Confessions of a Wall Street Analyst Part 14

I had heard nothing about the investigation and knew only what I'd read in the papers, but CSFB had opened its own probe into the events-centering on Frank Quattrone's inst.i.tutional sales group-and by June, three brokers from Quattrone's San Francisco office had been fired. A few weeks later, on July 12, 2001, in a weekend coup, Wheat was unceremoniously canned by his Credit Suisse bosses in Zurich. His replacement was none other than "Mack the Knife," John Mack.

John had resigned from Morgan Stanley earlier in 2001 after Morgan Stanley merged with Dean Witter and he lost the battle with Phil Purcell for the top job. The intracompany battle would keep raging for many years after Mack left, and would culminate in a virtual civil war between Dean Witter and Morgan Stanley factions that led to Purcell's resignation and Mack's reinstatement in 2005.

With Mack's reputation for cutting costs, it was clear that there would be many changes and probably a lot of layoffs. Many expected Mack to reduce the power of Frank Quattrone's technology group. Poor Wheat, I thought. What a naive guy. He had delegated too much and paid the price. But I was happy to see John Mack again. It had been six years since he tried to entice me back to Morgan Stanley. I hoped he'd clean up the place fast and work to get the regulators off the firm's back.

But the first thing John Mack did gave all of us in research a little bit of pause. Right around the time that he took over, Mark Kastan downgraded McLeodUSA, a startup local carrier that was buckling under the weight of the enormous debt it had taken on. Mark didn't tell the CSFB bankers or anyone at McLeod before doing so, of course. It turned out that the top guys at Forstmann Little, a giant buyout firm that had invested $600 million in McLeod, were furious about not being alerted and complained to John Mack.

So within weeks of getting there, Mack's research department promulgated a new and very scary rule: all a.n.a.lysts had to give advance notice to both the relevant banker and the company when they were planning a downgrade. I supposed the idea was to give the banker a chance to call the CEO and soften the blow, but Mack's rule put even more fear into the hearts of CSFB's a.n.a.lysts. It seemed to give the bankers and company management yet another opportunity to pressure us either by giving the banker and company one last chance to argue with the a.n.a.lyst or by discouraging downgrades altogether. I found Mack's move particularly strange at a time when the SEC and Congress were finally bringing the symbiosis between bankers and a.n.a.lysts under the microscope.

Changes were underway at other banks as well, but in the other direction. On July 10, Merrill prohibited its a.n.a.lysts from owning or buying shares in companies they cover. The previous month, it had started disclosing on the front page of its research reports whether the firm had or might have investment banking relations.h.i.+ps with the companies its a.n.a.lysts were covering. (The former had always been disclosed in fine print at the end of its reports; the latter was a new disclosure.) I figured this move couldn't hurt, but it didn't address the crux of the research-banking conflict, which in my view was that some a.n.a.lysts were writing opinions they didn't believe, and some were using over-the-Wall information improperly. I had always avoided trading in stocks that I covered anyway, because I knew that occasionally I would go over the Wall and receive nonpublic information. What if, a day before an acquisition was announced, I unwittingly bought shares of the acquiree? It would look as if I was profiting from advance knowledge.

Jack, the All-Knowing You would think that by this time Jack might have toned it down a bit. But just like the feisty boxer he claimed to be, when pushed into a corner Jack didn't cover up but instead came out swinging even harder, trying to remind people that he still ruled the roost and knew more about what was going on than anyone else. He loudly and frequently repeated his bullish views on his long list of favorite stocks, as if they were neglected children who needed his unconditional love in order to grow. Earlier that year, he had come out with a report he t.i.tled "Grubman's State of the Union: Does He Ever Stop Talking?," a ma.s.sive tome on the telecom industry whose t.i.tle might have seemed merely arrogant in his glory days but now sounded completely detached from reality.

In Jack's conference call to discuss the report, held on March 15, 2001, he had first made sure to point out that there were over 500 people listening in. "Over the next 12 to 18 months," Jack concluded, "which seems like an eternity...you will probably look back on some of the prices today and say gee, I wish I had loaded up...[on startup telecom stocks]." Jack was increasingly on the defensive, and since it was I.I. I.I. voting season, I didn't mind a bit. I wasn't looking too hot either, with my disastrous Strong Buy, or "1," rating on Qwest and a Buy, or "2," on Global Crossing, but I was getting accolades from clients for my cautious call on WorldCom and my long-held view that inc.u.mbent long-distance stocks were losers and the Baby Bells were winners. With the local startup collapse, the Bells were looking even better, since they would likely face less compet.i.tion and lose less market share. voting season, I didn't mind a bit. I wasn't looking too hot either, with my disastrous Strong Buy, or "1," rating on Qwest and a Buy, or "2," on Global Crossing, but I was getting accolades from clients for my cautious call on WorldCom and my long-held view that inc.u.mbent long-distance stocks were losers and the Baby Bells were winners. With the local startup collapse, the Bells were looking even better, since they would likely face less compet.i.tion and lose less market share.

