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WorldCom Case Study

FINC 621, Summer 2015

by
Hailun Cao
Mohammed Altuwaijri
Papamagatte Diagne
Qian Dou
David Ballantine
Yanchao Wu

Strategic Analysis – Hailun Cao

Bernie Ebbers, the chief executive officer, focused on acquisition business strategy. Major Acquisitions includes Advanced Telecommunications Corporation, IDB Communications group, Metromedia Communications Corporation and Resurgens, and Williams Telecommunications group (WilTel). All these firms perform different characteristics in the telecommunications industry.

WorldCom faced some issues and WorldCom tried to manage these issues through the expansion business strategy.

From the view of risk control, WorldCom met and solved challenges in the following aspects. Firstly, because of the increasing competition, increasing commoditization and low switching costs of long distance service, the long distance calls dropped obviously and long distance firms faced huge pressures under this circumstance. Therefore, WorldCom made acquisition of MCI in 1997. WorldCom made this decision through three main reasons. At first, since WorldCom was the No. 4 long distance provider and MCI was the No.2 long distance provider, the combination of the two firms could occupy 25% share in the U.S. long distance market. This situation consolidated WorldCom’s competiveness in such a depressing environment and decreased the risk in the long distance service market. In addition, the acquisition also combined different features and advantages for WorldCom and MCI. For example, WorldCom had been put emphasis on business customers, while MCI focused on the residential market, leading to a broad market coverage nationally and internationally, and for business and residential customers. Besides, all pieces of the modern telecommunication network were ensured such as local, wireless, long-distance and residential customers. This behavior diversified the risks through various markets in the U.S. telecommunication industry. Finally, when WorldCom acquired MCI, MCI was the second largest long distance carrier but WorldCom was a little known firm. So, the acquisition can help WorldCom build its reputation.

Another significant acquisition was MFS Communications. MSF is a digital fiber-optic cable network company, which owned UUNET technologies. This acquisition behavior also diversified the risks through various technologies. For the management aspect, MCI-WorldCom started to track WorldCom and MCI separately by late 2000. Different tasks and customers were assigned to them. For instance, WorldCom was responsible for high-end data services, international and commercial voice business, Internet and web-hosting and business and commercial customers, while MCI group focused on the customer and small business. Then, the efficiency of management was improved.

The acquisition also changed the value and management of the business organization. Ebbers reshaped the culture of MCI through many ways. For instance, Ebbers sold MCI’s corporate jets to promote efficiencies. And Ebbers announced new austerity policies that MCI executives’ flight prices and hotel prices were limited. In addition, by March 1999, 2215 people were laid off. According to the Wall Street Journal, 70% of MCI executives left the company after the austerity measures. As a result, the organization culture of MCI was changed significantly through integration.

By the end of 2001, general economic downtown caused telecommunications companies’ overoptimistic predictions, resulting in chronic overcapacity and unrealized revenues. Furthermore, the stock price of WorldCom continued to go down with the failure to acquire Sprint. Then, bankrupt risks occurred with some problems such as accounting irregularities.

Facing this challenge, WorldCom have some very valuable assets to solve the bankruptcy problem. Firstly, by the acquisition of MCI, WorldCom had 20 million telephone customers. Additionally, the numerous small acquisitions, which were not really integrated into the operations, would be useful assets to WorldCom. Finally, Long-term contracts with many large multinational companies and governments were helpful to let WorldCom recover from bankruptcy.

Situation Analysis – Hailun Cao

In 1998, The capital markets involved strong and contrasting currents of stress in international conditions and heavy demand for debt issues in the U.S. market.. WorldCom expected to raise $6 billion in one shot by positive market conditions. WorldCom intended to pay British Telecommunications (BT) $6.94 billion in cash for its 20% stake in MCI through bank debt, and then to pay off the bank debt through the newly issued bonds.

