Confessions of a Wall Street Analyst (24 page)

I had believed for a long time that the voice long distance business was
in big trouble because of competitive pressures. But it began to occur to me that the growth in data traffic from the Internet could possibly make up for the pressures on the voice side. If the demand for this stuff was as dramatic as Jim Crowe and others were saying, perhaps it wasn’t just the Baby Bells that would be the winners; perhaps everyone would win. Still, I was skeptical that anything could grow at the rate that some were predicting.

And the predictions were shocking. In 1997, Michael O’Dell, the chief scientist at UUNET, the Internet services provider that WorldCom had bought a year earlier, was the first of many to proclaim that overall Internet traffic was doubling every 100 days. Later that same year, at an analyst meeting for WorldCom, John Sidgmore, WorldCom’s vice-chairman, announced that demand for bandwidth was doubling every 3.5 months. By early 1998, even the U.S. Department of Commerce was echoing O’Dell’s 100-day statement and delivering bullish reports to Congress on the Internet’s potential.
¹
And these numbers were still being presented a year and a half later. In May 1999, Sidgmore told
Red Herring
magazine that “the Internet continues to grow at 1,000 percent a year in terms of bandwidth demand.”
²

These numbers were hard to believe. But, then again, I thought to myself, WorldCom does run the largest Internet transmission service in the world, so it was not unreasonable to view its traffic growth as a rough approximation of the overall market’s growth, even if it wasn’t sustainable forever. Reinforcing the bullish point of view was the fact that even the slow-growing Baby Bells were reporting 30 percent growth in their data services divisions, far beyond the 4–6 percent growth rates of more traditional Bell product lines. O’Dell’s and Sidgmore’s numbers would go on to become those “statistics” that everyone cited as gospel without knowing where they came from or whether they were actually true.

In May of 1998, I attended the grandly named Vortex Conference, a dot-com and technology get-together organized by Bob Metcalfe, the scientist from Xerox’s famous Palo Alto Research Center who invented Ethernet, today’s standard for rapid computer networking, and later founded 3Com. It took place at the Ritz-Carlton in Laguna Niguel, California, a gorgeous resort south of Los Angeles overlooking the ocean. But no one there cared much about the surf. The conference was chock-a-block with new companies trying to get funded, existing companies touting their technology, and, of course, bankers, analysts, and investors.

The speakers included John Chambers, CEO of Cisco Systems, Internet guru George Gilder, and others. Frank Quattrone, tech banker extraor
dinaire, was there, mobbed by startups looking for funding or merger partners. Sol Trujillo, CEO of US West, was there, trying desperately to gain some credibility as he tried to transform his company, and himself, from a boring old Baby Bell into a “new-economy” superstar. And Jim Crowe, my flat-topped buddy from MFS, was there, spreading the Internet word again, but this time on behalf of his new company, Level 3 Communications.

One afternoon as we sipped cocktails by the Ritz’s pool overlooking the Pacific Ocean, Jim explained to me that Level 3 was going to provide the tubes through which the information economy would flow. It would run a national long distance network that would carry only data, not voice. By this time, Jim Crowe was viewed as an Internet deity, having been early to the game with MFS and then selling it at a huge premium for WorldCom stock, which then soared. The response to his new company was as frenzied as a Michael Jackson concert in the
Thriller
days.

As we sat by the pool, Jim sketched out on a piece of paper his vision of the Level 3 network in the hope of convincing me to begin covering his company. I looked at the paper, which had a lot of swirls and chicken scratches, and saw nothing. To me, the whole thing seemed like just gibberish. I didn’t get it. And although it made me nervous that just about everyone else said they did get it, I wasn’t going to start coverage of a stock if I couldn’t fathom what the company actually did.

Some clients tried to convince me of Level 3’s merits. One was Bill Newbury of TIAA-CREF, who had helped talk me into the AT&T upgrade. Janus Funds, a big new-economy mutual fund group, loved the stock so much that its portfolio managers wouldn’t even meet with me when I came to Denver, because, I supposed, they figured I would dis the company and they didn’t want to hear it. I was beginning to feel like a Luddite, stubbornly sticking to the stuff that could be measured as the rest of the world rushed onward. Were they right, or was I?

