Qwest Swaps Earning Another Look

Qwest (Q) spent the better part of this week saying a federal inquiry into its books will reveal nothing untoward. But despite CEO Joe Nacchio's customary bravado, some investors aren't buying.

Nagging at these observers is the Securities and Exchange Commission's probe of Qwest's role in the controversial practice of swapping network capacity with competitors. Some analysts and industry insiders say these so-called indefeasible-right-of-use leases, or IRUs, helped Qwest pad not only its top line but its cash flow as well.

Qwest has long rejected the notion that it did anything improper in its swap accounting. But several analysts agree the company was "aggressive" in its treatment of the deals. They contend that boosting cash flow figures with swaps could have helped the cash-squeezed company stay in compliance with key debt covenants as the telecom industry went into free fall over the past year.

Now, should the SEC take issue with any portion of Qwest's $1 billion worth of 2001 capacity sales, the company may be forced to restate its financials, say analysts -- potentially putting Qwest, which is already involved in ongoing discussions with its lenders, in an even weaker position financially. Deals like last fall's last-minute swap with Enron, detailed recently by TheStreet.com, have raised investor concerns about the quality of Qwest's numbers.

"It wouldn't surprise me if they had to restate, though I don't consider it a foregone conclusion," says Standard & Poor's debt analyst Greg Zappin. S&P last month dropped Qwest's rating two notches above junk status and gave the bonds a negative outlook, suggesting further cuts are possible.

For its part, Qwest continues to stand by its accounting; the Denver telco says it won't comment on speculation about its numbers or its debt covenants. The company says it is making progress in its discussions with lenders.

Widening

The regulatory scrutiny comes amid a widening probe of the industrywide practices that came to be associated with the telecom bubble of the late 1990s. The SEC is reviewing the swap deals of telco network operators including Enron, Global Crossing, Qwest and 360networks.

Though legal, the long-term leases known as IRUs can make a company's growth and profitability look better than they really are through various accounting maneuvers, critics charge. Analysts note that many users of IRUs booked revenue upfront, bolstering the top line, while accounting for the costs of the acquired capacity as an investment in property, thereby keeping those expenses out of the earnings statement.

But while some industry insiders have long contended that some telcos were boosting revenue through so-called hollow swaps -- deals that dress up the income statement without serving any legitimate business purpose -- the bottom-line implications of the practice appear to have escaped many observers.

A number of people with experience in these sorts of deals say every dollar of swap revenue contributed as much as 85 cents to 90 cents to earnings before interest, taxes, depreciation and amortization. That fact is key in considering the cases of debt-gorged telcos needing to show solid EBITDA (earnings before interest, taxes and depreciation) figures to continue funding their cash-burning operations.

"They might have been legitimate swaps, but I think you can argue pretty clearly from an accounting perspective that the EBITDA margins should have been 10% to 20% instead of 50% or above," says CIBC World Markets analyst Tim Horan. He and other analysts note that margins that high made little sense in such a fiercely competitive, price-conscious industry.

Curiously, too, the industrywide popularity of these swaps grew just as large network operators were scrambling for revenue amid a growing surplus of network capacity. Qwest stopped its IRU sales last fall, citing a drop-off in demand.

"Communications services have EBITDA margins in the 30% to 40% range -- and then all of a sudden they have the most competitive product in history, with 50%-plus margins," says Horan. "It just doesn't pass the smell test."

Covenants

The key for Qwest investors is that if the SEC determines deals like an 11th-hour swap with Enron were indeed hollow, and therefore can't be treated as revenue-generating sales, then Qwest may not be able to avoid violating its debt covenants.

"If they had to restate as much as $800 million of their EBITDA, then they would be in violation of their covenants," says Horan, who has a buy rating on Qwest. CIBC has no underwriting ties to Qwest.

During the bubble era, Qwest had delighted the market as a bold hybrid of growth-ready global fiber optics and cash-steady local phone service. But debt burdens and sales declines have marred its path of late.

"They've maxed out on their credit line, they are under review for a downgrade to junk, and they are unable to access the commercial paper markets," says Gimme Credit analyst Carol Levenson, who was among the first analysts this week to take issue with Qwest's EBITDA figures last year.

In its periodic updates with investors, Qwest has said it is making progress with the banks. But the stakes are high for the cash-hungry company.

"If the lenders can get their money out, they are not going to force Qwest into a corner over something that is in the past," says Bill Trent, a New Jersey state employee pension fund manager who recently trimmed his Qwest holdings. "But if Qwest cannot make the numbers, they won't get any more money."

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