On July 24, about 30 cable and telecom sell-side a.n.a.lysts showed up at the Four Seasons Hotel in New York for a private dinner hosted by AT&T. About two weeks earlier, Comcast, the large Philadelphia-based cable television company, had made a $44.5 billion bid for the cable TV properties that AT&T had acquired with much fanfare over the previous few years, and we were there to hear more.

One very large conference table was set up for dinner. Each of us was a.s.signed a seat next to a specific AT&T executive. I sat next to Mike Armstrong, AT&T's CEO, while Jack sat across from us, next to Armstrong's CFO, Chuck Noski. Although Armstrong had already said publicly that Comcast's bid was too low, many investors and telecom specialists believed that it was a good offer and that AT&T was simply bluffing and would ultimately accept it. I remained restricted on AT&T shares because CSFB was the banker for its three-way split-up. So, unlike most of the a.n.a.lysts in the room, I couldn't make predictions or issue an opinion.

After Armstrong and Noski had finished their prepared comments, it was time for Q&A, and Jack was one of the first to speak up. He brought up the Comcast bid. "You know, uh, frankly," the eternal know-it-all bl.u.s.tered, "when I was talking with one of your board members the other day, it was clear you have no intention of accepting the current Comcast bid."

The room hushed. We all swallowed whatever we had in our mouths (dessert, I think), and my jaw grew slack. Had someone slipped a mickey into my mousse? Had Jack Grubman just publicly declared that an AT&T board member, perhaps his boss, Citigroup's CEO, Sandy Weill (that's who immediately came to mind), was telling him what was going on inside AT&T's board meetings?

"Did he really say that?" I whispered to the a.n.a.lyst next to me, shocked at Jack's recklessness. "Amazing what that guy gets away with," he responded.

AT&T's board had already announced that it wasn't interested in Comcast's initial bid, so the information wasn't officially insider information. But what Jack was doing-not in front of clients this time, but in front of compet.i.tors and executives, the oddest of all audiences, since this didn't help him win business or impress investors-was announcing that he was privy to what was supposed to be the most private forum a company could have. Jack was saying he knew something only the board could know-that it was not bluffing and that it had no intention of accepting that bid even if Comcast refused to up its offer. He was also insinuating that his source would tell him what was happening as the negotiations with Comcast-or any other bidder-unfolded.

If Jack had indeed had this conversation, it was dangerous, since he risked getting his source in big trouble for leaking confidential board deliberations, and it was stupid. But he simply couldn't help himself, I guessed. His seemingly pathological need to impress got in the way of his instinct for self-preservation. I turned to see what Armstrong was doing, but he had turned his face away and sat silent as a stone. In the end, Comcast did up its bid and AT&T took it.

Qwest and Global: The Swapstakes In the beginning of August, Gary Winnick broke his promise: Global Crossing missed its second-quarter 2001 numbers. With the stock now at $7 per share, I immediately downgraded the stock from Buy to Hold, or from "2" to "3," certain, finally, that this company was in big trouble.

It was apparent that Gary had no clue how bad things were, even very late in the quarter. That was almost as troubling as the disappointing numbers, because it meant he was either incompetent or completely out of the loop. Neither explanation was very comforting.

Even more disturbing was the fact that the company was using what it called "reciprocal purchase agreements" to generate more than one-fifth of its revenues. These agreements, also referred to commonly as "swaps," were the ultimate addiction of many of the companies that flamed out so spectacularly in 2001 and 2002. Basically, a swap was an agreement by two companies to purchase goods or services from each other at the same time, inflating both companies' revenues without any true economic purpose being fulfilled. In the case of Global Crossing or Qwest, the company would sell another phone company the right to use its fiber, as these companies did with the IRUs, and at the same time purchase the rights to use some of the other phone company's capacity. If done for legitimate business reasons and at market rates, there was nothing wrong with a swap. But if done to create the illusion of business that didn't really exist or if priced at above-market levels, swaps were inappropriate at best and illegal at worst. Either way, if not disclosed to investors, they were very misleading because they suggested that revenues were higher and growing faster than they really were.

