Techs duck and cover after WorldCom

It may be the fiasco du jour, but it's just one more dent in corporate confidence in the grand scheme of things. Techs will be closely scrutinized for a wide range of reasons.

Larry Dignan
4 min read
WorldCom's huge accounting belly flop is creating a ripple effect that is expected to go well beyond the telecommunications sector.

While Wall Street was pondering WorldCom's future, analysts were saying Wednesday that the company's announcement that it improperly accounted for almost $4 billion in expenses is just a symptom of a larger problem.

"The rotten egg here is not WorldCom and the telecom sector, but the accounting practices that are highly susceptible to interpretation," said Brownlee Thomas, an analyst at Giga Information Group.

WorldCom may be the fiasco du jour, but it's just one more dent in corporate confidence in the grand scheme of things. Tech companies will be more closely scrutinized for a wide range of reasons, including ties to auditor Arthur Andersen and use of various earnings measures such as pro forma earnings and EBITDA (earnings before interest, taxes, depreciation and amortization).

"It ultimately comes down to the integrity of management," said Paul R. Brazina, an accounting professor at La Salle University in Philadelphia. "We probably haven't seen the tip of the iceberg when it comes to accounting problems."

Here's a look at the WorldCom ramifications:

Telecommunications carriers
While some of WorldCom's rivals will benefit from poaching customers, analysts said the whole sector is likely to be marred by accounting concerns. Why? Like Enron, which rattled the energy sector, the telecom sector will be put under the microscope.

The Securities and Exchange Commission has already been investigating Qwest Communications International. And the practice of so-called swaps--when two companies agree to sell capacity lines to each other and book the revenue on each of their respective income statements--has been a controversial issue in the telecom sector for months.

"For any telecom company with credibility issues, the burden of proof just got higher," said Merrill Lynch analyst Adam Quinton.

"What has happened at WorldCom is unfortunate for our industry; however, Qwest is a different company," Qwest Chief Executive Richard Notebaert said in a statement issued Wednesday. "We continue to cooperate fully with the SEC inquiry of our accounting practices and we have met all requests for information. I don't believe that anything has changed," he said.

Even Baby Bells may get a closer look, since they counted WorldCom as a key customer. The bottom line: More scrutiny for all telecom companies, including the ones that are deemed to be safer than WorldCom.

Telecom equipment providers
Juniper Networks was already taking a hit in the wake of the WorldCom announcement, with its stock dropping more than 18 percent Wednesday to close at $5.13.

According to a SoundView Technology Group report, Juniper's customer base revolves around WorldCom and struggling companies like Qwest and Ericsson. Dating back to December 1998, WorldCom has been at least 10 percent of Juniper's sales for every quarter but one.

The WorldCom woes likely mean that Juniper will have to compete with Cisco Systems even more--largely because Juniper's customers are cutting back spending. Cisco has limited exposure to WorldCom, but rivals such as Nortel Networks are expected to take their lumps too.

Nortel issued a statement Wednesday saying it had "no material exposure to WorldCom" and no customer financing with the company. Equipment maker Ciena said its exposure was less than $1 million and was "insignificant."

The biggest worry is that WorldCom's issues are pervasive throughout the industry, casting a pall over Lucent Technologies and Alcatel to name a few, SoundView said.

Stock option scrutiny
New Economy companies are finding that the stock options they were built upon are increasingly under fire. A few analysts noted that accounting abuses wouldn't be so rampant if executives didn't have incentive to fudge quarterly results to make a quick buck.

In a research note, Donald Coxe, a portfolio strategist at BMO Nesbitt Burns, argues that the real problem is "the real costs and culture of stock options." Coxe, like some legislators, want stock options listed as an expense--an idea opposed by tech executives. As accounting scandals pile up, the drumbeat for stock option reform may get louder.

"WorldCom is not a big enough story to justify an all-out bearish attitude," Coxe said. "It's just one of the hundreds of stories of deceit, deception and delusion that together defined the tech-telecom mania."

Questionable earnings numbers
Jeffrey Saut, a strategist at Raymond James, said investors clearly think the game is rigged when it comes to the financial figures put out by companies. That's why he is increasingly skeptical of companies that use EBITDA, pro forma earnings, off balance sheet transactions--and companies that use a lot of footnotes to explain their financials.

"I'm not a big advocate of EBITDA, don't like pro forma and don't like the 'other income' line," Saut said.

Saut said telecom, media and cable companies use EBITDA--which has been labeled by some skeptics as "earnings minus all the bad stuff"--to overstate their financials. And that attitude is becoming increasingly prevalent among investors--meaning companies, such as AOL Time Warner, that are defined by EBITDA and other measures may take a hit.

IT spending
Giga's Thomas said she thinks tech's accounting woes are likely to influence how companies pick key IT vendors. She said the WorldCom fallout has resulted in a bunch of panicky client calls from Fortune 500 companies looking for advice.

"People relied heavily on WorldCom and now want to diversify," she said.

Thomas recommends to clients that they plan on spending no more than 65 percent of their budgets with one vendor. Companies need backup providers, alternate software providers and escape clauses in contracts just in case one vendor unravels.

That advice counters what a lot of software, hardware and telecom companies are pitching: reliance on one vendor for a customer's needs.

"We've been recommending diversification of suppliers for years," Thomas said. "You have to think of it like your investment portfolio."