Level 3 was a virtual fee machine for Wall Street firms because it was constantly raising money by selling bonds and stock. Making matters worse was the fact that Crowe, who obsessively quantified everything, also quantified the performance of the banks he hired. He developed a bizarre measurement system that graded the banks on everything from the number of calls a banker made to Level 3’s CFO or treasurer each month to try to drum up business to the number of calls an analyst made to buy-side clients to talk about Level 3’s stock. How he got that data, I have no idea.

A Level 3 document I received in 1999 listed the criteria he used to
measure the banks’ performance. Number two on the seven-point list was “Equity Research Commitment,” measured in the following ways: “Analyst calls made to institutions/investors. Analyst one-on-ones with investors. Perceived strength of analyst and analyst’s understanding of, and confidence in, Level 3’s Plan. Ongoing research coverage of Level 3.”
³

All of these factors were compiled into one total score that would presumably determine the portion of Level 3’s business each bank would be awarded. Clearly, Crowe saw the analyst and the banker as inextricably entwined. It was troubling. I never heard of another company that had such an explicit method for monitoring its investment banks. But this was Jim Crowe to a tee. Needless to say, he wasn’t a big fan of mine, and the three firms I worked for never got much business from him.

By March 1999, my refusal to cover Level 3 was becoming a major problem for Merrill, made even worse by two rah-rah reports issued by Jack Grubman the month before. The first one, a two-pager on February 18 that raised Jack’s target price to $70 from $54, came out the same day that Level 3 announced plans for a huge secondary stock offering—underwritten, of course, by SSB.

Four days later, he put out a massive, 39-page report titled, “Level 3 Communications: Optimizing a Layer of the Telecom Value Chain: The Intel Inside of Telecom.”
⁴
In it, he outdid himself. Discussing how bandwidth was the “enabler of the Internet,” he exclaimed that bandwidth-centric companies such as Level 3, WorldCom, Global Crossing, Qwest, and a startup local carrier called Metromedia Fiber Network were
“good values at any price.”
Jack’s reasoning? Internet-based applications were growing exponentially, he said. “This is why we believe
the value of these stocks will perpetually rise
as long as management executes.”

The National Association of Securities Dealers (NASD), the securities industry’s self-regulatory organization, requires that all Wall Street research reports have a “reasonable basis” for their conclusions. How could a view that stocks will rise “perpetually” and that some stocks are “good values at any price” be reasonable? This wasn’t analysis by any stretch of the imagination. It was hyperbole and should have been stopped by SSB’s compliance department, its research directors, or the NASD. If he had stood outside on a street corner yelling these inanities at the top of his lungs, people would have thought he was completely bonkers. But, when this stuff showed up in a Wall Street report by a big-name analyst, even professional money managers with Harvard MBAs lapped it up.

Jack’s target price increase looked to me like an overt attempt to “condition” or hype the market for Level 3’s offering by building demand for the new shares. And condition it did! Despite the fact that announcements of secondary offerings almost always temporarily depress a company’s stock price, according to
The Wall Street Journal,
his target price increase caused the stock to jump from $51.75 to $54 a share.
⁵

With such strong demand, Jim Crowe decided to up the number of shares offered by 25 percent, to 25 million. By my calculations, without Jack’s report, Level 3 shares normally would have traded down to roughly $50 per share. So, in effect, Jack netted Level 3 a cool $100 million because Level 3 was able to sell its 25 million shares at a price of $54 each, approximately four dollars higher than it would have otherwise. Advantage: Level 3 and its bankers. Disadvantage: small investors, who had no clue what was going on and paid $4 per share more than they would have just days before. The amazing thing was that this was happening in plain sight of everyone, from investors to regulators to the readers and writers of
The Wall Street Journal
—and no one seemed to mind. No wonder every CEO wanted Jack on his side!

Jack’s lock on Level 3 didn’t stop my Merrill buddies on the banking side from trying to get a seat on its gravy train. Although Level 3 did most of its business with Salomon, Crowe also liked to spread the business around a bit, with the expectation that the research side would play ball. On one deal, with no help from me, Merrill managed to get included as a low-level co-manager, and Frank Maturo, a pushy banker who had just moved to Merrill from Salomon, decided to pay me a little visit. He sat down in my office and told me that Level 3 was simply the greatest “fucking company” he had ever seen.

“Fuck, you guys, you’re missing the fucking boat,” he said, mentioning his “great fucking relationship with Crowe.” Lots and lots of business would come Merrill’s way, he said—as soon as I started recommending its stock. He even said that Jack was not responsible for all the business Salomon did with Level 3; instead, Frank claimed, “I fucking was.” Frank had quite a broad vocabulary.