For example, Qwest might purchase an IRU from Global Crossing giving it the right to use the latter's New York to Houston fiber-optic line, while Global purchased rights to use Qwest's Los Angeles to Seattle line. The two companies might agree to pay each other $100 million. It was reasonable to think each company was filling in geographic holes, but you couldn't really be sure. Each would then book the $100 million received as revenues in "year one," while spreading out the $100 million paid over the 20 or so years it expected to use that fiber-optic line.

The net effect: each company had juiced its revenues by $100 million and its operating cash flow by some large fraction of that. Both companies could therefore proclaim a lot of new business and meet their revenue goals even though it wasn't clear if this was a real transaction or just a mutual backscratching exercise. Most companies didn't report the results in enough detail to know for sure. Some, including Qwest, didn't even tell us they were doing swaps at all.

Global Crossing, to its credit, had first mentioned its swaps in May of 2001 when it reported its first-quarter results. But the mention was buried in one vague sentence in a long press release full of self-congratulatory quotes from Global Crossing executives. As far as I know, no one-including me-took any note of it, which isn't surprising considering the company had exceeded most a.n.a.lysts' expectations for revenues and cash flow. And the market didn't notice either: Global's stock rose 30 cents to $14.10 the day after the swaps were reported.

By the second quarter, however, it became clear that swaps were making up a good deal of Global's revenue growth. It wasn't certain there was anything wrong with the accounting-Andersen, Global's accountant, had apparently okayed the approach-but it seemed odd to me and many of my clients that so much of its new revenue was coming from these seeming quid pro quos. Swaps became the topic de jour; we all began to ask every company we covered how much of its revenues, if any, came from swaps and how it was accounting for them. It wasn't until near the end of the year that Qwest publicly disclosed its swap revenues.

On August 6, a few days after Global missed its numbers, Gary Winnick called me again. I called back and was patched through to him at his new home in Beverly Hills, where I could hear the sounds of hammers and power saws. Gary's new home was not just any old new home: this palace, formerly owned by Conrad Hilton, had at least a dozen bedrooms and a dozen bathrooms. Gary had paid some $60 million for the Bel Air estate, making it, at the time, the largest sum ever paid for a private home.

Global Crossing, although it had never made a dime in profit, had just two years before boasted a market capitalization greater than that of General Motors. And Gary Winnick, unlike some of his compet.i.tors, had sold a portion of his shares while the stock was still high, netting an astonis.h.i.+ng take of over $700 million. Now the stock was trading at $6.28 per share. Either he was a d.a.m.n smart investor, understanding that his new company's shares were propelled by an unsustainable bull market, or he knew something the rest of the world didn't about Global's problems.

To be polite, I asked him how the renovations were going. "Good," he said. "It's a big project [and indeed it was, costing something like another $30 million], but it's coming along nicely." Pleasantries over, Gary got down to business. He acknowledged that he'd been wrong when he a.s.sured me second-quarter revenues would come in on target.

"Dan, I know we didn't make the numbers," he said. "You know, I have been leaving Tom [Casey] alone and thought he could handle it. But I'm gonna get back involved now, as I want to make sure we get back on track."

"Oh, okay," I said, not sure what else to say.

"Gotta go," Gary said, over the din of pounding hammers and static from the cordless phone. "Someone's at the door."

Get back involved? From my perspective, he'd always been part of day-to-day management, or if he hadn't been, why hadn't he? Yes, he was the nonexecutive chairman of the company, but he was also its founder and had billions still riding on it. I thanked Gary for the call. At least he was man enough to acknowledge how wrong-or misleading-he'd been. I didn't know which it was, but neither was good. No top executive had ever given me a.s.surances that were missed so widely. And no top executive had ever admitted to me he was not sufficiently involved in his business. From my perspective, he'd always been part of day-to-day management, or if he hadn't been, why hadn't he? Yes, he was the nonexecutive chairman of the company, but he was also its founder and had billions still riding on it. I thanked Gary for the call. At least he was man enough to acknowledge how wrong-or misleading-he'd been. I didn't know which it was, but neither was good. No top executive had ever given me a.s.surances that were missed so widely. And no top executive had ever admitted to me he was not sufficiently involved in his business.

Vindicated-But So What?

On September 10, 2001, Qwest reduced its earnings guidance for the first time. Joe Nacchio was finally admitting that Qwest wasn't necessarily going to be the ultimate Survivor and was not immune to the problems affecting everyone in our industry. He refused, however, to admit that there was anything funny going on with the numbers.

"There is no accounting issue," Joe said in a conference call that day. "Let me say this one hundred percent clear." Referring to Morgan Stanley, he continued, "There is one house on Wall Street that doesn't understand.... We follow the rules."

