Taking Stock: WorldCom Misled Even The Most Careful Investors - InformationWeek
IoT
IoT
News
Commentary
7/3/2002
11:59 AM
Commentary
Commentary
Commentary
50%
50%
RELATED EVENTS
Ransomware: Latest Developments & How to Defend Against Them
Nov 01, 2017
Ransomware is one of the fastest growing types of malware, and new breeds that escalate quickly ar ...Read More>>

Taking Stock: WorldCom Misled Even The Most Careful Investors

Expansion plans--not just earnings--were overstated.

WorldCom is the largest accounting fraud in U.S. history, so I had to get in my 2 cents' worth--about all the stock is worth right now (OK, I had to get my cheap shot in, too). I think the average person can only shake his or her head and wonder what motivates these people. Notice I said people, not company. A company isn't greedy; only the specialists of the animal kingdom have that personality trait.

Investors often ask how they can avoid these mistakes. In some cases, there's no way to see the train coming until it's too late. As a portfolio manager and analyst, I try to make good buying decisions based on as many facts as I can get my hands on. I look at the audited 10-K financial statements, read the proxies, follow the company's conference calls, even talk to most of its competitors and customers. I try to assess the amount of price risk in the stock and the potential for upside over a reasonable time frame, but, at best, I'm dealing with only about half the facts. No matter how hard I dig, there's still a substantial amount of information of which I'm not aware. I mitigate this information vacuum by lowering my estimates on my financial assumptions about the company.

But one thing I generally assume to be correct is the audited financial statements. I can discount for bad management, but I can never discount enough for fraud.

WorldCom's (WCOME-- Nasdaq) stock fell from its high of $62 in mid-1999 to $18 at the end of 2000, a decline of almost 71% in 18 months, as investors worried about debt requirements, capital expenditure needs, MCI's decline, and the excess supply of fiber-optic capacity. Also, investors were concerned about overall revenue and profit growth slowing domestically with the slide in the economy. However, the company still had sizable positive pre-tax profits (it appeared) and a fairly stable, although slowing, business.

The worst thing about WorldCom's manipulation of routine expenses into capital expenses is that it misled even the most diligent of investors. I believed that WorldCom was spending capital to complete its network last year. Based on a broader, more capable network across more geographies, I assumed that revenue growth might be better than anticipated, as the newer network would give the company a competitive price and an operating advantage. The cash flow from operations and previous large-scale build-out of telecom infrastructure would drive significant cash flow for the next few years. Historical growth rates for revenue were clearly unsustainable, but my financial models forecasted revenue growth rates might remain in the high single digits. By freeing up future cash flows from capital expenditures, shareholders would benefit by seeing larger amounts of share repurchases or increased dividends. Much has been made of the overstated capital expenditures as WorldCom was growing at a much faster clip than its peers. By overstating capital expenditures, it wasn't spending nearly as much as we thought to increase the company's long-term competitive network.

The difficulty in analyzing the valuation of the company is directly related to the misclassification of $3.8 billion in expenses last year and the first quarter of this year. It now appears that routine operating expenses weren't included in costs of goods sold, thus inflating operating earnings. In addition, it appears that of the $5.5 billion in capital expenditures WorldCom reported for 2001, only $2.5 billion was actually spent. The implication is that WorldCom significantly misrepresented its expansion plans: It now appears it was spending only enough to upgrade existing equipment--a far different picture than the one painted by management only a year ago.

I'm offended by many of the people in charge, both in top management and on the board of directors. Investors should get outraged. However, my belief in the capitalist system tells me that our anger should be directed at fixing the problem. After all these years, our financial markets have worked well with only minor adjustments. They're not broken, but some prudent adjustments must be made.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

Comment  | 
Print  | 
More Insights
Comments
Newest First  |  Oldest First  |  Threaded View
How Enterprises Are Attacking the IT Security Enterprise
How Enterprises Are Attacking the IT Security Enterprise
To learn more about what organizations are doing to tackle attacks and threats we surveyed a group of 300 IT and infosec professionals to find out what their biggest IT security challenges are and what they're doing to defend against today's threats. Download the report to see what they're saying.
Register for InformationWeek Newsletters
White Papers
Current Issue
2017 State of IT Report
In today's technology-driven world, "innovation" has become a basic expectation. IT leaders are tasked with making technical magic, improving customer experience, and boosting the bottom line -- yet often without any increase to the IT budget. How are organizations striking the balance between new initiatives and cost control? Download our report to learn about the biggest challenges and how savvy IT executives are overcoming them.
Video
Slideshows
Twitter Feed
Sponsored Live Streaming Video
Everything You've Been Told About Mobility Is Wrong
Attend this video symposium with Sean Wisdom, Global Director of Mobility Solutions, and learn about how you can harness powerful new products to mobilize your business potential.
Flash Poll