It turned out that we had made a few mistakes. We had forgotten to include the value of some additional fiber-optic capacity that Frontier Corporation had decided to buy from Qwest. We had also overestimated the company"s debt, which we quickly corrected. When we plugged the new information into our models, we arrived at a new valuation of $1.8 billion, in line with Cy Harvey and his gang but still $400 million below Jack.
This was a very large difference, given that most of us used similar models and a.s.sumptions. What was going on? Merrill banker Tom Middleton and his team looked closely at the Salomon numbers and found that Salomon had not accounted for what is called a "private-to-public" discount, which is the fact that virtually all publicly traded stocks trade 1525 percent below their theoretical value, also known as "private market value."
Did a summer intern prepare these numbers? It seemed nuts to all of us. We also noticed that Jack"s valuation model had an extremely high a.s.sumption for an arcane but important input called a terminal multiple. His was 13, much higher than our more conventional a.s.sumption of 8.5. If we plugged our a.s.sumptions on those two items into their model, Salomon"s model fell to $1.88 billion-very close to our valuation. The bankers called Qwest"s CFO, Robert Woodruff, and walked him through the adjustments, explaining that all three of us (Merrill, Qwest, and Salomon) had almost the same number. Hopefully, we"d avoid some of the conflict that had ruined our meet-and-greet back in January.
Silly me. Joe Nacchio and his team were fixated on Salomon"s number, regardless of its methodological flaws, and consumed with maximizing the value of the IPO. So the word came down: Joe Nacchio wanted to talk to me directly and immediately. Here we go again, I thought. There was just one problem with his intimidation strategy: I wasn"t going to be around to listen to it. After all, it was spring-I.I. campaigning season-and even Joe Nacchio wasn"t going to keep me from visiting my clients. campaigning season-and even Joe Nacchio wasn"t going to keep me from visiting my clients.
I had just had dinner with the telecom a.n.a.lyst at Franklin Funds in San Mateo, California, and had hopped a flight to Portland, Oregon. As I checked in to the Heathman Hotel there at about 11:30 PM PM, the clerk handed me 20 pages of faxes. The first six pages were charts comparing the various Qwest valuations, followed by four pages of Mark"s and Megan"s a.n.a.lyses, then six pages of news clips and stock prices and four pages of copied phone-message slips, one of which was from Mark Vander Ploeg, a Merrill banker. It confirmed that a conference call had been set up with Joe and his CFO, Robert Woodruff, for the next morning, Thursday, April 3, at 9:30 New York time, which meant 6:30 AM AM in Portland. in Portland.
As brutal as that sounds, the timing was intended to accommodate my schedule, which included a breakfast presentation to Portland money managers at 7:30 AM AM, a 9:00 AM AM meeting with Columbia Management, an 11:00 meeting with Columbia Management, an 11:00 AM AM flight to Seattle for a lunch meeting, a meeting with Bank of America at 2:00 flight to Seattle for a lunch meeting, a meeting with Bank of America at 2:00 PM PM, and finally a six-hour flight home, arriving after midnight. h.e.l.l of a day indeed-especially now that I would have the pleasure of beginning the day by getting reamed out by the biggest loudmouth in the telecom business. I tried in vain to get some sleep. This one was going to be a doozy.
I got up at 5:00 AM AM, checked my voice mails, and skimmed The Wall Street Journal. The Wall Street Journal. Then I showered and reviewed the valuation charts that Megan had prepared. I knew we weren"t going to be bullied; we would only make a change if it turned out that we had overlooked something in the modeling. Then I dialed in to the conference call. Megan and Joe were already waiting. Then I showered and reviewed the valuation charts that Megan had prepared. I knew we weren"t going to be bullied; we would only make a change if it turned out that we had overlooked something in the modeling. Then I dialed in to the conference call. Megan and Joe were already waiting.
Nacchio"s voice boomed through the receiver: "Dan, you"re on the call, right?"
"Yep, I"m here, Joe," I said, stifling a yawn.
Nacchio didn"t waste any time. "I don"t understand why you are so much lower than Jack," he bellowed. Geez, I thought to myself, it"s 6:30 in the morning and I"m already getting that "Why can"t you be like Jack" c.r.a.p? I cleared my throat to be sure my reasonable self emerged, instead of the cranky one who just wanted to put the blankets back over my head.
"Joe," I said, "I don"t know if you have seen the latest comparison sheet, but it looks like we are all circling around $1.81.9 billion when we apply common a.s.sumptions. Jack-or his banking folks-have been using some pretty aggressive and, frankly, indefensible a.s.sumptions."