Qwest's guide-down was big, and bad, news. But just as I was trying to decide whether this signified the end of this company's run as a growth stock, the terror attacks of September 11 made this huge s.h.i.+ft in the telecom business seem irrelevant and unimportant.

On that Tuesday, Paula and I were in Italy, partway through a bicycling trip in Parma. I had been trying to call in to my voice mail as we pedaled along (this time I'd brought a cell phone), but AT&T's international circuits were constantly busy. We walked into the lobby of our hotel, sore from biking 30 miles, and saw a group of people huddled around the television. We a.s.sumed it was a soccer match from the emotional intensity of the crowd. But it wasn't.

We glimpsed the screen with the pictures of the falling towers and stopped in shock, unable to move or speak. It was the most terrifying image I have ever seen in my life. We held each other, horrified, thinking of all the people we knew-and didn't-that might not have made it out alive. We frantically tried to call home to check on friends and family, but we couldn't get a circuit to the States. Fortunately, the hotel concierge let us use her computer, and using e-mail, we learned that our kids, our kids' friends' parents, and our niece and her boyfriend, who lived just a little bit north of Ground Zero, were okay. CSFB's offices, located in lower Midtown, were not at Ground Zero but were not too far from the carnage.

I finally managed to get through to my office and spoke to everyone on my team, urging them all to just go home to be with their families. But many thousands of people, some of whom were family members of people I worked with, were not okay. After years of nonstop work, I realized in a split second-as, I'm sure, most people did-that our obsessions with work and careers were meaningless in the face of such tragedy. All of these years of a.n.a.lyzing, picking stocks, competing: did any of it really matter?

On Wall Street, the attacks simply froze every a.s.sumption and every thought process in its tracks. They may also have halted many of the investigations into these companies or individuals in their tracks, partly because the SEC's Wall Street investigation office-with all of its doc.u.mentation and casework, including that Grubman file that had ostensibly been started years earlier-was located in one of the World Trade Center buildings. Its findings simply dissolved into dust like everything else.

Yet Wall Street, animal that it is, never grinds to a halt for too long. So even though it wasn't known when the markets would reopen, we were told to be ready to make a call on our sector and stocks. Would they be helped or hurt by what had just happened?

On Monday, September 18, when the markets finally reopened, Paula and I were still in Europe, since we couldn't get a flight home. We were driving from Milan to Paris, since Paris had far more U.S.-bound flights. I used my cell phone to call in some comments about how phone companies, particularly Baby Bells, do well in uncertain times and tend to be countercyclical, but I was deflated and depressed, as was everyone. It all seemed so pointless. Whether or not WorldCom or any other company made its numbers seemed so irrelevant.

In reality, the tragedy of September 11 provided convenient cover for many of the struggling telcos-as well as many other companies. The uncertainty it brought on froze the purchase and expansion plans of many of them. If M&A had been drying up before, it was now as parched as a desert. Any earnings disappointments or misfires that came up could now be laid at the feet of the global disruption rather than any flaw in a company's business model or execution.

Right in this midst of the chaos, the news I'd been waiting to hear for so long finally arrived. After four long years, I had finally regained the number one position in the Inst.i.tutional Investor Inst.i.tutional Investor ranking of research a.n.a.lysts in the wireline telecom category, because my picks, the Baby Bells, had held up relatively well compared to WorldCom and some of Jack's other favorites. Jack was second, though still tops in the startup local carrier sector, not that there were many companies left in it. ranking of research a.n.a.lysts in the wireline telecom category, because my picks, the Baby Bells, had held up relatively well compared to WorldCom and some of Jack's other favorites. Jack was second, though still tops in the startup local carrier sector, not that there were many companies left in it.

In May 2001, when clients had voted, what they knew was that the inc.u.mbent long-distance companies, especially WorldCom, Jack's favorite, had crashed, while the Baby Bells were looking like the survivors, to use Joe Nacchio's word. Jack had done such a great job of being identified with WorldCom's success that he was now twinned with its failure. He began to look like the Wizard of Oz-a lonely, powerless man behind a flimsy curtain-rather than the all-powerful, all-knowing, larger-than-life magician so many believed he had been.

In a normal year, I would have been thrilled, proud, victorious. Now, in the context of a terrifying new world and a dying industry, it didn't feel like much of a victory. I had achieved the professional goal I'd worked toward for many years. Sure, the number one ranking on the Inst.i.tutional Investor Inst.i.tutional Investor magazine poll made my team and me feel happy, relieved, even vindicated, but there wasn't any partying or cheering. magazine poll made my team and me feel happy, relieved, even vindicated, but there wasn't any partying or cheering.

