In October last year, the company at the heart of the largest corporate collapse in financial history was given court clearance to emerge from Chapter 11 bankruptcy protection by the end of February 2004. The firm has since applied for a further 60-day extension to that deadline, but some time within the next few months, MCI—the reincarnation of long-distance telecom giant WorldCom—will almost certainly be preparing to return to the corporate bond market after a two-year absence.
Less certain, however, is what reception MCI should expect from an investor community that, after all, cannot have forgotten the allegations that WorldCom executives perpetrated an $11 billion accounting fraud. MCI seems likely to come under a good deal of scrutiny before investors will commit to a stake in its future.
Naturally this is a likelihood that MCI is more than aware of. Shortly after the scandal broke and WorldCom filed for bankruptcy in July 2002, the firm hired former Hewlett-Packard president Michael Capellas to replace chief executive officer Bernard Ebbers, on whose watch the questionable bookkeeping took place. Capellas has since pulled out a variety of stops to regain investor confidence and shore up WorldCom’s crumbling facade.
One of Capellas’s first moves was to shed the scandal-tinged WorldCom name in favor of MCI. A subsidiary of WorldCom acquired in 1998, MCI is a brand that has broad recognition in the US, where MCI has 20 million customers. More dramatic, however, have been the sweeping reforms of corporate governance at the firm.
An ethical makeover
Much of this overhaul has taken place under the auspices of the corporate monitor appointed by the bankruptcy court, former Securities and Exchange Commission (SEC) chairman Richard Breeden. And the task has been Herculean. In a report to district judge Jed Rakoff on the future of MCI’s corporate governance entitled Restoring Trust, Breeden notes that “one cannot say that the checks and balances against excessive power within the old WorldCom didn’t work adequately. Rather, the sad fact is that there were no checks and balances.”
As chief executive officer, Ebbers was permitted an almost imperial reign over WorldCom’s affairs, with the board of directors exercising little or no restraint on his actions. One vivid example of his abuses is the $400 million in ‘loans’ from shareholders to Ebbers that were initially put in place by two directors that were long-term associates of his. It is unlikely that these loans will ever be repaid.
However, under Breeden’s direction, the former WorldCom has since replaced most of the firm’s senior executives, including every member of the company’s board of directors as it stood when the fraud took place. The 11-member board has now had a full refit with 10 independent directors—Capellas is the only member of management on the board—and it has adopted 78 corporate governance measures as outlined in Breeden’s report to the bankruptcy court.
The measures are far-reaching and intended to establish MCI as a model of excellence in corporate governance. And in terms of restoring confidence in the company, they have already had their first major success. In July last year, the government body responsible for securing services for federal agencies had suspended MCI-WorldCom from bidding for government contracts, citing weak accounting controls and ethics programs at the firm.
But just five months later, corporate governance reforms had made sufficient progress for the ban to be lifted, allowing MCI to once more bid for contracts from its largest customer, contracts accounting for around $1 billion per year.
However, one analyst at a major bank suggests that while governance measures have certainly made significant progress, there are still a good number of loose ends to be tied up before investors will feel that the WorldCom scandal can be put to bed. WorldCom remains under investigation by the Justice Department, and although some of the executives involved face trial later this year, some key figures have still not been brought to book for their role in the fraud. The most glaring omission is undoubtedly the former CEO Bernard Ebbers. While he remains under civil and criminal investigation, to date Ebbers has still not been charged.
What’s more, regardless of all the spit and polish applied to corporate governance at MCI, corporate bond investors are still voicing concerns about the company’s fundamentals. As one high-yield telecoms analyst explains, “There is a common misconception that WorldCom collapsed because of fraudulent accounting practices, but the truth of the matter is that the fraud was used to cover up the fact that WorldCom was already in a state of collapse.”
So while MCI’s improved corporate governance measures are certainly laudable, the question remains over whether the company has done enough to repair and improve its business model to ensure that it is financially viable in the long term.
A federal bankruptcy judge approved WorldCom’s reorganization plan in November last year in a deal that will permit the company to keep virtually all its assets while eliminating more than $35 billion in debt from a balance sheet that was laden with debts of $41 billion in July 2002.
More precise details of MCI-WorldCom’s restructured balance sheet are as yet unclear and will remain so until its formal emergence from bankruptcy, now set for the end of April. Having already gained federal and state regulatory approvals and approval from its creditors, MCI’s last remaining hurdle before emerging from bankruptcy is to complete its financial filings.
According to Bob Blakely, MCI’s chief financial officer, “Accounting and disclosure matters have been properly resolved and our 2002 10K is almost ready for filing. We are working diligently on 2003 and are in the process of auditing the results and preparing the filings.”
But to get to this point, MCI-WorldCom has had to jump through a series of hoops, not least coming to a $750 million settlement with the SEC to resolve civil charges of fraud concerning its improper accounting—the largest civil penalty ever to be imposed by the SEC. And one analyst points out that litigation in the civil courts could continue for some years to come.