One of the bankers then offered to walk Joe through the models, but he wouldn"t have it. He was stuck on Salomon"s valuation. Joe either didn"t understand the methodology or didn"t want to hear about it. He simply wanted the highest number possible, and once he got it from one bank, he wanted it from all of the banks. "Dan, I don"t understand why you would be lower than the other a.n.a.lysts," he whined. "We"re gonna beat all these numbers, you know."
After listening to him drone on for a while, my slow burn picked up speed. Plus I needed to get to my breakfast on time. "Look, Joe," I snapped, "we can debate this all day and all night and you can tell me I"m too conservative and I should be more like Jack. But the truth is, none of us is going to price this deal. The market is going to price it, and that means that Fidelity, Capital Group, Alliance, and a few others are the ones you should be lobbying." In other words, it didn"t ultimately matter a whit what Joe, Jack, or I thought the IPO would be worth. It mattered only what the market was willing to pay for it-and that was something that had become highly unpredictable in this bull market.
One of the bankers jumped in, trying to smooth over the rough edges I"d just created. "If the portfolio managers think we"ve undervalued your shares, Joe," he said, "they will place larger orders and we"ll raise the IPO price to clear the market. So it may not really matter if we all agree on an exact price."
"But wait," said Joe, "there"s more sizzle coming than the $1.8 billion reflects! We are soon going to announce an investment in Mexico, an expansion into the southeastern U.S., and three or four new executives. All of these should increase the value of the company." Sizzle? I had no idea what "sizzle" meant in a financial context and still don"t. Joe, however, was a salesman at heart, and a salesman lives for sizzle. I excused myself, as it was time for my breakfast presentation. Nothing had been resolved.
Joe didn"t get me to change my estimates, but as it turned out, he was more right than I could ever have imagined. After a three-week road show-the traveling circus in which Qwest"s top executives traveled around the world, visiting inst.i.tutional investors in 10 cities in the U.S. and five in Europe, to try to sell the stock-it went public on June 24, 1997, at $22.
Jack"s $2.2 billion and our $1.8 billion estimates looked laughable after the first day of trading, when the stock closed at $28, valuing the company at an unbelievable $2.8 billion. We had all dramatically underestimated some things that didn"t figure in to our models at all: the market"s appet.i.te for new economy telecom startups and the degree to which an a.s.sociation with the Internet-a big part of Qwest"s road show-would propel valuations. Yet Jack, even though he had blown up his numbers with an air pump, was still closer to reality than I was. It killed me. Ultimately, Qwest would peak at $66, three years later. It didn"t matter how meticulous our research was in an environment like this, I realized. The only way to get close to this new reality would be to add a line to our valuation model and label it "adjustment for "irrational exuberance.""
5. MERGER MANIA MERGER MANIA.
JULY 1997 JANUARY 1999
Our once-sleepy industry was suddenly looking like Barbarians at the Gate Barbarians at the Gate all over again, with breathtaking hostile takeover offers fueled by a stock market that was making anything possible. In four short years, a tiny upstart company run by a former gym teacher had catapulted itself into the same league as old Ma Bell. WorldCom symbolized how the telecommunications industry had transformed itself from a snooze-inducing swampland to the glamour girl of the Street. all over again, with breathtaking hostile takeover offers fueled by a stock market that was making anything possible. In four short years, a tiny upstart company run by a former gym teacher had catapulted itself into the same league as old Ma Bell. WorldCom symbolized how the telecommunications industry had transformed itself from a snooze-inducing swampland to the glamour girl of the Street.
The Case of the Secret Doc.u.ment.
QWEST"S INCREDIBLE STOCK MARKET DEBUT signaled a new phase in the telecommunications world. Now, momentum began to have more impact than the good old-fashioned a.n.a.lysis I loved to do. It was worrisome. Were my methods outdated, or was the market beginning to act irrationally? I didn"t know. In addition, the frenzied pace of antic.i.p.ating and a.n.a.lyzing every deal to come down the information superhighway had worn me out. signaled a new phase in the telecommunications world. Now, momentum began to have more impact than the good old-fashioned a.n.a.lysis I loved to do. It was worrisome. Were my methods outdated, or was the market beginning to act irrationally? I didn"t know. In addition, the frenzied pace of antic.i.p.ating and a.n.a.lyzing every deal to come down the information superhighway had worn me out.
So in July of 1997, Paula and I went to Italy for a long-awaited vacation. We headed to JFK as soon as our kids boarded their bus to summer camp, looking forward to eight days of wine, pasta, and-most important-serenity along the sh.o.r.es of Lake Como. From there, we planned a drive to Venice. It was already pouring when we arrived at the Grand Hotel Villa Serbelloni in Bellagio, formerly the country home of an aristocratic Milanese family, with a breathtaking position on the promontory jutting halfway out into the lake. And it kept pouring for three days straight. We spent most of our time sitting in the hotel lobby reading, and, at dinnertime, sprinting, umbrellas in hand, to various restaurants near the hotel.