Our team was evolving, too; Ehud-who I had hoped would soon take over the bulk of my coverage of stocks-left to work at a hedge fund. And Ido, Julia, and Connie understood that one of my primary motivations for keeping going for so long-to beat my chief rival-was no longer there. I'm sure they wondered whether I would quit soon.

For me, the victory couldn't help but feel hollow. When I arrived home and told Paula the news, she congratulated me, but it didn't take long for her to ask, "So what's going to keep you going now?" It was a good question. The twin towers were down, the markets were down, much of the telecom industry was down, the reputation of a.n.a.lysts was down, and even Jack Grubman was on the way down. Every part of my professional world was unraveling, from the companies I followed to the firms I worked for. I still felt good about the way I'd done my job, but I didn't feel good about doing it in an environment like this one. As we talked, it was clear that I'd lost my pa.s.sion for the business.

There was one moment of personal satisfaction, however, and it happened in late September, when Inst.i.tutional Investor Inst.i.tutional Investor scheduled a photo shoot for all the top-ranked a.n.a.lysts at a studio on the far west side of Manhattan. I walked in to see about 50 a.n.a.lysts, most of whom I didn't know. Someone called my name and I looked up to see an old colleague from Merrill. scheduled a photo shoot for all the top-ranked a.n.a.lysts at a studio on the far west side of Manhattan. I walked in to see about 50 a.n.a.lysts, most of whom I didn't know. Someone called my name and I looked up to see an old colleague from Merrill.

Standing next to him was Jack, who was still ranked first in the local startup category, although I had recaptured what was called the telecom or "wireline" slot. When he saw me, his jaw dropped and his face went gray. Even with the dramatic fall of WorldCom's stock, his reversals on AT&T, and the virtual demise of most of his favorite startup local phone companies, it seemed it had never crossed his mind that he wasn't still the king of the telecom hill. Until that moment, he clearly had no idea that he had lost in the wireline category. Doing what I thought was the right thing, I stuck out my hand to "congratulate" him. He muttered something incomprehensible and turned away, clearly mortified that not only had he been unseated, he'd had to learn about it in front of all his peers.

Outed: Qwest's Accounting Gimmicks Almost immediately, more bad news set in. On September 27, the next-to-last trading day of the quarter, I got a phone call from Rob Gensler, my client at T. Rowe Price, a large mutual fund company. Rob headed up T. Rowe's Telecom/Media fund and also served as T. Rowe's in-house telecom a.n.a.lyst. He was the most aggressive person I ever encountered on the buy-side. He had a memory and quickness with numbers that was unbelievable, and he was better at wheedling information out of people than anyone else in the business.

Rob had quite a colorful resume: he had both worked at Salomon's infamous arbitrage desk for several years and taught in the Peace Corps in Botswana. He lived in Baltimore and traveled virtually nonstop all over the world to visit companies. He relentlessly worked the phones to keep up on what company executives were saying and influential a.n.a.lysts were thinking. He also tried to influence sell-side a.n.a.lysts' opinions, because that might help his picks do better.

Calls with Rob were usually long ones, full of energetic debate. Generally we had covered every company in the industry by the time we were through, and I always felt that I'd learned more from him than he from me. So when I got his message around noon, I didn't call back right away, because I knew it would require some quality time. Instead, I called back after the markets had closed. Qwest shares had fallen precipitously, about 15 percent, that afternoon, so I fully expected this would be a key discussion point with Rob. And it was.

"Dan, I've already told six of your compet.i.tors this," Rob started off. d.a.m.n, I should have called back earlier.

"It looks like Qwest is doing some funky deals to gin up revenues for the quarter. They are selling equipment at big markups to a company called Calpoint [he said 'Calpoint,' but I thought I heard 'Calport'] that, in turn, is going to establish an Internet and data transport company. Calpoint needs to raise $600 million to buy the equipment, and Qwest is guaranteeing its debt. It's a joke and it looks like it is being used to bulk up third-quarter revenues."

"How Do You Know This?"

It turned out that Calpoint had circulated some financial doc.u.ments to the unit of T. Rowe Price that invested in bonds and other debt instruments. Apparently, this Calpoint company-which neither Rob nor I had ever heard of-was trying to borrow money from large investment firms, hedge funds, and pools of private money. Only a select group of professional money managers hear about these kinds of investments, referred to as private placements. private placements.

