Wall Street trembled and Qwest bristled after Morgan Stanley downgraded the communications provider's stock to "neutral" from "outperform" Wednesday. Qwest's stock price lost as much as 10 percent before shares recovered slightly. The company closed the day down 4 percent to $30.02.
In a research note issued early Wednesday, Morgan Stanley analysts Simon Flannery, Jeffrey Camp and Trevor Harris said they were concerned that Qwest's accounting could hurt the company's ability to maintain its current pace of earnings growth.
The Morgan Stanley report did not suggest any rule violations by Qwest, but the analysts did suggest that the company's accounting decisions could result in slower profit growth in years to come.
Qwest CEO Joseph Nacchio took issue with the content and tone of the report--and with the brokerage--during a conference call with analysts.
"Innuendoes on our integrity are not going to be tolerated, irrespective of who makes them, including what I used to think was a reputable, branded firm like Morgan Stanley," Nacchio said during the conference call. "This report is laced with innuendoes that are unsupported and are a direct attack on our intelligence and our integrity."
Morgan Stanley's report came a day after Qwest said it expects to hit its second-quarter targets. Qwest in recent months has been lauded as one of the strongest companies emerging from the slowdown gripping the entire telecom market, but Morgan Stanley's report suggests that the company's profits aren't growing as fast as many observers believed.
In fiscal 2000, as much as 28 cents per share--or more than a fifth of Qwest's cash earnings--can be traced to accounting moves rather than growth in the company's business, Morgan Stanley analysts wrote. The brokerage believes that Qwest:
was "unusual" in writing down more than $3.1 billion in assets after last year's merger with US West;
assumed unrealistic credits to earnings from its company pension plan;
has yet to account for a decline in the value of its investment in the KPN Qwest joint venture; and
is recording higher-than-usual costs for software, which is recorded as a capital cost rather than an operating expense that detracts from earnings.
Those concerns, combined with evidence of slowing growth in the telecommunications industry as a whole, justify a downgrade of Qwest's stock, Morgan Stanley analysts believe.
"These actions arise from a deteriorating economic and industry environment and from greater uncertainty stemming from accounting decisions made since the Qwest merger with US West," they wrote. "We continue to see more evidence of slower growth for the telecom industry. And while we believe Qwest will likely be one of the long-term survivors in the telecom sector, we advise investors to be cautious for now."
Qwest speaks up
Qwest executives derided Morgan Stanley's report as an inaccurate argument based on old information.
"Today is a call challenging our integrity," Nacchio said. "There are no accounting issues or improprieties in our reporting...That is hogwash. I don't know where it comes from. And I don't know where it's supported."
Company executives were especially disturbed by any suggestion of an attempt to conceal information. Morgan Stanley said Qwest "quietly" wrote down $3.1 billion in assets after the US West purchase was completed.
"I don't understand what they mean by quietly, because the requirements are that we file (forms) 8K and 10K and every other letter of the alphabet with the SEC," Nacchio said. "If you ever talk to (Morgan Stanley)--I'm sure we won't--you might ask them what they mean by 'quietly.'"
Although accounting issues affect net earnings under the rules of U.S. Generally Accepted Accounting Principles (GAAP), none of the financial reporting concerns mentioned by Morgan Stanley affect operating cash flow, Qwest executives and other analysts said. Operating cash flow includes only income directly from operations and excludes interest, taxes, depreciation and amortization. Many analysts consider operating cash flow a more accurate way than earnings per share to track a communications company's performance.
"I look at (the Morgan Stanley report) and say, 'What's the point?'" said Marc Crossman, an analyst with J.P. Morgan H&Q.
The merger write-downs from the US West merger were required by SEC rules, Qwest executives said. The value of the KPN Qwest investment will be written down soon, said Robin Szeliga, chief financial officer of Qwest. And Qwest's software expenses are higher than those of other regional Bell operating companies because Qwest is doing more work to upgrade and expand its network, executives and analysts said.
Brokerage trims estimates
Morgan Stanley's analysts did cut their forecast of Qwest's annual earnings growth and operating cash flow. Morgan Stanley now predicts earnings and operating cash flow will increase 11 percent a year for the next five years; the brokerage previously projected annual earnings gains of 19 percent for Qwest.
The Morgan Stanley analysts see much of the slowdown in Qwest's earnings growth fueled by a flat-out decline in the rate of sales growth. Morgan Stanley cut its estimate of Qwest's average annual revenue increases for the next five years to 12 percent from a prior estimate of 14 percent. For 2002, the difference between Morgan Stanley's old and new revenue estimates is about $354 million, or almost 60 percent of the $596 million gap between the brokerage's old and new forecasts for Qwest's operating cash flow.
Morgan Stanley's estimates are lower than Qwest's own targets. Qwest executives on Wednesday repeated their belief that revenue will grow at least 15 percent a year. The company sees operating cash flow increasing 20 percent annually.
But the mere association of "accounting" with possible problems was enough to spook Wall Street investors, who typically flee from any hint of problems with financial reporting.
"Bringing in accounting issues draws people's attention," Crossman said. "That's a very powerful statement to make. How do you fight something like that?"