We decided to pack up and head south. Our plan was simple: drive until we saw sunlight and cloudless skies, which happened as we entered Tuscany. With no reservations and not much in the way of guidebooks, we found a hotel in Siena and spent a day touring there, learning about the special horse race called the Palio di Siena that happened in the main square once a year. We then drove south to Montepulciano, a beautiful walled city on a hilltop.
I did call my voice mail once a day, but there wasn"t much happening, and for once in my Wall Street career, I felt completely relaxed. Eventually, we stopped at an agriturismo, agriturismo, a bed-and-breakfast on a farm. This seemed like the perfect place to unwind for a few quiet, sunny days. The guest rooms had no phones, which I figured would be a welcome change for me. I could always use the phone in the farmer"s living room, which doubled as a guest bar, to check my voice mail. a bed-and-breakfast on a farm. This seemed like the perfect place to unwind for a few quiet, sunny days. The guest rooms had no phones, which I figured would be a welcome change for me. I could always use the phone in the farmer"s living room, which doubled as a guest bar, to check my voice mail.
The serenity lasted for about 36 hours. We had spent a day and a half playing tennis, swimming, and hiking when I checked my messages. One, marked as urgent, was from Megan reporting that MCI had just announced it was having a conference call for a.n.a.lysts and investors at 4:00 PM PM EST, which would be 10:00 EST, which would be 10:00 PM PM in Italy. It was now 9:50 in Italy. It was now 9:50 PM PM. I instinctively knew that this meant trouble for MCI. Why else would a company hastily set up a conference call just a week before it was slated to release its second-quarter earnings? As I had learned many years earlier at MCI, good news can await the earnings release, but the stock market had to be softened up for bad news. I wondered if it could have something to do with British Telecom"s (BT"s) deal to buy the company.
That transatlantic deal, which had been announced with great fanfare the previous November, was a $21 billion transaction, one The Wall Street Journal The Wall Street Journal called "colossal." called "colossal."1 If completed in the next few months, as widely expected, it would be the largest foreign takeover of an American company in history and the telecom industry"s first cross-border merger. MCI shareholders would receive a whopping $36 per share, a 40 percent premium, making my Neutral rating look dead wrong. My relaxed state evaporated into the starry Tuscan night. If completed in the next few months, as widely expected, it would be the largest foreign takeover of an American company in history and the telecom industry"s first cross-border merger. MCI shareholders would receive a whopping $36 per share, a 40 percent premium, making my Neutral rating look dead wrong. My relaxed state evaporated into the starry Tuscan night.
I ran back to our room to find Paula. I told her I had to deal with some MCI nonsense and would be in the bar. Quickly returning to the farmer"s house, I tried to explain to him, using futile hand gestures, since I spoke no Italian, how sorry I was, but there were some big doings back in the States and I needed to use his phone for a while. He and his wife stared at me blankly. Using my AT&T calling card, I settled into a creaky wooden chair in the farmer"s living room, with my pen and notebook ready, and dialed in to the conference call.
As I heard Doug Maine, MCI"s CFO, being introduced, the farmer"s wife turned down the living room lights, a signal that the bar was closing and it was time to go to sleep. But there was no way I was going to miss this call. The farmer came into the room and stared at me, first confused, then perturbed, as I proceeded to spend the next 45 minutes listening without saying a word and feverishly jotting notes in my notebook. I doubt he had ever seen anyone spend 45 minutes on a phone without speaking a single word. Was this some newfangled kind of American telepathy?
What Doug had to say was not good. He said that the challenges of entering the U.S. local market, a $2 billion, 20-city initiative MCI had announced in 1994, were proving to be far more difficult and expensive than antic.i.p.ated. The punch line: MCI would earn in the range of $1.20 per share next year, instead of the $2.00 most of us had estimated. With one exception, this 40 percent cut in expected earnings was by far the largest cut I had seen in my 14 years in the telecom industry. I was shocked.
After Doug finished, the moderator announced that the lines were open for questions. I had plenty and I was anxious to get started. Someone had to get to the bottom of what was going on, and I figured it might as well be me. Not that that was an easy task. On calls like these, with upward of 1,000 listeners (a.n.a.lysts, inst.i.tutional money managers, journalists, and others), those of us who were lucky enough to be allowed a question had to speak fast and get our follow-ups in before they moved on to another caller.
"Doug, it"s Dan Reingold. I have a question." I had finally spoken, and my yawning farmer was visibly relieved.