Rob was basically saying that Calpoint was "buying" Qwest's equipment, which Qwest could then book as revenues, in return for Qwest's guaranteeing its debt. In other words, Calpoint was essentially a sh.e.l.l company, backed by Qwest. Sure, it was promising to buy equipment from Qwest, but those purchases would be funded with borrowings backed by...Qwest! Oh, s.h.i.+t, I thought, Joe Nacchio wouldn't manufacture revenues that wouldn't exist without the sh.e.l.l company, would he?

"Rob," I said nervously, "I can't believe that Joe would book this stuff as regular recurring revenues. That would be preposterous. This sounds like it is simply a financing transaction like the ones we used to do at MCI back in the 1980s. We never even considered booking the proceeds as revenues. There's no way Qwest could put that over on their accountants!"

"I've called Lee Wolfe [Qwest's IR guy] for the past three days," Rob said, "and told him I need to know how this is going to be accounted for. But he hasn't called back. Why don't you call him or even try Joe and see what you can get?"

I agreed, then hung up and left a voice mail for Lee. "I need to talk to you and Joe immediately," I said. "This Calport [sic] thing, or whatever it is called, is spooking many of your holders. I need to have a coherent answer on how it will be accounted for."

At around 10:30 that night, Lee and Joe called me at home. Joe, effusive as ever, told me that no decisions had been made yet on the accounting for Calpoint and that it would be a few days until they had fully determined which deals were complete and thus booked in the third quarter and which weren't. That scared me, so I asked him a more basic question: "How do you feel about making your revenue target for the quarter?"

"Oh, we're gonna be right on target," he said, selling as always. "We just can't comment on a deal-specific basis yet. At the end of any quarter, there are all kinds of b.a.l.l.s in the air, and I can't tell you which ones will land in this quarter and which ones in the next."

It seemed to me that Joe wanted the flexibility to book the Calpoint revenues in the current quarter if some other deals didn't come through. He also wanted to be able to hold it over until the fourth quarter in case it was needed to cover any shortfall then. Like a broken record, he kept coming back to that message: "We are on target. We have no reason to alter any guidance we have given in the past. The third quarter looks real good."

It was late, I was exhausted as usual, and I was getting frustrated.

"Look, Joe, I think it is important that you fully disclose this deal and that, if it is what I think it is, you make sure to identify it separately from your regular revenues. At least that way, investors will be able to deduct it from their revenue models, as I plan to do. If you don't call it out separately, investors will think the worst, which is that perhaps you have other undisclosed nonrecurring revenues too." I had no idea how close I was to catching on to Qwest's game of boosting revenues with swaps and one-time equipment sales.

Joe hemmed and hawed, but promised nothing. As worried as I was, I didn't consider a downgrade, primarily because the stock had already dropped 15 percent on this news and I had no idea how Calpoint was going to be booked. This might turn out to be a false alarm. If Qwest did do the right thing or if these concerns turned out to be exaggerated, its shares would surely rebound and it would have been exactly the wrong time to downgrade. In retrospect, to my detriment and the detriment of anyone who followed my advice, I had focused too much on the cheapness of the stock and not enough on trying to figure out whether or not Qwest was playing fast and loose with the numbers.

I a.s.sume Rob Gensler and his colleagues at T. Rowe Price avoided a big loss by selling their Qwest shares before he called the a.n.a.lysts. Qwest shares dropped nearly 20 percent, from $19.40 to $15.60, in just five days. There was nothing illegal about this: Gensler was being rewarded for being astute and for reading all the doc.u.ments available to him-in this case, the private but entirely legal Calpoint prospectus. If he'd been at a hedge fund, he would have been able to go one step further, not only selling his Qwest shares but shorting them, too, for a much larger profit.

This time, the group that was most in the dark was the Street a.n.a.lysts. There was no way we would have seen that Calpoint private-placement prospectus-since it was confidential and distributed only to a small group of potential investors-without connections on the buy-side like Rob. Even the pros got knocked out of this insider game sometimes. We still knew more than the little guys did. But often it wasn't enough.

Thirty days later, on October 31, 2001, Qwest reported its third-quarter results very early in the morning and held its usual conference call for the investment community. The press release crossed the wires and the results were very disappointing. Revenues were flat, almost $100 million shy of my forecast, and operating cash flow had fallen more than 5 percent over the same period. Even the US West side of the company looked bad, with local revenues up only 1 percent, significantly below my 5 percent forecast and worse than the other Baby Bells.

I got the information while I was uptown at Columbia University, where I had agreed to speak to a business school cla.s.s. I was shocked. Just as had Gary Winnick, Joe had been wrong, or lied, or something. I urgently needed to lower my forecasts, target price, and, I decided, my rating too. I had been very wrong about Qwest shares. Its torch suddenly seemed to be flickering.

