Shares of Qwest plummeted last week after Morgan Stanley analysts Simon Flannery and Jeffrey Camp suggested Qwest used subtle but legal accounting tricks to improve its earnings growth picture.
According to the Morgan Stanley analysis, accounting maneuvers last year produced at least 22 percent of Qwest's cash earnings, or 47 percent of its "as reported" earnings under Generally Accepted Accounting Principles (GAAP), the rules governing corporate financial reports. The brokerage believes Qwest's earnings growth will slow once it's no longer able to take advantage of accounting rules related to mergers, pension plan returns and software installations.
Flannery and Camp stand by themselves on the issue. Every Wall Street analyst who responded to Morgan Stanley's conclusions took the opposite side.
Qwest executives quickly denounced Morgan Stanley and its conclusions, which came out in a report the morning after Qwest issued an update on the quarter's progress on Tuesday. Before the market closed on Wednesday, Qwest executives were back for their second analyst conference call in two days.
CEO Joseph Nacchio was nearly yelling on the call as he defended his company's books and slammed Morgan Stanley as a peddler of unsupported "innuendos" that amount to nothing more than "hogwash." Chief Financial Officer Robin Szeliga expressed puzzlement about the Morgan Stanley report. And they at least managed to convince analysts, if not investors. Qwest rebounded from its low point of last week, but has yet to recoup all of its losses following the Morgan Stanley note.
"If you take out all the personalities involved in the whole story, it's very good for a company in Qwest's position to come out early and refute these allegations," Pacific Crest Securities analyst Simon Reeves said Friday. "They came with an absolutely detailed answer, and they did it quickly, and that's really impressive."
At least nine brokerages issued research notes after Qwest's rebuttal, and they were unanimous in defending the communications company. Virtually all of them echoed the same theme: The accounting issues have nothing to do with future growth. Some analysts were direct in their criticism.
"Suspect to us at worst and perplexing at best," was how Tony Ferrugia of A.G. Edwards described the Morgan Stanley research. "The note references the 10-K (annual report) which is several months old. Why not the concern when the stock was in the 40s rather than after a decline to $30?"
Lehman Brothers analyst Blake Bath's response was among the more muted ones: "Without getting bogged down in accounting esoterics and lending credibility where it is not due, the points of contention raised yesterday by (the Morgan Stanley) report, in our opinion, do not represent real impacts to Qwest's ability to generate revenue and cash flow for investors."
Bath goes to the central point of contention: how Qwest should be measured. None of the analysts who responded to the report disputed the figures cited by Morgan Stanley regarding Qwest's write-downs of intangible assets, assumptions of pension plan growth and classification of software costs; but Flannery's and Camp's colleagues believe the duo has been looking at the wrong numbers.
"If a Wall Street firm was going to decide to do an academic white paper on accounting practices that are largely backwards-looking and have no bearing on fundamental drivers of the business, why pick on just one company?" asks Salomon Smith Barney analyst Jack Grubman.
"In a capital intensive industry, where there is a lot of software development and where there has been a multitude of acquisitions, all companies--including those that most Wall Street firms are bullish on--have probably the same academic accounting issues that have been pointed out for Qwest," he said.
Write-downs and amortization affect a company's earnings on paper. As the market value of a company's assets change, or different assumptions about pension-plan returns are made, adjustments are made on the accounting ledgers.
But money never changes hands. The amount of cash generated by Qwest's operations isn't affected by any of the areas targeted by Morgan Stanley, analysts from other brokerages said. How Qwest accounts for intangible assets has no bearing on how many phone calls are made by its customers, or how much data is carried over its fiber optic network.
And it's operating cash that truly measures the success of a company, most telecom observers believe.
"It's nice for a professor to write an accounting paper," Grubman writes, referring to the fact that Morgan Stanley's analysts enlisted the help of a Columbia University professor for their report. "We believe it would have more credibility if it was applied to all the companies in the industry. We think that the conclusions would likely be similar."