"Jack, go ahead with your question," Doug said. Jack had a tendency to spout off for a while and give his spin on what we had just heard, leaving everyone on the call wondering what his question was. His spin blamed the evil Baby Bells, not MCI. Of course, Jack had a Buy rating on MCI and had looked very astute when the BT-MCI deal had been announced eight months earlier. Meanwhile, I had looked pretty bad with a Neutral rating on MCI. Unlike Jack, I had argued that the best partners for BT would be the Bells or the new startups, not an inc.u.mbent long-distance company like MCI.
"Next questioner please," the moderator announced once Doug was finished responding to Jack"s non-question.
"It"s Dan Reingold, I have a question," I blurted again as quickly as I could.
"Go ahead, Blake," said Doug. Blake Bath was the telecom a.n.a.lyst at Lehman Brothers and a former junior financial guy who worked for me at MCI for a few months before I left for Wall Street.
d.a.m.n, I thought to myself, I wonder if the overseas delay is causing me to be drowned out by the other questioners" voices or if Doug simply doesn"t want to give me a chance.
Blake"s question was also innocuous, perhaps intentionally. Like Jack, he, too, was a bull on MCI shares and I suppose they saw no point in making Doug and MCI look any worse than they already did. Or perhaps he was simply as stunned as I was.
When the monitor asked for questions again, I yelled, "Reingold, question, can I ask a question please?"
"Dan, it is hard to hear you, but go ahead with your question," Doug finally said.
"Thanks Doug," I responded. "I actually have several questions. First, you"re cutting your forecast by 80 cents, or 40 percent. Can you split that between your long distance business and your local initiatives?" Doug seemed to be trying to spin us to believe that the entire problem was in the local business. But I knew that MCI"s stock price was far more sensitive to its long distance outlook, as long distance produced 100 percent of its earnings and cash flow.
The farmer, who had been staring impatiently at me all this time, sighed again, mollified. At least this weird American understood that the purpose of a telephone was to talk as well as to listen. He was probably terrified that I would stick him with an enormous bill for this call.
Doug"s answer was a study in obfuscation, designed to give the appearance of answering the question without actually doing so. I remembered his approach well from my days at MCI. I needed to know more, but h.e.l.l would freeze over before they"d let me ask another question. Fortunately, there were a lot of BT shareholders on the call, and they kept hammering Doug on MCI"s outlook, but without eliciting much added information.
It was obvious to everyone on the call that both BT"s and MCI"s shares would be hit hard in the morning, since MCI"s disastrous earnings outlook translated into a noticeable earnings. .h.i.t for BT as well. BT"s management suddenly looked like a bunch of bozos for believing that a struggling MCI would be its savior.
After several more questions from British investors, Doug finally admitted that somewhere around 20 to 30 cents per share, or one-third of the shortfall, would come from trouble in the long distance division. It seemed like a disclosure of minor importance, but it would turn out to be a major victory for me. To me, Doug"s statement clearly contained a key piece of information, but it would somehow be ignored by virtually everyone on the U.S. side of the Atlantic Ocean-the arbitrage community, many portfolio managers, and most of my sell-side compet.i.tors.
By the time the call ended, it was 11:30 PM PM in rural Italy and 5:30 in New York. My poor farmer, who doubtless had to rise very early in the morning, was still yawning. But I was as wired as if I"d just downed 12 espressos. Here I was in the middle of one of the most beautiful, serene places in the world, and all I could think about was that I was cut off from the information I needed most. in rural Italy and 5:30 in New York. My poor farmer, who doubtless had to rise very early in the morning, was still yawning. But I was as wired as if I"d just downed 12 espressos. Here I was in the middle of one of the most beautiful, serene places in the world, and all I could think about was that I was cut off from the information I needed most.
What was going to happen to this deal, I wondered to myself. And how was I going to write this up and talk to my team? I had no cell phone, no wireline phone once the farmer kicked me out of his living room, no fax machine, no nothing. I was afraid to hang up and give the farmer an opening, so I just hit ##, got the AT&T USA Direct redial service, and called my voice mail, which was already full of messages from reporters, buy-siders, arbitrageurs, and Merrill"s traders wanting to know what I thought of MCI"s announcement.
I forwarded my messages to Megan and Mark, asking them to return the calls once we figured out our stance. Then I left a seven-minute message for them outlining my thoughts. My message to Mark and Megan went something like this: "MCI"s announcement, shocking to some, makes starkly evident what we have been arguing for two years now: it is going to be extremely expensive and time-consuming for the inc.u.mbent long-distance companies to add local service. And, at the same time, pressures in the long distance business will only get worse when the Baby Bells start competing with them." As soon as I"d finished, I started another voice mail, continuing my thoughts. By the time I finished this one (14 minutes had now elapsed), I"d received several new messages from Megan and Mark responding to my first one. We were playing voice mail tag.