So, as the 9:00 AM AM Qwest conference call was approaching, I called Ido and Julia, who hooked me into CSFB's squawk box system. I stoically told CSFB salespeople around the globe that there were too many uncertainties lining up and that I simply could not recommend the stock as a Strong Buy anymore. I downgraded the stock to a Buy, or "2," rating, down one notch. Qwest conference call was approaching, I called Ido and Julia, who hooked me into CSFB's squawk box system. I stoically told CSFB salespeople around the globe that there were too many uncertainties lining up and that I simply could not recommend the stock as a Strong Buy anymore. I downgraded the stock to a Buy, or "2," rating, down one notch.

Looking back, I can see my decision to drop Qwest's rating only one level was a huge mistake: much too little, much too late. Qwest shares would fall 24 percent or $4.05, to $12.95 per share, by the end of trading that day, down from an all-time high of $64 and $48.62 a year ago. I had prided myself on my hard-nosed a.n.a.lysis, but that perspective had caused me to miss the forest once again. Part of me saw trouble; the other part of me, the value investor, saw a company that still had a lot of valuable a.s.sets and was cheap as h.e.l.l. My gut told me one thing and my brain another. I went with my brain. It was a low point in my career.

As soon as I hung up, Ido and Julia pointed out that I'd just violated John Mack's new rule that a.n.a.lysts were supposed to inform the bankers as well as the company before they issued a downgrade. I guess I'd blocked out the rule because I didn't like it. So as I signed on for the Qwest conference call, I hurriedly left a voice mail message for Lee Wolfe at Qwest informing him of the downgrade, as well as for the CSFB banker a.s.signed to the company. But the Qwest call was already beginning, so there was no way Lee could have heard the message before the call began.

Joe Nacchio and Robin Szeliga, the CFO, were the speakers. Joe spun the story as always. He admitted that the economic effects of the September 11 terror attacks were hurting Qwest's performance, but proclaimed that everything else was moving along nicely. After their opening remarks, they opened the call to questions. I was the second questioner, and politely asked Robin if she could tell me what the profit margins were on the Calpoint deal.

Despite my warnings, they had indeed included Calpoint in their financials. They had, however, fully broken out its revenue impact, so a.n.a.lysts like me who didn't want to count it as recurring revenue had enough information to remove it from their models. I also wanted to deduct it from the quarter's reported cash flow, and to do so, I needed to know how much profit came from Calpoint or any other swaps. The margin number would solve that puzzle and I a.s.sumed it was on the tips of Joe's and Robin's tongues, since they had to know this would be a big topic on the call.

Instead, they stonewalled.

"You know, I don't have that in front of me," Robin said.

Joe b.u.t.ted in, making it clear to Robin that he didn't want her to say more: "Call us after the call. We'll dig up whatever numbers you're looking for."

I tried again. "Let me go back to this margin question," I said. "I mean, you know the margin. I know it fluctuates with contract and with customer and quarter to quarter, but I'd like to understand what it was a year ago and what it is now."

"Dan, call us after the call," Joe said, irritated. "We don't know that answer right now. We're not trying to not tell you. We're trying to give you the accurate information."

I was getting more and more frustrated. I was harried, having missed some of the opening remarks while making those Mack-rule calls, and I fretted that I had missed some key information. My BlackBerry wasn't getting a signal at Columbia, either, so I was cut off from whatever stories were hitting the newswires, including how much Qwest shares were falling.

Robin tried to speak again, but was quickly cut off by Joe. "If you want to know about that specific contract," she managed to say, "we'll dig up the numbers and we'll tell you what it was."

After a bit more of this, I had had it. The low-key, a.n.a.lytical guy I knew so well disappeared. I lost control.

"What are we hiding here?" I yelled.

"We're hiding nothing here, Dan," Joe replied after a brief pause, his voice dripping with condescension. "Let me answer," he snapped at Robin, who had just begun to speak. "Dan, we have local equipment sales like every other [Baby Bell]. The margins are the same. We will tell you what they are when we go back and look at that third-quarter sale. We don't know that right at this moment. There's nothing being hidden. nothing being hidden. If you want to write a note about it so everyone else knows, that's fine. Call us after the call." If you want to write a note about it so everyone else knows, that's fine. Call us after the call."

Knowing that was all he was going to say, I moved on to another question. That day, Qwest's trading volume surged to seven times the previous day's level. The sell-off continued the next day, with Qwest falling another 95 cents.