Four tranches of debt were offered: $1.5 billion in 3-year notes, $1.0 billion in 5-year notes, $2.0 billion in 7-year notes and $1.5 billion in 7-year notes. The interested rates are expected to rise, because WorldCom was regarded as an industry leader and many investors were interested in the company.
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The table above shows a part of the financial performance information (in thousands) and demonstrates a growing trend for the financial performance. For instance, from 1994 to 1997, the net income increases from -$124013 to 383652 (in thousands) and Return on assets (ROA) increased from -3.6% to 1.7%. All these circumstances shows that WorldCom was in a good operation and would increase its interest rates.

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This graph also illustrates the increasing trend for corporate bonds and short-term treasury interest rates straightly.

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In addition, the “spreads” on the costs of debt will be increased. According to the table, long-term corporate yield spreads over treasuries had increased from 1996 to 1998 (from 72.2 to 99.8), and if the market would not settle soon, further widening of the spread would appear. This situation is due to the fact that the large supply coming to market put pressure on corporate bonds. So, the debt was concerned about the quality and was priced by investment-grade companies with two to three days, leading to the widening spreads on the costs of the debt.

In terms of the conditions for debt, there were some limitations for WorldCom. Firstly, Credit Facility Covenants limited additional debt unless WorldCom had sufficient cash flow to serve it. Secondly, WorldCom could not sell an asset unless the Company was regarded receiving fair Market value and unless at least a portion of the proceeds from the Asset are received in cash, reducing the flexibility for WorldCom. Finally, there were limitations of restricted payments and investments, such as avoiding company from prioritizing its cash flow for the benefit of junior creditors.

Bond Ratings – Mohammed Altuwaijri

Bond rating agencies help in the analysis and evaluation of the credit worthiness of the corporate and the issuer of the debt. Therefore, the companies help to assess the interest payable of the bond (Megginson &Smart, 2009). For example, higher credit rating individuals pay relatively lower interest rates with lower risk premiums than low rated issuers. In addition to that, the credit ratings determine whether one is eligible for debt and other financial instruments for the investor’s portfolio. The bond rating agencies also analyses both public and private financial and accounting information about economic and political factors that may affect the ability and willingness of a government or firms to meet their current obligations efficiently.
Such companies also provide an overview used to measure the risk characteristic in the financial instrument. Thus, an investor is able to assess the level of risk and compare it with expected rate of return, which he is capable of optimizing the risk-return trade off. According to Megginson and Smart (2009), the bond agencies provide enough information concerning the company that is riskier to invest, therefore, providing advice to any investor willing to invest in that particular company where the bonds ratings are low. Therefore, the responsibility of major agencies to the investment market is that it helps to reduce informational asymmetry between the investors, the lenders, and issuers about the credit worthiness of corporate institutions.

Financial Strategy – Mohammed Altuwaijri

From the given financial information of WorldCom Inc., it is possible to compute its financial ratios, debt to total assets, current ratio and return on assets. According to Moody’s Bond Rating Definitions, based on analysis of debt/total asset ratio, the bond rating is Baa2 in the year 1996, Ba1 in 1997, B2 in 1994 and C1 in 1995. The same ratings will be applicable when current ratio is selected. The current ratio measures the ability of the company to pay its liability. For instance, the ratings Baa, would apply in 1996 with a good current ratio of 1.2.

Therefore, it implies that despite the current asset being able to offset the current liabilities, the return is low and thus is risky for the company because getting positive return would not be possible. In 1997 the debt /total assets is 39.7%, the current ratio is 0.8 and the return on asset is 1.7%. It shows that the return is lower despite having a considerably fair current ratio; therefore, the rating would be Ba.

The factors contributing to the difference in ratings is the change of forecasts of default by a significant amount and not changes in the short-run credit risk. Another factor is the contract between the firm and investor, for example a contract to pay more quickly and increase collateral thereby raising the cost of financial instruments. Moreover, the existence of other external support such as guarantees, insurance and collateral would reduce the impact of risk.