I decided to do what had always served me best—play it straight. “Frank, let me tell you three things,” I said, beginning with a nice one. “One, it’s very nice to meet you. You are truly different from anyone I have ever met at Merrill and I suppose your high energy level and aggressiveness might be needed in this somewhat sleepy firm. Two, I doubt Level 3 is the greatest company in the world. And three, we’re pretty busy here and Level 3 seems to be getting hyped up all over the Street. Its stock is very high, so it may be
too late to recommend the shares anyway. If we can find some time, we’ll take a look, but no promises.”

Frank didn’t hear a word I’d said. He just kept repeating what an incredible stock Level 3 was going to continue to be, how well connected he was, and how much money he could make for Merrill Lynch if only the telecom research analyst would get on board. He wasn’t there to listen to an analyst. He looked on analysts as the first wave of privates on Omaha Beach, the heroes to be sacrificed for the higher good. But this was one war I wanted to sit out.

“You Know He Can’t Keep His Mouth Shut”

March 1999 was a tense time: our Global Telecom CEO Conference was fast approaching and we were in the final stages of panic, praying, as we did every year, that our key speakers wouldn’t cancel. This year, I had invited everyone from WorldCom’s Bernie Ebbers to AT&T’s Mike Armstrong to Ed Whitacre, SBC’s chairman and CEO, as speakers. On Thursday, March 11, just four days before the conference was to begin, I was on the way back from visiting clients all over the southeastern U.S. when I got a call from Michael Costa, Merrill’s telecom M&A banker: “Dan, we need to bring you over the Wall on something tomorrow afternoon. Will you be back in time for a 2:00
PM
meeting at the midtown offices of [top law firm] Skadden Arps?”

A day later, I was sitting in a conference room with Jack Grubman as a bunch of bankers briefed us on Global Crossing’s pending confidential offer to acquire Frontier, the former Rochester Telephone Company, which had recently added long distance, data services, and Web-hosting to its repertoire of phone services. These assets made Frontier a very attractive acquisition. Both Salomon and Merrill were representing Global. My old colleagues at Morgan Stanley were the bankers representing Frontier. Talk about incestuous!

Global Crossing was the new international long distance company that had gone public with a bang in August 1998. It had laid cables under the Atlantic Ocean and intended to run fiber-optic cable all the way around the world to meet the exploding demand for Internet and telecommunications access. Global Crossing had sold just 25 percent of its cable capacity under the Atlantic Ocean—the “Atlantic Crossing”—and had already recouped 90 percent of its costs.

In March 1999, Global looked like a home run. From its IPO price of $19, it was now at $48, having doubled in the first three months of this year alone. Before Global’s IPO, former president George H. W. Bush gave a speech to the company’s most important customers and opted to be paid in pre-IPO stock instead of taking his usual $80,000 honorarium. That decision netted him $14 million.

Global Crossing’s founder was Gary Winnick, a former junk-bond salesman at Drexel Burnham Lambert, Michael Milken’s hotshot firm, whose fortunes had evaporated when Milken pleaded guilty to securities law violations in 1990.
⁶
Winnick was a heavyset, wide-shouldered Long Islander who would have looked right at home in a used car lot. I initiated coverage of Global Crossing shares with a “2,” or Accumulate, rating, meaning I predicted a rise of 10–20 percent over the next 12 months—fairly unimpressive numbers in the context of what was happening to most stocks in the tech and Internet categories. Yet I was intrigued by what appeared to be very strong demand for the company’s undersea fiber.

Because Global was perhaps the premier “new-economy” company in the telecom sector and had been seen as purely an international play, its decision to acquire Frontier was a shocker. Frontier was an old-economy real telecom company, not a virtual one. This meant a major strategy change for Global Crossing. The deal, which preceded the AOL–Time Warner merger by almost a year, was the first case in which an upstart new-age company with few customers but major growth expectations used its high stock valuation to buy a traditional company. Global Crossing was offering a very rich price for Frontier of $62 per share, 41.3 percent above Frontier’s current price of $43.88. I was very happy with the transaction. It validated my Buy rating and target price of $60 on Frontier, and my view that Frontier was a takeover candidate. Moreover, the Luddite in me thought it was terrific for Global, since it now would own a traditional company with real assets, real customers, real revenues, and real earnings.