Qwest (Q Quote - Cramer on Q - Stock Picks) is covered by more than 25 brokerage analysts, all of whom are paid to pore over and interpret the telco's financial statements.
It appears one of those analysts finally did just that -- and didn't like what he found. After crunching Qwest's financial statements for 1999 and 2000,
Morgan Stanley telco analyst Simon Flannery says a good chunk of the company's 2000 profits came from accounting maneuvers that were possibly aggressive or poorly disclosed.
Flannery reckons as much as 28 cents of last year's 59 cents in per-share earnings came from three sources that appear vulnerable to accounting legerdemain. These were: reduced depreciation costs resulting from asset writedowns, adjusted assumptions concerning the company's pension scheme and capitalization of software costs. Flannery doesn't come out and say it, but the inference is clear: Qwest may have used these actions to boost 2000 profits.
Falling Down
Flannery detailed his findings in a Tuesday research note, in which he also downgraded his Qwest rating to neutral from buy. (Morgan Stanley has done recent underwriting for Qwest.) The company issued a press release and held a conference call Tuesday afternoon to rebut the report's assertions, but these moves didn't keep Qwest stock from falling 6%.
The Qwest release said the Morgan Stanley note was "inaccurate and misleading." On a conference call Tuesday afternoon, CEO Joseph Nacchio slammed the report and Morgan Stanley. He called the report "a direct attack on our intelligence and integrity" and said Morgan Stanley was guilty of "irresponsible behavior." Flannery's assistant said he wasn't commenting on the report.
Flannery says the accounting issues cast a question mark over Qwest's future earnings power, though he left his 2001 earnings forecast unchanged at 58 cents a share, which is a penny above the 57 cents expected by analysts surveyed by
Thomson Financial/First Call. In the release, Qwest said that the information contained in the Morgan Stanley note wouldn't have "any bearing whatsoever on the sustainability of its future earnings growth" and it affirmed recent earnings guidance.
Qwest's stock has sunk 50% from its 52-week high, but the company is still extremely popular with investors, who believe it's destined to dominate the telco sector now that many of its rivals have been marginalized or gone belly up. Qwest trades at 52 times expected 2001 earnings, a rich valuation that underscores the market's deep belief in the company.
However, if seen as accurate and relevant, Morgan Stanley's report will lead investors to question whether Qwest's blow-out 2000 numbers were as good as originally believed, which, in turn, could create skepticism about future performance.
Tangible Assets
Flannery's research focuses mainly on reductions in the values of tangible assets acquired in connection with Qwest's mid-2000 merger with
U S West, a large regional phone company covering Western states. Around three months after the official closing of the deal on June 30, 2000, Qwest executives reduced the value of the old Qwest's tangible assets by $2.1 billion on a pretax basis, according to Flannery. This reduction wasn't disclosed in press releases concerning the merger. Morgan Stanley has calculated it using numbers from Qwest financials filed with the
Securities and Exchange Commission.
Some $1 billion of that $2.1 billion reduction came from writing down the value of plant property and equipment, he says. With less assets to depreciate, Qwest likely experienced a smaller depreciation expense, which probably boosted earnings. Flannery reckons the plant writedown could reduce annual depreciation charges by $100 million, or 6 cents a share. Qwest finance chief Robin Szeliga disputes Flannery's calculation, saying the depreciation reduction amounts instead to 4 cents a share.
The other $1.1 billion of Qwest asset writedowns are connected to provisions for contracts and legal liabilities, the analyst says.
Flannery also wonders why Qwest didn't reveal these writedowns before the U S West deal closed at the end of June 2000. The company eventually included the asset reductions in that deal's price calculations. But, to be able to include the writedowns in the pricing, the factors that gave rise to them had to have occurred by the time the deal closed, according to U.S. accounting regulations. Comments Flannery: At June 30, 2000, "Qwest either had to be unaware they existed or unable to estimate any value for them." Purchase accounting rules allow a company a year after closing to adjust the price.
Flannery also calculates that Qwest's pension benefit credit contributed 15 cents a share to 2000 profits. The company's accounts say the credit was worth $319 million. Flannery notes that the credit would have been significantly boosted by changes in two of the assumptions that are used in calculating the pension credit. The discount rate used for future pension obligations rose from 6.75% in 1999 to 8% in 2000, which is above an average of 7.75% for Qwest's peers, according to Flannery. A higher discount rate translates into a lower present value of future obligations.
Szeliga said the rate change put the company in compliance with
Securities and Exchange Commission guidance on the appropriate discount rate.
Other Figures
Meanwhile, Qwest raised its expected return on pension assets from 8.8% in 1999 to 9.4%, higher than a sector average of 8.9%. This move would also have helped boost the pension credit. Szeliga said the higher rate, Qwest was adopting U S West's expected return number. This projection was in line with similar pension plans and was examined and approved by outside actuaries, she added.
The other big item Flannery honed in on was the capitalization of software costs. Capitalization refers to the process of taking an expense and placing it on the balance sheet as an asset whose value must be reduced over time. Flannery notes that the amount of software capitalized appeared to go up in 2000 -- by an estimated $780 million. That sum translates into a 30 cents a share boost to earnings after tax, he says. Spread over a typical five-year amortization period, that would benefit earnings to the tune of 6 cents a share on an annual basis, says Flannery.
However, Szeliga says the $780 million sum wasn't abnormally large. She says it was "approximately the same" as in 1999, combining capitalization done at both U S West and Qwest.
Peter Eavis
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