Mark and Megan argued that this was a disaster for MCI and that they thought the company was hiding an even worse long distance problem under the cover of problems in the local market. I agreed. The whole thing jibed with my belief that the inc.u.mbent long-distance players like AT&T, MCI, and Sprint were likely to suffer from intense price cutting in the long distance market even before before the Bells entered the market. There were big implications for virtually every telecom stock, and Doug"s comments were giving me the perfect opportunity to reiterate my point of view. the Bells entered the market. There were big implications for virtually every telecom stock, and Doug"s comments were giving me the perfect opportunity to reiterate my point of view.
Paula and I had planned to drive to the medieval walled city of Lucca the next day, with numerous stops along the way. Since I didn"t have a cell phone and I hoped to salvage a little bit of the vacation, I asked Megan and Mark to write up the report and to speak the following day on my behalf at Merrill"s internal "squawk box" morning meeting for the sales force and brokers. I also asked them to speak for me on the conference call for inst.i.tutional investors that was being set up.
It was now half past midnight. I went back to our room, where Paula, who"d been asleep for a while, woke up just long enough to ask what was going on. I whispered, "Those jerks at MCI have really, I mean really, messed up this time!"
The next morning, we began our drive to Lucca. We drove as quickly as possible, but Italy"s roads can be slow and there are lots of interesting towns along the way, including Pisa, where we did the obligatory photo op pretending we were holding up the famous Leaning Tower of Pisa. We continued driving as trading of MCI shares was about to begin in New York. BT shares had already been trading for several hours in London. I a.s.sumed both would be down significantly on the MCI news, but I had no way of knowing. I had stupidly not rented a European cell phone and I had no way to receive faxes or e-mails.
As we drove along those winding Tuscan roads, I wondered whether the BT-MCI deal would hold up at all. From my rural perch, I didn"t know how investors in the U.S. were reacting, or what BT"s executives were saying. Was this news a surprise to BT too? If so, were they considering backing out of the deal entirely or trying to renegotiate its terms? Or had BT been fully aware of MCI"s problems? Was BT still committed to the deal at its original price?
We arrived at the hotel at 4:15 PM PM to a pile of faxes, including a long list of phone messages, the MCI press release, Mark and Megan"s report, and the announcement that the conference call I was ostensibly hosting for inst.i.tutional clients was set for 10:00 to a pile of faxes, including a long list of phone messages, the MCI press release, Mark and Megan"s report, and the announcement that the conference call I was ostensibly hosting for inst.i.tutional clients was set for 10:00 AM AM New York time, which meant it had started 15 minutes earlier. We rushed to the room. New York time, which meant it had started 15 minutes earlier. We rushed to the room.
For these calls, I would usually have prepared an outline and had time to study it a bit. But this time I was just going to wing it. I hurriedly dialed in to the Merrill conference call, where hundreds of my clients were waiting to get some answers. I had to explain to the skeptical operator that I was indeed one of the speakers, and heard Megan handing off to Chris McFadden, Merrill"s London-based a.n.a.lyst covering European telecom companies, including BT. Chris had a Neutral rating on BT shares, largely because he, too, was concerned about the future of MCI.
It was a very tense moment. I had no idea what Megan and Mark had already said, what my compet.i.tors were saying, or whether new information had come out overnight that might have changed our point of view. I didn"t even know for sure what we had said in that morning"s report. When Chris finished his comments, I interjected that I had just joined the call from Italy and was available to answer questions.
The first one came from a portfolio manager at a large British pension fund who apparently owned a large slug of BT shares. "Do you guys think BT will proceed with this deal, as many sell-siders and MCI seem to be suggesting, or will the terms be renegotiated to a lower price?" It was a perfectly reasonable question and, boy, was it chock-full of information. His words suggested to me, though I couldn"t be sure, that while I was sleeping, MCI executives had rea.s.sured investors the deal was going through as planned, and that, apparently, most of my compet.i.tors believed them.
Chris, Mark, and Megan all knew that I should be the one to take that question. I realized I had a split second to make the call on something I hadn"t really thought through. I had not read the MCI-BT merger agreement and thus I didn"t even know what rights BT had to terminate or force a renegotiation.
But sometimes even a.n.a.lytical types have to fly by the seat of their pants. So, sitting on the edge of the hotel bed, I blurted, "Of course this deal is getting renegotiated! MCI just cut its earnings outlook by 40 percent, and we"ve cut our earnings estimates from $2.00 to $1.15 a share, in part because of local entry costs, and also because of a much tougher long distance business, problems we"ve been forecasting for two years [never miss a chance to toot your own horn]. I can"t imagine that BT, or its shareholders, could stomach paying as much for a company with $1.15 of earnings power as one with $2.00 of earnings power." Chris picked up the logic and backed me up.
