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Get ready for a tidal wave of new




In the wake of a weak fourth quarter, the Denver-based telco is considering raising $1.5 billion to $2 billion to reduce its massive debt load. The company plans to do this by issuing equitylike securities, such as bonds that convert to stock, and by selling assets.

But a sober look at Qwest's business outlook suggests the company may in fact need to raise more than $3 billion through stock sales alone to keep its debt ratios at safe levels and forestall a costly credit downgrade. (Moody's put the company's Baa1 rating on review for a possible cut earlier this month.)

The alternative to selling stock is asset sales. But Qwest's willingness to use these may wane, given the weakness in the telecom market and the fact that the assets produce valuable cash. As a result, the company's weedy cash flows and backbreaking debt load could force it to flood the market with new equity, punishing its already trampled stock.

A Qwest spokesman said that the company was considering a range of options to raise cash, not just equity issuance. On an earnings conference call Tuesday, Qwest CEO Joseph Nacchio said, "We're committed to the health of our balance sheet, and we're going to take steps to de-lever it."

Qwest slumped $1.01 Wednesday to close at $10.75, a 52-week low.

Cash-Flow Worries

When assessing how much stock Qwest will have to issue, three issues stand out: cash flows, capital spending and debt.

Qwest's total debt rose 30% last year to $25 billion. That figure towers above the $2.1 billion the company has in tangible equity, or shareholders' equity minus goodwill and intangible assets. These kind of numbers might be bearable if the cash were flowing in. But cash flow was weak in the fourth quarter, and on the Tuesday conference call execs offered little sign of an imminent recovery.

The company has projected cash flow -- expressed as earnings before interest, taxes, depreciation and amortization of goodwill -- of between $7.1 billion to $7.3 billion for 2002, but Tuesday, Qwest said the number would be toward the bottom end of that range. Meanwhile, the company has about $4.7 billion of debt coming due over the next 12 months. The company also noted Tuesday that it's cutting its 2002 capital spending target to $4 billion, from an earlier $4.2 billion forecast.

First observation: Qwest's EBITDA -- which overstates usable cash -- can't pay back all the short-term debt and cover its capital expenditures. Of course, if the markets stay friendly, it can expect to rollover its short-term debt. About $1.1 billion of long-term debt falls due over the next year that needs to be paid back, according to Scott Berman, Qwest's treasurer. He says the company plans to "refinance short-term debt of $2 billion to $2.5 billion" this year.

So, if, as Qwest projected Tuesday, it raises up to $2 billion through equity and asset sales, it can use that to pay down the remaining debt coming due in 2002.

So where is the capex of $4 billion going to come from? EBITDA gives us no help because it excludes cash uses, like interest payments and working capital. Berman says Qwest wants to get its working capital use down to $1.3 billion in 2002 from $2.3 billion last year. Meanwhile, its interest bill will be about $1.55 billion this year. If we subtract those numbers from the $7.1 billion EBITDA projection, we get an approximation of usable cash of $4.25 billion, which would be enough to cover the capex.

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High Bar

So why the need to sell stock? Qwest's forecasts look tough to attain. For one, its EBITDA forecast is aggressive. Simon Flannery, the Morgan Stanley analyst who's had his bearish stance on Qwest vindicated over the past year, thinks Qwest will actually churn out EBITDA of $6.6 billion in 2002, according to a report published Wednesday.

In fact, there's talk that recent EBITDA numbers were weaker than the ones Qwest posted. How so? There is a balance sheet item that suggests Qwest may have been capitalizing expenses that normally run through the income statement, although the company denies this. Capitalizing in this context means treating an expense as an asset on the balance sheet and thus excluding it from the income statement and any EBITDA calculations.

Exactly what number could point to this?

Well, in the third quarter, the number for goodwill and intangibles on the balance sheet increased to $34.79 billion from $34.69 billion in the preceding quarter. All else being equal, goodwill amortization in the quarter of $315 million should've led to a


of the goodwill and intangible stock by that amount and left it at $34.37 billion. Instead it was $420 million higher than that $34.37 billion. Could the difference have been capitalized expenses?

Qwest finance executive Bryan Treadway says the company did capitalize more than $200 million of software costs into the intangible line in the third quarter. But he adds that Qwest has consistently used this accounting treatment for software expense. In other words, Qwest did not do this to artificially expand its margins in the quarter, Treadway says.

Treadway also commented on another key subject that had analysts chattering away this week: Does Qwest have any off balance-sheet debt? In answer to that query, the executive says operating lease payments to entities called

Calpoint and KMC will cost Qwest between $1.5 billion and $2 billion over the next five years; the company pays out $300 million to $400 million annually on these leases, he explains. The leases aren't on the balance sheet, but the payments do run through the income statement, and any EBITDA calculation, on the cost of services line, according to Treadway.

Back on the 2002 cash flows, Qwest also has to make a substantial effort to reduce its working capital use by $1 billion. If EBITDA is as weak as Flannery's $6.6 billion estimate and the working capital use declines by only $500 million, usable cash would fall to $3.3 billion -- some $700 million short of the capex goal. Then if the markets don't want to rollover more than, say, $1.5 billion of short-term debt, Qwest would have to find $1 billion more, taking the shortfall to $1.7 billion. Add that sum to the $2 billion that Qwest already admitted that it needs, and it's not hard to see how the telco could end up issuing more than $3 billion of equity securities.

Dark Fiber

Of course, the big unknown in this equation is what sort of assets Qwest would sell and how much it might get for them. But do note that Qwest isn't spouting the usual corporate refrain that it's going to get rid of noncore assets. No, its potential for-sale list included telephone access lines, wireless operations and directory services. That means sales of these could take chunks out of EBITDA down the road. This could persuade management against selling too many assets.

Finally, Qwest could always cut its capex below $4 billion. But it needs to spend that much just to cover its depreciation expense, which is supposed to represent the cost of upgrading its plant.

That leaves stock as the only other realistic -- and sensible -- alternative source of funds. Get ready for the Qwest Kahuna.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.