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Trying to Catch WorldCom's Mirage

The New York Times June 30, 2002

In Dec. 6, 1999, AT&T replaced the chief of its huge business services division, Michael G. Keith, after barely nine months on the job. To the outside world, it appeared that C. Michael Armstrong, the company's chairman and chief executive, had moved Mr. Keith to the company's wireless unit simply because he was not getting the job done.

Now some people close to AT&T say Mr. Keith was actually transferred mostly because his division could not match the reported profit margins of its biggest competitor, WorldCom.

'He was being held to WorldCom's margins and he was screaming to Armstrong that it couldn't be possible and so he got moved out,' one person who was close to Mr. Keith recalled last week. 'It now turns out that the pressure that was put on him and on AT&T generally was based on a false assumption. And that happened across the industry.'

WorldCom's announcement last week that it had misrecorded $3.8 billion in costs has forced the company to the brink of bankruptcy. The ranks of the losers are legion: employees, investors, perhaps even consumers. In some ways, however, the most far-reaching effects of the financial shenanigans at companies like WorldCom, Global Crossing and Qwest were the dislocations and costs they caused for the companies that tried to compete with them.

It is even possible that had it not been for AT&T's inevitable comparisons to WorldCom, Mr. Armstrong would not have felt compelled to set the company on the path to a three-way breakup.

As WorldCom and Qwest, in particular, reported spectacular growth and gross profit margins - as much as 62 percent at WorldCom and 70 percent at Qwest in recent years - they made their peers seem sluggish and they may have compelled those companies to alter and even distort their strategies in an attempt to keep up.

'Our performance did not quite compare and we were blaming ourselves.' William T. Esrey, chief executive of Sprint, the No. 3 long-distance company, said in an interview last week. Mr. Esrey echoed other senior telecommunications executives in saying that the vicious price wars that decimated the long-distance industry in the 1990's were driven by an unsustainable, almost irrational pursuit of growth. 'We didn't understand what we were doing wrong,' he said. 'We were like, 'What are we missing here?''

Several top executives said last week that competing against WorldCom for the attention of investors and Wall Street analysts in recent years was essentially like running track against an athlete who is later discovered to be using steroids.

A bird's-eye view of the numbers can illuminate the pressures on older companies. In 2001, for instance, WorldCom reported a gross profit margin of 62 percent while Qwest reported 64 percent. The comparable figures were 50 percent for AT&T and 51 percent for Sprint.

Last week, WorldCom acknowledged misreporting its costs only as far back as the first quarter of 2001, yet the Securities and Exchange Commission had already begun an inquiry into WorldCom's accounting going back as far as the beginning of 1999.

The costs of trying to keep up with the industry's highfliers may have extended far beyond the individual travails of executives like Mr. Keith, who is now a senior executive at AT&T Wireless, an independent company, and who declined to comment. (Some other people close to AT&T say that Mr. Keith really was removed from the business-services unit because he was not up to his job.)

In October 2000, AT&T announced that it would break itself into three separate companies with four separate stocks. It made the move for many reasons, and some seem rational no matter how many of its competitors might have operated fraudulently.

Nonetheless, it now appears at least possible that had it not been for comparisons with some bad seeds like WorldCom, AT&T could still be one company.

In the months leading up to the breakup announcement, AT&T's shares had been hammered by investors concerned about the company's cable strategy and because Wall Street did not believe that AT&T's core operations were being run as well as, say, WorldCom's.

'Wall Street was more than captivated by these new guys; they were eating the lotus leaves and it made companies like AT&T and Sprint look stodgy in comparison,' said Howard Anderson, an investor who founded the Yankee Group, a research firm in Boston. 'There was never any question that in terms of the strength and reliability of the network, none of these new guys compared to AT&T. AT&T made a lot of legitimate moves and the stock market did not reward them and in fact they were punished. In the end, that helped lead to the breakup.'

Charles H. Noski, AT&T's vice chairman, said the factors that prompted the company's break-up ranged far beyond its stock price. Nonetheless, he agreed that competing against WorldCom for the hearts and minds of investors at times seemed Sisyphean.

'We were constantly dissecting all of the public information about WorldCom and we would scratch our heads and try to figure out how they were doing it,' Mr. Noski said. 'We were certainly frustrated because we couldn't figure it out. We sort of absorbed the beating and kept our heads down and kept trying to get better.'

Sprint's Time of Trial
For all of AT&T's difficulties, in some ways the company that has best exemplified the evolution of the telecommunications industry over the last two decades has been Sprint, which but for the grace of regulators would have become a part of WorldCom.

From its roots as a rural local telephone company founded in 1899 in Abilene, Kan., Sprint sprouted to become the nation's No. 3 long-distance carrier in the 1980's and a major national wireless carrier.

During the 1990's, many young long-distance companies, including WorldCom, Qwest and Global Crossing, entranced Wall Street even as they helped transform long-distance into a commodity business.