I didn"t realize it, but my off-the-cuff prediction had just propelled me into a hailstorm of controversy. I had locked myself into a position that absolutely no one else supported. With our vacation coming to an end, we drove north to Milan to catch our respective flights. Paula flew home, and I began a week of prescheduled meetings with inst.i.tutional investors in Milan, Zurich, Amsterdam, Edinburgh, and London. Many of the clients, especially the British, happened to be loaded up on BT shares and were extremely upset about the MCI news and the negative impact it was having on BT"s stock.
As I traveled from meeting to meeting, I received numerous press calls and returned one to Richard Waters, a reporter I knew from The Financial Times. The Financial Times. Talking to the media was an easy way to broadcast my point of view quickly without having to call scores of clients and salespeople. Talking to the media was an easy way to broadcast my point of view quickly without having to call scores of clients and salespeople.
Richard quoted me in the next day"s Financial Times, Financial Times, one of the most widely read financial newspapers in the world: "A renegotiation is imperative-it"s absolutely going to happen." Further, he said, I was predicting a 20 percent reduction in the price BT would pay for MCI. one of the most widely read financial newspapers in the world: "A renegotiation is imperative-it"s absolutely going to happen." Further, he said, I was predicting a 20 percent reduction in the price BT would pay for MCI.2 I also received a barrage of calls from my traditional buy-side clients, as well as from a new const.i.tuency: risk arbitrage funds. I also received a barrage of calls from my traditional buy-side clients, as well as from a new const.i.tuency: risk arbitrage funds.
Arbitrageurs, or arbs, for short, make their money on the difference between the stock prices of companies involved in a merger. In this case, arbs had earlier bet that MCI"s price of $25.13 on the day before the deal was announced would slowly rise to BT"s takeout offer of $41.80 as the deal neared completion. As a hedge, they had also bet that BT"s stock would fall in the same period of time, which is what usually happens to the acquirer"s stock in a takeover. But now that MCI"s earnings had tanked, the arbitrage bet had been called into question.
Needless to say, the arbs were completely spooked by the MCI news. If MCI"s bad news led BT to pull out of the deal or to demand a lower price, the arbs would lose lots of money. Not only would their ownership position in MCI shares get killed when MCI shares tanked, but BT shares would rise, doubling their pain. It would be the opposite of what they had bet, and it would squeeze the arb community harder than anything had before.
Nothing matches the intensity of an arb whose bet on a merger is going awry. The arb guys are tough guys-smart, quick, and probing. They often are lawyers or have access to the best and most expensive legal advice in the world. Much of their work depends on understanding the fine contractual details of merger agreements.
Although it seemed totally logical to me that the deal would be renegotiated, I was nervous about my stance. Logic, I"d learned, didn"t always matter when it came to the stock market or corporate decisions. Most of my clients and the arbs thought I was wrong, and they had no problem telling me so, sometimes forcefully. Merrill"s retail brokers and salespeople were razzing me, too, because they were hearing from their clients that most of the "smart guys" on Wall Street (including some well-known arbs and, of course, Jack Grubman, best known for his inside connections in the telecom industry) had opposite opinions from mine.
Even my own team was beginning to get worried. None said it out loud, but I sensed they were definitely wondering if I had jumped the gun with too little information. After all, they knew I hadn"t even read the merger agreement yet.
With my London meetings done, I hustled to Heathrow Airport, checking my voice mail en route using the driver"s cell phone. The first call I returned was to an American reporter at the Dow Jones News Service, at that time the most widely read electronic news source in the investment world. Asked why my opinion was so different from everyone else"s, I said I was puzzled too. "Those who don"t see a change coming must have taken those little pink pills that I refused to take in college," I chuckled. "That stuff can come back on you years later." As we hung up, I thought to myself: She"s not going to use that quote, is she? She"s not going to use that quote, is she? Of course she was. Of course she was.
We were stuck in London traffic. So I returned another call, this one from an investor client whom I had known for several years and respected. He was a very thoughtful and clever attorney-turned-investor who had put the arb spread on the BT-MCI deal. He had read the merger agreement several times, it seemed, and he had talked to Jack Grubman too.
This client was usually as gentlemanly as they come. But not this time. He barked into the phone, "Dan, you are wrong. Have you read the agreement? You"ve got to, especially the part about a confidential addendum. It says BT has no right to back out of the deal if MCI"s problems stem from its attempt to enter the local market."
Uh-oh. Confidential addendum? This was the first I"d heard about any confidential addendum, and it terrified me.
