WorldCom's False Profits Torment Telecom

Telecom's false profits are about to cast the industry's already staggering suppliers into a lake of fire and brimstone.

Evidence has been mounting over the past year that the telecommunications sector's fundamentals aren't just deteriorating -- they were never anywhere near as good as they appeared in the first place. That means that players along the industry supply chain are likely to see less and less cash from the greenback-starved big telcos. That will surely mean more pain for investors and probably more work for bankruptcy lawyers everywhere.

Take the WorldCom, please. The big telco's now twice-revised numbers show that operating profits were some 35% lower for the past three years than originally reported. On Thursday, WorldCom boosted its restatement to a staggering $7.1 billion -- and counting.

WorldCom looks plenty bad on its own. But if you add to that Qwest's (Q Quote) revelation late last month that it misbooked $1.1 billion in sales and costs -- mostly relating to controversial network capacity swaps -- you begin to get the sense that a fair amount of the industry's recent growth was built on rather shaky foundations. And again, with government probes sweeping through the books of big companies, it's fair to expect additional restatements in coming weeks.

The problems aren't limited to the investors who lost their shirts in WorldCom and Qwest, though. No, the weakness is more far-reaching: It seems WorldCom and its similarly fraud-suspected rivals like Qwest and Global Crossing helped create the illusion that the once-bland, utility-like business of telecom was suddenly reborn as a lucrative new economy enterprise.

Fessing Up to Fewer Profits Getting closer to WorldCom's real operating income

*Total for the past three years, including the first quarter of 2002

That was bad enough in terms of luring investors who would later be fleeced. But worse still is that the fiction of new sales and high profits helped open the door to an industrywide price war and equipment buying arms race. Those forces further robbed earnings at the supposedly solid players, leaving them bleeding precious cash and undercutting everyone else up and down the industry food chain, say analysts.

"Judging by WorldCom's actual margins, profitability was much less than we ever thought," says Paine Webber analyst John Hodulik.

Over the past three years, WorldCom was pulling in an average operating margin of 33%, according to the company's original financial reports. Now, subtracting the bogus cost manipulations, WorldCom's real margin was less than half that at 13%.

"WorldCom's aggressive pricing generated only moderate profitability at the operating line," says Hodulik.

Not only does that dispel the myth that WorldCom had reinvented a telco profit machine, it also shows that WorldCom was actually a victim to the very trend of underpricing and overspending that has crippled much of the industry.

As the irrational practices are revealed and squashed, investors and analysts anticipate a return to more rational practices, namely, higher prices for communications services. And once prices start to climb, real profits ensue. Then the debt-heavy telcos can start trimming their obligations, say observers.

Unfortunately for the networking gearmakers, like Nortel (NT Quote) and Lucent (LU Quote), already besieged by a steep drop in demand, the purchasing spigot will not suddenly spring open.

"We're not going to see any burst of spending anytime soon," says Hodulik.

The cycle of exaggerated spending on the newest, fastest gear is likely to be followed by a similarly exaggerated period of underspending, as the phone companies -- free from breakneck competition -- turn their attention to mollifying their creditors and investors.

"Capital spending will continue to come down in 2002 and 2003," says Hodulik.

And what happens after that?

"Well," says Hodulik, "2004 is a lifetime from now."