Financial Structure – Papamagatte Diagne

In 1998 the firm filed a shelf-registration statement with the SEC seeking permission to raise up to$6 billion over the next two years but outsiders expected the funding raised through several small offers. The issue includes four tranches of debt: $1.5 billion in 3-year notes, $1 billion in 5-year notes, $2 billion in 7-year notes, $1.5 billion in 30-year bonds. The tranches offer different degrees of risk to the investor. The average coupon rate on the bonds from 3 to 30 year maturity was 7.6% with the 30-year tranche with a yield of 8.25% which was 2.6 percentage points above the 5.66% rate investors were receiving on 30-year Treasurys at the time (www.wsj.com/articles/SB1020179510717846160). The higher yielding bond was especially attractive to investors looking for high yielding bonds with the Federal Reserve cutting interest rates. The issues carry an annual fixed coupon rate with the interest payable to bond holders on a semi-annual basis. The issuance was perceived as normal, ‘plain vanilla’ debt with a high value.

Covenants regarding mergers, consolidations, and transfer of assets allow WorldCom to freely merge with another company as long as it continued to exist as a corporation. The intent was to retain their high credit rating by not allowing a company with a lesser rating to decrease their credit rating. A merger or acquisition can cause the combined company’s credit rating to drop. In a study of 150 US merger and acquisition deals since 2000, A&P found that 25% of the time the initial ratings impact after the transaction’s announcement was a downgrade of the buyer by on or more notches. Years after the deal a decline in credit is more likely with 53% of buyers eventually downgraded by one notch or greater (http://ww2.cfo.com/ma/2013/09/strategic-acquirers-jeopardize-credit-ratings/). Covenants regarding liens do not allow a subsidiary to create a lien against any property or assets, currently owned or acquired later, at higher rates than other debt. The goal is to maintain bondholder’s priority of payback in case of liquidation.

Credit facility covenants limiting additional indebtness limit the ability of the company to incur additional debt that exceeds a specified ratio of EBITDA to interest expense or a certain level of total debt to total capitalization. The ratio of EBITDA to interest expense is a measure of financial durability and a ratio above 1 indicates a company has enough cash flow to cover the interest on debt interest expense. The debt to total capitalization ratio measures financial leverage. A company that is over leveraged has a greater default risk which could lower their credit rating. Limitations on asset sales and disposition of the asset sales proceeds say the company cannot sell assets unless the Board determines the asset is priced at the fair market value and some portion of the proceeds from the sale are cash. Proceeds from the sale may have to be used to repay senior debt or be re-invested within one year. The purpose of this covenant was to maintain enough assets to cover the debt. This capital structure provides a relatively low risk of default on debt. Additional situational covenants stated the $7 billion credit facility would be reduced to #4 billion if the MCI merger was not completed October 5th, 1998 (My birthday; junior year of high school). The extended credit facility was intended would have been supported by the new cash flow from MCI. Limitations on restricted payments and investments covenants limit the ability of the company to pay dividends, repurchase stock or invest in joint ventures. WorldCom could make “restricted payments” of up to 50% of net income plus a defined “restricted payment basket”. The goal was to have enough cash to cover obligations to junior creditors.

Investor Approaches – Qian Dou

To repurchase the 20% stake British Telecommunications held in MCI, WorldCom announced intentions to market $3 billion to $4 billion of debt in the first week of August 1998. If there was sufficient demand, the offering could even reach $6 billion, which exceeds the previous record of $4.3 billion set by another company in May 1997. WorldCom offered to purchase MCI Corp. for $37 billion in November 1997. After this acquisition, WorldCom would become the fourth-largest long-distance telephone company in United States.

WorldCom war rated Baa2 by Moody’s and BBB+ by Standard & Poor’s, which is in the medium-grade obligations and has speculative characteristics.
Generally speaking, bonds have interest rate risk, redemption risk, credit risk, liquidity risk, economic risk and industry “event” risk. In June 1998, the interest rates of treasuries tend to increase. And Baa-rated corporate bonds experience a decrease in yields from Jan 1997 to Jun 1998. In fact, WorldCom’s bond had relatively significant interest risk. Considering the devaluation of the Thai currency and Japanese yen and signs of slowing corporate profitability in the domestic U.S. economy in the second quarter, the corporate bond also faced serious economic risk. In addition, considering the fluctuation in telecommunications industry, industry risk may exist.