The restructuring plan itself has also faced hurdles, having to overcome a series of objections from the various classes of debt holders. When the plan was first presented to the bankruptcy court in April last year, it emerged that the accounts of WorldCom and its various subsidiaries were too tangled to individually address the 222 legally separate entities. This was largely the result of a succession of poorly integrated acquisitions—WorldCom had taken on 27 different billing systems and had then failed to keep accurate records of transactions between the company’s various entities. The auditors therefore had little choice but to combine the assets of WorldCom with those of its subsidiaries.
However, at the time that WorldCom filed for bankruptcy, WorldCom held most of the corporation’s $41 billion in debt and MCI had 90% of the assets. Holders of debt in MCI felt that this unfairly benefited WorldCom creditors at the expense of others who owned debt in the subsidiaries. Since the debt that they owned was originally tied to MCI’s assets, they argued that they deserved to be paid in full.
Although these dissident creditors—holders of MCI’s subordinated debt and WorldCom’s trade debt—owned less than 3% of the company’s $41 billion in total debt, they threatened to disrupt MCI-WorldCom’s emergence from bankruptcy by challenging the central element of the plan for reorganization. In September, MCI-WorldCom finally overcame these objections with a combined payout of more than $400 million. These debt holders will be paid in cash and equity once the company finally completes the bankruptcy process.
The task of untangling MCI-WorldCom’s jumbled accounts has produced one core requirement for corporate bond investors and analysts looking at the company, argues Richard Siderman, telecoms analyst at rating agency Standard & Poor’s. “MCI will need to have strong financial and operational controls to establish investor confidence,” he says.
But Siderman points out that from a long-term perspective, this may in fact be the least of the problems facing MCI. A far more crucial factor in the analysis is that MCI is on track to exit bankruptcy at a time when the telecommunications industry is struggling with the consequences of rapid technological evolution and huge competitive pressures.
Siderman says that this will be one of the most difficult aspects of the ratings process for MCI. “Rejiggering the balance sheet will have a relatively limited impact for MCI in the current operating environment. A key aspect of the analysis is going to be an examination of how MCI chooses to respond to industry pressures.”
For 2004, MCI has projected a 4% increase over its 2002 revenues of $24.5 billion, with a predicted further 2% increase in 2005. One credit analyst at a major bank argues that these growth estimates appear to assume that MCI will be able to take significant market share from fellow long-distance providers AT&T and Sprint. “My feeling is that these estimates are unduly optimistic in the current environment,” he says.
Despite a strong backbone in the form of its high-speed internet service, analysts agree that as a provider of long-distance telephone services, MCI may actually be on a losing ticket in the contest between the various communications companies: long-distance, wireless, regional bell operating companies (RBOCs) and cable.
According to Joe Robison, director of credit research at fund management company National City Investment Management, “Long distance as a stand-alone business is a losing proposition. Long-distance rates have plummeted in recent years as the service has been commoditized with the advent of increased competition.”
This has, in part, been the result of increasingly relaxed regulatory policies which have allowed the RBOCs to compete for long-distance customers and vice versa. This has forced prices down as operators attempt to retain subscribers or compete for market share. At the same time, however, technological substitution has increasingly caused demand to shift to newer and more flexible technologies such as wireless networks.
MCI is making some progress on the pricing level with the strategy to move away from traditional circuit-switched networking toward internet protocol (IP) standards. While the former relies on creating a direct connection between two callers, IP divides a conversation into millions of fragments which each find the most efficient route to their destination before being reassembled in order. IP is considerably more efficient, providing companies with huge savings since the phone company no longer needs to pay the cost of access fees to other regional companies.
However, while this would certainly be a step forward for MCI, S&P’s Siderman points out that it could be some time before the benefits of this system become clear. “The Federal Communications Commission is reviewing voice-over IP and their decisions could impact all wire-line competitors, in particular the access fees that the long-distance providers pay to the local phone companies,” he says.
The other long-distance providers in the market are also feeling the pressure. Robison from National City Investment Management describes AT&T as being “in the midst of a desperate and seemingly futile effort to rediscover itself,” while Sprint is “stable but increasingly reliant on its wireless business for growth.”
Michael Weaver, telecoms analyst at rating agency Fitch, says, “Within the current environment, operators with the greatest scale and diversity and most flexible infrastructure for meeting customer demands will be the most successful.” MCI simply does not have that diversity. The company has no wireless component and no wire-line footprint, but instead leases lines from other companies to compete at the regional level.
So although Robison argues that there is still some remaining value to the solid but ebbing cashflow in long distance, particularly for the commercial customers that are MCI’s key remit, “the landline long-distance business that somehow avoids being displaced by wireless substitution seems destined to be swallowed up amid the forces of industry consolidation.”
It seems that regardless of whether Capellas is successful in ridding investors’ memories of the connection between MCI and WorldCom, and regardless of whether MCI succeeds in becoming a paragon of corporate virtue, Capellas cannot change the industry that MCI finds itself in. If MCI has any hope of a long-term future as a stand-alone company, the future will have to involve changing their business lines and not just changing the staff who run them.
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