruptcies, Fallacies and Scandals A Closer Look at the WorldCom Case Dr. Fotios Harmantzis Assist. Professor, Stevens Institute."— Presentation transcript:

1 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 PerfEcTNet Research Group

2 Outlook of Presentation Introduction: Defaults in US Telcos in Distress The WorldCom Case –The Scandal –Chapter 11 Process –Plan of Re-organization –Emergence form Bankruptcy Credit Models for Telcos Telcos the Road of “Recovery” Ending Remarks/Thoughts 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

3 Introduction 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

4 2002 Defaults TotalCommunications Default Rate (per $) 12.8%6.65% Par Value Defaults$96.89bn$50.38bn Issues34488 Firms11226 Recovery Rate25%16%

5 2002 Bankruptcies TotalCommunications No of Fillings11231 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)

6 2002: Largest Telecom Bankruptcies CompanyBankruptcy DateLiabilities WorldCom7/21/2002$45.9bn Adelphia6/25/2002$17.3bn Global Crossing1/28/2002$14.6bn NTL5/8/2002$14.1bn Williams Comm.4/22/2002$7.1bn XO Comm.6/17/2002$5.8bn

7 Historical Default Rates in U.S.

8 Companies Defaulted

9 Recovery Rates in Telecom

10 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)

11 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).

12 What Went Wrong 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.”

13 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).

14 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.

15 Chapter 11 Process 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.

16 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.

17 Plan of Reorganization 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.

18 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.

19 Emergence of Bankruptcy: 2003 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.

20 Emergence of Bankruptcy: 2004 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.

21 Altman’s Z-Score Model (1969) 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. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

22 WorldCom’s Z-Scores

23 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 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

24 Ending Remarks/Thoughts 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

25 Thank You Dr. Fotios Harmantzis 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

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