Qwest Quakes on Quarterly Qualms

Network capacity sales came back to haunt Qwest (Q) in the third quarter, causing CEO Joe Nacchio to raise the ghoulish specter of 75% spending cuts next year.

Quit It Qwest keeps falling

In noting the prospect for even deeper spending cuts in the coming year, Nacchio sought to reassure analysts and investors who are increasingly concerned about the debt-laden, cash-burning company's prospects during a deepening recession. But coming on top of Qwest's stunningly weak results, Nacchio's brash words were received as another signal to head for the exits. Qwest, already at a 52-week low and more than 70% off its high for the year, plunged 20% Wednesday to $12.72.

Flagging

Critics, including TheStreet.com's own Detox, have been waving a red flag over Qwest's reliance on so-called indefeasible rights of use, or IRU, agreements. The suspicion has been that these sales of network capacity to other phone companies have padded Qwest's results disproportionately because of the way they're accounted for. Qwest didn't immediately return a call seeking comment.

Now Qwest's many critics are crowing. Third-quarter results showed a sudden and dramatic fall in IRU sales, revealing that beneath a blanket of hyperbolic growth talk lies an anemic patient.

"This is exactly what everyone feared, that IRUs would disappear," said one money manger who asked not to be identified. "And boom, they didn't have a whole lot of growth without them."

Free Falling Qwest's ugly third quarter by the numbers
Category	Result	Comment
Earnings	Loss of 9 cents a share	Analysts expected 3-cent profit
Revenue	Fell 12% sequentially	Growth hopes out the window
EBITDA	Fell 9% sequentially	Cash burn threatens positive cash flow target
EBITDA Margin	Dropped 2 points to 37%	Margin worries ramping up
Source: Detox.

IRUs make some investors nervous because of the way they are accounted for. Capacity sold by Qwest to another phone company is recorded as a sale of inventory and booked as revenue. Meanwhile, the transaction is termed an investment in property, plant and equipment, and therefore doesn't enter the income statement as an expense. Hence IRUs are suspected of padding the top and bottom line, with little or no drag on costs.

Some investors expected Qwest's IRU business would pull in around $1 billion annually. But in the third quarter, IRU revenue was a mere $133 million. "That makes $1 billion a huge stretch goal," says the money manager, whose firm is long Qwest.

A Qwest spokesman emphasizes that the Denver telco books its IRUs according to generally accepted accounting principles. He says the dramatic decline in IRU revenue stemmed from a shift in spending behavior among customers.

Firing

Perhaps equally scary was Nacchio's fire-breathing insistence that Qwest will be cash-flow positive in the second half of next year. To get there, Nacchio said he'd have to "manage capital tightly." One of the options Nacchio has at his fingertips is equipment spending; Qwest cut 4,500 jobs last month in the last round of belt-tightening.

According to Nacchio, if there is no sales growth next year, Qwest could spend as little as $2 billion on capital equipment as the cost-cutting noose tightens. Qwest estimates general network maintenance costs would be around $2 billion meaning, all expansion and upgrades would stop. Qwest has already slashed capital spending more deeply than its rivals, cutting its 2002 target by 35%, to $5.5 billion; most of the big telcos have been cutting by around 20%.

As Friedman Billings Ramsey analyst Susan Kalla pointed out in a note Wednesday, deeper cuts would be nasty news for networking gearmakers such as Ciena (CIEN) and Juniper(JNPR), which rely on Qwest for 25% and 10% of revenue, respectively.

Cutting spending certainly cuts costs, but usually at the expense of growth. "Starving capital expenditures is what got U S West into trouble not too long ago, when they couldn't provide new telephone lines to some of their growing cities," says the money manager.

Fright Night

In floating the draconian $2 billion spending scenario, Nacchio sought to show he's fully prepared to manage Qwest through a deepening recession. But to some investors, this worst-case scenario talk says more about Qwest's falling revenue and margins and less about the state of the industry, which is bad enough in its own right.

Nacchio counters that Qwest's ambitious marriage of an old local phone system with a cutting-edge fiber optic network is the future. Technologically speaking, the goal across the industry is that other networks "will look like us," Nacchio says.

But investors can't be liking the way Qwest's numbers are looking right about now.

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