"Okay, I"ll look at the agreement as soon as I get home," I said, trying to remain calm but quaking inside. This guy knew his stuff, especially with regard to mergers, and he was telling me BT couldn"t renege on this deal.
"But, tell me," I continued, "how do you know what"s in in the confidential doc.u.ment?" the confidential doc.u.ment?"
"Grubman"s got it. He told me," was my client"s smug reply.
My frustration boiled over. Once again, Jack was claiming to have information that no one else did and using it to bolster his case.
"Get a copy of the d.a.m.n doc.u.ment and then let"s talk, okay?" I snapped. He agreed and we hung up. We talked several times over the next few weeks, but if he ever got a copy, I never heard about it.
Could Jack really have a secret doc.u.ment that only BT and MCI insiders had access to? Since I knew how skilled he was at getting information, his a.s.sertions made me very, very nervous. If he was right, I had made a grievous error in judgment, the merger would go through as announced, and I would look as if I had no idea what I was talking about. I hadn"t done a lot of digging into the merger agreement, but when I finally got my hands on it and looked at the fine print, there was indeed a reference to some kind of confidential addendum. Yikes!
When I thought about it, however, I couldn"t understand why a renegotiation clause would be kept secret. Wouldn"t that be something shareholders-the company"s owners-had the right to see before approving the merger? More sensible to me was that the addendum included some confidential compet.i.tive information, such as MCI"s plans for local entry, which the company didn"t want to get out to compet.i.tors. So even though Jack had been right about the existence of the addendum, the idea that it actually locked BT into this deal with no way out still seemed pretty unlikely to me. I also figured MCI"s financial strength was weakening so much that the last thing CEO Bert Roberts wanted was to lose this deal. I thought he might be willing to take a lower price for fear of losing the deal entirely. So I stuck to my guns and told anyone who would listen that the price BT would pay for MCI would be cut by roughly 20 percent.
Once again, Jack and I were on opposite sides of an argument. But as increasingly seemed to be the case, his argument had the most believers by far. I was all alone on this one.
MCI/BT: The "BloodBath"
For the next month or so, the worried calls from investors continued to stream into my office, MCI kept insisting the BT deal would stand with no changes, and I kept insisting that it couldn"t. And then, one early August morning in my New York office, I received an interesting call from two guys from BT"s strategic a.n.a.lysis group. They told me that the executive team was holed up in a conference room at MCI headquarters in Washington, where they were reviewing MCI"s new financial forecasts and trying to figure out what had gone wrong.
I asked whether they were considering renegotiating, but they wouldn"t tell me. Instead, they had a lot of questions for me. This was unusual, but it wasn"t unheard of. I sometimes received calls from telecom executives, asking for further elaboration on my reports or outlook. In some cases, they hoped to change my mind or glean some tidbit about a compet.i.tor. I had often been asked to make presentations to management and, in some cases, to the boards of the companies I covered. There was nothing nefarious about this, at least as long as they didn"t share any nonpublic information with me.
The BT folks asked me about Qwest, and it quickly became clear to me that they knew virtually nothing about the company. This made it all the more amazing that the top executives at BT had been willing to get into bed with MCI without adequately understanding its compet.i.tors. Were they asking because they were interested in buying Qwest or because they were finally realizing how tough a market long distance was? I felt the tiniest bit of hope that maybe, just maybe, these guys were questioning their decision.
I had just written a lengthy report initiating coverage on Qwest, with an Acc.u.mulate, or "2" out of 5, rating. They asked me to fax it to their hotel. About five days later, on August 5, the BT strategy guys called again. This time, they asked me to meet with BT"s CEO, Sir Peter Bonfield, and its CFO, Robert Brace, in Sir Peter"s suite at the Four Seasons Hotel in Georgetown. So I flew down to D.C. and slipped into the Four Seasons around 11:00 PM PM.
At 10:00 the next morning, I took the elevator up to the appointed suite. I hadn"t told a soul about this meeting. Certainly, Merrill"s M&A bankers would have eagerly accompanied me if they had known about it. They had been frozen out of the big fees from the BT-MCI merger and would have loved to pitch some different strategic moves to Sir Peter and Robert Brace. But the BT guys wanted this meeting kept quiet and I saw no reason to ignore their wishes. I wasn"t sure what they wanted from me, so I"d prepared some handwritten notes about various options for partnering in the U.S.
As I sat in the lavishly appointed suite, I realized I had a chance to influence how this deal would end up. I believed that BT should hightail it out of Dodge, because merging with MCI could be the worst decision in its long history. The existing long distance companies were already suffering early signs of decline, and their market was about to be invaded by the Baby Bells. Sir Peter, an understated British executive with a gray beard and a slight frame, led the questioning. First, he asked what his shareholders were telling me.
