Qwest-Enron Deal Puts Swaps Back in Spotlight

Like swapaholics at last call, Qwest (Q Quote) and Enron (ENRNQ Quote) bellied up to the bandwidth bar last fall for one last deal before the lights came on and the music stopped.

On Sept. 30, 2001, the last day of the third quarter, Qwest and Enron subsidiary Enron Broadband Services agreed to buy $112 million worth of communications network capacity from each other, according to documents filed this week in federal bankruptcy court in Manhattan. Considering that debt-burdened Qwest already had a huge, new, shiny fiber-optic network in place, the deal struck some investors and analysts as odd.

Industry observers were further intrigued the next month, when Qwest reported a sharp third-quarter earnings and revenue shortfall. The Denver-based telco, which already had come under intense scrutiny for its heavy reliance on nonrecurring network-capacity sales, attributed the shortfall to a sudden drop in demand for these wholesale bandwidth deals.

But to some people, the nature of the swap and its timing suggested a last-minute act of desperation to patch up a particularly weak quarter.

"EBS had been out engaging with all the carriers. What brought these two together was necessity," says an industry insider familiar with transactions like these. "Enron needed to move assets off their books, and Qwest was very willing to help them out if they could -- and in turn report some revenues from it."

For its part, Qwest says many large deals typically don't get finished until the last day of the quarter, and that the Enron deal gave it key backup network routes. Qwest, which has dropped 75% over the past year as investors worry about growth and cash-flow issues, jumped $1.23 Wednesday to $10.08.

Eager Beavers

But industry insiders and analysts familiar with these transactions say the deal underscores the eagerness of some cash-strapped telcos to meet investor expectations in an industry awash in surplus capacity. More importantly, it raises new questions about the current market values of all telecom assets, from network capacity to next-generation optical gear.

"Nearly all the trades between carriers by 2001, after the networks were all completed, were questionable," says Friedman Billings Ramsey analyst Susan Kalla, who has no rating on Qwest. Friedman has no underwriting ties to Qwest.

"If all the service providers were forced to write down the assets to what they are really worth today, it would cause the biggest destruction of shareholder equity you've ever seen," says John Abraham, former director of global wholesale markets for Enron Broadband and now a telecom consultant with Novus Partners in Dallas.

With rival phone companies filling the void where real customers should have been, the revenues were unsustainable. As we've seen, several of the biggest IRU (indefeasible rights of use) wheelers and dealers, like Global Crossing, Enron, 360networks and ICG, have collapsed. The Justice Department and the Securities and Exchange Commission are investigating the capacity sales of failed broadband network operator Global Crossing and of a number of telcos, including Qwest, which played a role in the deals.

To be sure, capacity sales themselves aren't illegal. But the accounting methods that some swappers have used have drawn criticism from investors.

Typically, an IRU is a long-term lease of capacity. But instead of spreading the revenue from that lease over the length of the contract, many companies booked it all at once as a one-time sale. Likewise, companies that purchased capacity typically characterized the deal as an investment in property and assets, not as a traditional expense. So in these tit-for-tat deals, a company could use IRUs to enhance both the top line and the bottom line of their financial statement.

'Good Deal'

According to the court documents, Enron Broadband, the wholesale network-capacity trading arm of the failed Enron Corp., paid Qwest $112 million in their $195 million agreement to buy live optical network capacity. In exchange, Qwest paid Enron $112 million of a $308 million contract for a stretch of idle unequipped cable, known as dark fiber, between Salt Lake City and New Orleans. Qwest confirms cash changed hands.

Another former Enron Broadband manager who was familiar with the Qwest deal defended the transaction. "At the time, we were trying to realign ourselves, and Qwest would have been a strong strategic relationship," the manager says. "I think it would have been a good deal had we not gone bankrupt."

Despite all the market value that's melted away in companies such as Qwest and WorldCom (WCOM Quote) amid liquidity concerns and slipping credit quality, there still may be a deeper fall before the true values are laid bare.

"Everyone knows what this stuff is really worth," says former Enron executive Abraham, referring to the values attached to many of these transactions. "But no one has the guts to say: 'The emperor has no clothes.' "