Trying to satisfy Wall Street demands, the new companies cut prices but still reported spectacular revenue growth, making old-line companies like AT&T and Sprint look sick by comparison. While the dot-com boom lasted, with its wildly growing demands for data networking, that trend was sustainable. But as the Internet bubble collapsed and financing dried up over the last few years, the entire long-distance industry found itself in a shakeout.

The local phone business, meanwhile, has remained a relative haven. As long-distance companies watched their revenue shrivel, the regional Bells and other local phone companies managed to survive.

All of those trends found their expression at Sprint.

Sprint had always used its stable local phone business, which remains the nation's fifth-biggest, to generate the cash needed to expand into arenas like long distance in the 1980's and wireless in the 1990's. But while the local operations were stable, they also prevented the company from reporting explosive growth rates like WorldCom's.

'You should have seen in the '92, '95, '96 period, all of the guys from New York would come by with their suspenders - you know, the investment bankers - and would say: 'You've got to get rid of this slow-growing local business. It's a dog!' ' Mr. Esrey recalled.

He questions whether Sprint would have remained solvent in recent years without its local phone business. But at some level, the bankers were right. Through the 1990's, Sprint was not able to match go-go companies in Wall Street esteem. WorldCom used its highflying stock to acquire MCI in 1998 and to agree to buy Sprint for $115 billion in October 1999. It would have been the biggest corporate acquisition in history.

'At the time, you had to look at the payout for our shareholders,' Mr. Esrey said last week. 'It was $115 billion and this is a rural local phone company.' (At least it was.)

Then Mr. Esrey got lucky, though he did not realize it then. In 2000, European regulators and their American counterparts rejected the deal on the grounds that it would create a company with too much market power.

'You've got to say, 'Thank you Lord, you saved us from that,'' Mr. Esrey said.

The Remnants of the Bubble
In in its overall structure, the telecommunications industry has returned to where it was not only before the landmark Telecommunications Act of 1996, which was meant to allow new companies and forms of competition to flourish, but to where it was 15 years ago. After the industry's financial crash and accounting implosion, the only stable major carriers remaining are the Bell local phone companies, AT&T and Sprint, just as in the late 1980's.

So was anything of lasting value created? 'What happened was that the carriers did spur innovation and we had new technologies that might not have been seen before,' said Mr. Anderson, the Yankee Group founder, who has been following the telecommunications industry for three decades. 'But ultimately, the answer is no.

'It's hard to say anything was created when trillions of dollars in value have been destroyed,' he added. 'Of the 29 or 30 public companies that are carriers, easily 20 of them could declare bankruptcy.'

Senior telecommunications executives are hoping at least that the industry may have hit bottom.

'If you look at the remaining substantial players in the sector, clearly you've got AT&T and Sprint and the regional Bell operating companies, and given the monopoly position of the Bells, I would be surprised if there were any revelations there,' said Mr. Noski of AT&T.

'I think Sprint has clearly taken actions to try to secure their financial position,' he added. 'Obviously, I think we'll be in good shape as well. I've been surprised in recent months so I guess I would never say never. But it's hard for me to imagine greater problems than the industry has today.'

If any industry has been in deeper trouble than the long-distance sector, it may be the wireless business, where ruthless competition has sent stocks plunging.

'Has the industry hit rock bottom?' asked John D. Zeglis, chairman of AT&T Wireless and a former president of AT&T. 'Right now the wireless industry is looking up at rock-bottom thanks to a herd mentality that failed to differentiate wireless companies on the substance of the economics and the fundamentals of their financial and operating performance. But this insanity is temporary.'

Daniel F. Akerson, chairman of XO Communications, an upstart communications carrier operating under Chapter 11 bankruptcy protection, shares the belief of many in the telecommunications industry that the current troubles will prompt a newround of corporate acquisitions. 'This may be a galvanizing event,' said Mr. Akerson, a former MCI executive. 'This may define the low point and we can start back up. But there is so much debt in the industry that I think what you'll see is fewer competitors and ultimately there will be a wave of consolidation.'

The conventional wisdom in the telecommunications industry is that one of the Bell companies will try to acquire Sprint over the next few years. After completing the sale of its cable television business to Comcast, the remaining AT&T would also be an attractive acquisition target for a Bell carrier.

But, as pointed out by Edward E. Whitacre Jr., chairman of SBC Communications, the No. 2 local phone company, the regulators usually have the last word in the telecommunications arena.

'This current situation shows that the rules that are in place from all of our regulators have some serious problems,' Mr. Whitacre said. Referring to the chairman of the Federal Communications Commission, he added, 'We need a leader, and that's Michael Powell, to step up and make some decisions to give some clarity to all of this.'

Mr. Esrey of Sprint did not exactly tout his company's stock, but pointed to its long-term potential for growth.

'If your investment horizon is three months or six months, then I don't know what might happen,' he said. 'But if you want to be conservative, and I know it sounds strange to put it that way, but if you want to make an investment in telecom and put it away, I think in two or three years you would be absolutely delighted.'

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