"The British fund managers," I said, "who own far more BT shares than MCI shares, clearly want this deal to go away or, at the least, for you to pay a much lower price. The Americans, on the other hand, tend to hold more MCI shares than BT shares, and thus are praying the deal closes with no change in terms. And then there are the arbs," I continued, "who own very large blocks of MCI shares and have bet against BT shares, and who desperately need you to bail them out by sticking to the original price."
Sir Peter moved on. "What about the new telecom companies in the U.S. market? Are they going to amount to anything?"
"If I were going to buy a long distance company," I said, "I would much rather buy something like Qwest than MCI. Qwest will have a brand-new network, using the latest and most cost-efficient technologies, and thus will be able to offer long distance service at prices far lower than MCI, AT&T, and Sprint." I was telling them the same things I was saying to investors and anyone else who would listen-that buying MCI would be a bad move. "Further," I continued, watching Sir Peter"s and Robert"s stony faces, "Qwest can target the best long distance customers, stealing those who generate the highest profit margins."
No one said anything to me about what they intended to do, and I didn"t ask. Robert chuckled at one point, nervously (or was it just that British way), that they had "alternatives," which I hoped implied that they weren"t locked in by any confidential addendum. But of course I couldn"t be sure.
Clearly, Sir Peter was in a tough spot. His board could easily turn on him if he went ahead with such an obviously overpriced deal. On the other hand, his board could also nail him if, after three years of partnership with MCI, the merger and BT"s global strategic plan fell apart. If he tried to renegotiate the deal with MCI, MCI might fight back on legal grounds or simply try to prolong the process, further pressuring BT"s share price.
Sir Peter thanked me and abruptly ended the meeting. It had lasted only 30 minutes. I didn"t know what to think. Had he cut the meeting short because he thought my perspectives were ridiculous or because he agreed? I had no idea.
As it turned out, I wasn"t the only a.n.a.lyst having secret meetings. According to several buy-siders, in the middle of August the Lehman Brothers telecom a.n.a.lyst, Blake Bath, claimed he"d had a private conversation with MCI"s CFO, Doug Maine. On the morning of Wednesday, August 20, Blake went on Lehman"s squawk box announcing that he had it on good faith from sources within MCI that the deal would definitely not be renegotiated. This was good enough for many members of the arb community, who a.s.sumed that Blake"s source was Maine and that his former boss wouldn"t lie to him. They piled back into the stock, believing that MCI"s shares had fallen too much in all the confusion and controversy. If Blake was right and the deal closed as planned, they"d make a ton of dough as MCI shares rose sharply and BT shares fell.
Poor old Blake Bath. He must have forgotten the a.n.a.lyst"s golden rule: just because management tells you something doesn"t make it true. That very evening, the news broke that the deal was, indeed, being renegotiated. Shareholders in MCI would now get the equivalent of $33.80 for every MCI share, down $8, or 22 percent, from the original $41.80 deal and making the Lehman a.n.a.lyst look like a clueless rube. The next day, MCI shares cratered, falling $6.13, or 17 percent, while BT shares rose 7 percent. This was how he earned the moniker "BloodBath" among some investors. MCI"s CFO, Doug Maine, by the way, denied ever telling Blake the deal would or would not be renegotiated.
I couldn"t have asked for a more perfect outcome, since I had been predicting a 20 percent drop in what BT would pay for MCI shares. Whatever secret doc.u.ment Jack allegedly saw didn"t do much to change the fact that the deal simply no longer made sense at the original price, given MCI"s poor performance.
By several accounts, Salomon"s arbs lost around $100 million on the deal, since they apparently listened to Jack and his pitch about the confidential doc.u.ment. That was huge bucks even for the bizarre world I inhabited, and rumor had it that this big loss was one of the major reasons why Salomon Brothers sold itself, on September 24, 1997, to Smith Barney, a subsidiary of Travelers Corporation, the acquisitive financial supermarket led by Sandy Weill.3 I received a little public vindication as well when CNBC"s David Faber called me one of the "winners" in the deal. "Back on July 31, Dan Reingold at Merrill Lynch said "I think this deal"s going to be renegotiated,"" Faber said. "Everybody was saying: "Dan, you"re out of your mind." But apparently Mr. Reingold knew something that a lot of other people on Wall Street did not." The report went on to name Jack Grubman and good old Blake Bath among the losers. I didn"t mind a bit.4 I had been completely out on a limb on this deal, but it had worked out for the best. Ironically, the insider edge that Jack was making his signature hurt him this time, while my status as a true outsider-physically removed from the information I needed at a critical time-somehow worked to my advantage.