Julia and Ido told me afterward that they were amazed. Yes, I had had some rough Q&As over the years, but it had never gone this far. At first, I was embarra.s.sed and thought those listening to the call would think I'd been unprofessional. But it turned out to be the opposite. Even people who didn't know about the downgrade suddenly knew that one of Qwest's major supporters was challenging Nacchio, and they applauded the move.

I thought back to Simon Flannery's report. His accounting points had been a bit off, but his instincts about revenue shortfalls had been spot-on. Qwest's revenues and revenue growth rate, just as we later learned about so many other telecom companies, were inflated by swaps and one-time equipment sales that, in reality, were nothing other than schemes to cover up revenue shortfalls. Qwest was playing fast and loose with the accounting rules and inflating its revenues and cash flow in ways that were misleading and unsustainable.

The next day, I got a call from the senior CSFB banker handling Qwest. He said he'd been speaking to someone at Qwest who had been in the room with Joe Nacchio during the conference call, and he related what he thought was a pretty funny behind-the-scenes story. During the conference call, when I asked them what they were hiding, one of the executives in the room reportedly whispered (with the microphones on mute, of course), "What an a.s.shole!"

Joe, who was still unaware that I'd downgraded the stock, smiled. "Yes," he quipped, "but he's our a.s.shole."

Not anymore, I wasn't.

* With a 20-year IRU, for example, Global would sell to a telecom company such as Deutsche Telekom or to a corporation such as Exxon-Mobil the right to use a certain amount of its capacity for 20 years. The payment by DT or Exxon-Mobil would be made up front at a discount. Global Crossing, Qwest, and many other telecom companies sold a lot of IRUs, and it made their numbers look terrific as well. In certain circ.u.mstances, if a customer paid 100% up front, a company could book the entire payment as revenue in the first year instead of having to spread it out evenly over 20 years. With the explosion in demand for communications, pricing had been fantastic for IRUs and customers were happy to pay up front for them. But as demand began to slow, it wasn't certain that customers would still pay in advance rather than stretching out payments into cheaper multiyear leases. If prices were falling, why buy 20 years of capacity today, at today's rates, if you could buy it cheaper later? With a 20-year IRU, for example, Global would sell to a telecom company such as Deutsche Telekom or to a corporation such as Exxon-Mobil the right to use a certain amount of its capacity for 20 years. The payment by DT or Exxon-Mobil would be made up front at a discount. Global Crossing, Qwest, and many other telecom companies sold a lot of IRUs, and it made their numbers look terrific as well. In certain circ.u.mstances, if a customer paid 100% up front, a company could book the entire payment as revenue in the first year instead of having to spread it out evenly over 20 years. With the explosion in demand for communications, pricing had been fantastic for IRUs and customers were happy to pay up front for them. But as demand began to slow, it wasn't certain that customers would still pay in advance rather than stretching out payments into cheaper multiyear leases. If prices were falling, why buy 20 years of capacity today, at today's rates, if you could buy it cheaper later?

10. Jack Fell Down

2002april 2003

I watched the decline of my industry and the collapse of the reputations of some of my compet.i.tors and colleagues with a jumble of bewilderment, frustration, mortification, schadenfreude, and, perhaps most significant, relief that I wasn't going to be dragged into this mess. At least, that's what I was hoping. But on September 30, 2002, when I got a call from a CSFB attorney named Jennifer Huffman, I couldn't help but feel my heart sink.

The Worm Turns IT WAS A NEW YEAR, all right, but champagne toasts were few and far between in my world. All of 2001's problems seemed to be s...o...b..lling into even bigger ones, with no end in sight to the carnage in our industry-or to the investigations, which kept revealing yet more incriminating information. all right, but champagne toasts were few and far between in my world. All of 2001's problems seemed to be s...o...b..lling into even bigger ones, with no end in sight to the carnage in our industry-or to the investigations, which kept revealing yet more incriminating information.

On January 22, 2002, CSFB announced that it was settling the SEC's and the NASD's charges of doling out IPO shares to funds willing to pay inflated commissions. The fine was $100 million, the fifth-largest regulatory settlement in the history of Wall Street.

"The profit-sharing activity was pervasive at CSFB," the SEC proclaimed, blaming "senior executives" without naming names. This particular scandal had nothing to do with research, fortunately, but it was yet another stain on the reputation of my firm and Wall Street at large. I had a feeling that this wasn't the last of the checks Wall Street was going to write, but still, as huge a number as it was, it was little more than a swat on the hand by the regulators. After all, $100 million was what one CSFB banker-Frank Quattrone-had made in one year.