Why did Qwest (Q Quote - Cramer on Q - Stock Picks) fall 8% in heavy trading Thursday? Blame growing murmurs about the Denver-based telco's accounting.
The chatter has focused on how Qwest books large network-capacity deals with other telcos. The bears are speculating that Qwest's recent financial results got an unnatural boost from these deals. These critics point out that such transactions are accounted for in a manner that, while entirely legal, particularly helps Qwest's bottom line.
In an interview Thursday, Qwest's president, Afshin Mohebbi, and its finance chief, Robin Szeliga, dismissed such allegations and stood by their accounting practices. Mohebbi says "Qwest categorically denies" the charge that it has been using such deals to meet earnings estimates.
Adds Szeliga: "We've been recognizing capacity sales as an ongoing part of our business since Qwest's inception."
Feeling the Pressure
Qwest stock has been under severe pressure over the past month, falling 25% since the beginning of July. This has been a source of considerable consternation. The Denver-based telco giant, chiefly due to its diversified revenue base, has long been viewed as one of the few dependable performers in a troubled industry. The bulls are at loss for a trigger for the stock skid. After all,
Qwest recently reported in-line second-quarter numbers; CEO Joseph Nacchio confidently affirmed earnings guidance last month; and Wall Street analysts, for the most part, have stood loyally behind the company.
Qwest's detractors believe revenue is about to hit a wall and its $23 billion of debt could soon become a heavy burden. In other words, Qwest is
WorldCom-in-waiting -- and its accounting has helped obscure that from investors, these people say. They believe Qwest may not be able to follow through on its guidance for hearty growth in sales and earnings in the second half of 2001.
The company expects revenue of around $11.2 billion in the second half of 2001, which is 8% more than the first half's $10.3 billion. In addition, it expects second-half earnings before interest, taxes, depreciation and amortization of around $4.5 billion, a hefty 12% more than in the first half.
The accounting snipes center on Qwest's use of network-capacity deals with other telcos that are classified as IRU, or indefeasible rights of use, agreements.
Getting the Treatment
Question marks hover over these deals for several reasons. Most important is the way they are booked. Capacity sold by Qwest to another telco is recorded as a sale of inventory and thus revenue. However, capacity acquired in an IRU is booked as an investment in property, plant and equipment, and therefore doesn't enter the income statement as an expense.
Looking at that accounting treatment, critics deduce that Qwest may have entered capacity swap agreements that conveniently allow it to add large sums to sales but bear few associated costs in the income statement.
Szeliga says this is a mischaracterization of the way IRU deals work. She says costs related to the capacity sales do flow through the income statement, in the cost-of-goods- sold line. And Szeliga stresses that purchases of capacity are correctly booked as capital expenditures. IRUs aren't used to keep expenses out of the income statement and have been used by Qwest since it began business, she adds.
She says all IRUs are cash transactions.
In a recent report on Qwest's second quarter, Morgan Stanley analyst Simon Flannery wonders "how much, if any, of the revenues for the quarter were due to one-time capacity swaps." (Flannery rates Qwest as neutral and he declined an interview for this piece.)
Szeliga declined to break out the contribution IRUs made to recent results, saying that such disclosure would put Qwest at a competitive disadvantage.
By contrast, Global Crossing said in its second-quarter earnings release Wednesday that it had done IRUs worth $1.1 billion in the first half of 2001.
Changing the Guard
And there's a fresh development on the IRU front. Accounting guidelines regarding IRUs have just changed and may prevent companies from using them to book large upfront revenue gains, according to an official with the Financial Accounting Standards Board, the body that establishes accounting practices.
On July 19, the FASB-sponsored Emerging Issues Task Force decided that, if ownership of the assets isn't transferred, gains from IRUs have to be recognized over the period of the arrangement, rather than at the IRU's inception. If Qwest has been forging sizable IRUs, and the new rule applies to its IRUs, these swaps may produce markedly less revenue over the next few quarters.
Szeliga declined to say if Qwest's revenue would be affected by the rule change. "I really don't know the answer to that because I'd have to go back and look at it on a contract-by-contract basis," she explains.
The other accounting issue that raised eyebrows in second-quarter numbers was related to the 540,000 access lines that Qwest had planned to sell to
Citizens Communications (CZN Quote - Cramer on CZN - Stock Picks) for around $1.7 billion. The deal recently fell through and Qwest therefore booked a catch-up depreciation charge of $222 million in the second quarter.
After the deal was announced in 1999, Qwest classified these lines as held for sale, so it didn't run depreciation associated with them through its income statement. Now that it's keeping them, the unbooked depreciation had to be recorded. If it had depreciated these lines in 2000, earnings per share for that year would've been reduced by 6 cents, according to Flannery's report.
Accounting rules no doubt sanctioned Qwest's exclusion of the depreciation. However, at the same time, Flannery points out that Qwest appeared to be including the revenue from these lines in its income statement. Szeliga says this is allowed under Statement of Accounting Standard 121.
She adds that sales from these lines were "absolutely immaterial" and says annual revenue per line is well under half the $1,600 that has been mentioned in some quarters.
Szeliga says Qwest has made no change in the earnings and revenue guidance laid out by CEO Nacchio on the second-quarter conference call on July 24.
Peter Eavis
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