WorldCom planned to raise up to $6 billion over the next two years in January 1998. WorldCom had a large commercial paper program, and MCI was cash-rich following its sale of Internet business. In addition WorldCom had recently agreed to a new $12-billion band credit facility. However, all these factors seemed to argue in favor of a smaller public offer. Brandt, treasurer of WorldCom Inc., planned to use the bank debt to pay BT for the 20% stake, and thereafter to pay off the bank debt with newly issued bonds.

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The above graph shows the trends of Moody’s Baa-rated corporate bonds and U.S. treasury over 10-year composite rate. Yields of both of them decreased since May 1997, and the spread tend to increase.

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The above table shows corporate bonds in telecommunication industry. Coupon rate of WorldCom’s bond were based on the basis-point spreads for corporate bond over comparable-length treasury securities and the industry status.

The firm planned to raise up to %6 billion within the next two years. The issuance called for four tranches of debt to be offered: $1.5 billion in 3-year notes, $1.0 billion in 5-year note, $2.0 billion in 7-year notes, $1.5 billion in 30-year notes. Large part of the debt has a medium-length maturity or even shorter. Only $1.5 billion of total $6 billion debt is long-term debt.
The MCI merger has boosted awareness and interest in the firm. Investors had responded favorably to the announcement of the merger. This fact can be proved by the stock-price response to recent telecommunications mergers. Compared to 22% increase in S&P 500 and 40% increase in Industry index, stock price of WorldCom increased by 72% after the announcement of this merger. The company had cobbled together various communications company, and by the summer of 1998, the company was viewed as the industry leader by many observers. In addition, WorldCom reported $2.61 billion revenues in the second quarter of 1998, a 45% increase over the same period of the previous year. Net income was $228million, compared with $44 million the previous year. From 1994 to 1997, WorldCom kept increasing in revenues. And the debt to asset ratio is at about 40% in 1997.

Also, many analysts believe that WorldCom’s debt would be upgraded to the low single-A area, which shows the confidence and the optimistic attitude toward WorldCom.
Considering the significant fall in the Dow Jones Industrial Average on Monday and Tuesday of the projected issue week, some money flowed from stock market into corporate and Treasury securities, which also shows investors’ preference for bonds at that time.

Market observers believed that WorldCom’s debt, which was currently rated Baa2 by Moody’s and BBB+ by Standard & Poor’s, would be upgraded to the low single-A in the upcoming year. They seemed to have a positive view to WorldCom’s debt.
Based on Moody’s Bond-Rating Definitions:
Baa bonds are considered medium-grade obligations, which are neither protected nor poorly secured. Security for interest payments and principles are adequate for the present, but certain protective elements may be lacking or may be characteristically unreliable. Such bonds lack outstanding investment characteristics, and actually have speculative characteristics.
Bonds are rated A possess many favorable investment attributes and are considered upper-medium-grade obligations. Factors giving securities to principle and interest are considered adequate, but may suggest a susceptibility to impairment sometime in the future.

Based on the covenants contained in WorldCom’s public bonds and bank credit facilities, the company will: Restrict mergers, consolidations, or sale of all assets that would result in an impaired credit; Protect relative seniority to income producing assets; Restrict additional debt unless cash flow is sufficient; Maintain credit quality/rating; Maintain asset coverage of debt and ensure assets remain dedicated to main lines of business; Extend the large credit facility with the support of MCI’s additional cash flow; Prevent cash from leaving company to benefit the junior creditors/equity.

Outcomes – David Ballantine

It seems that the market and its participants did not accurately evaluate risk and reward in regard to the WorldCom (WC) experience. First of all, WC had been accumulating and acquiring companies for many years prior to the MCI merger. They paid top-dollar for these companies as well (including MCI) because of the high growth telecom industry. The market should probably have taken into account the increased risk that comes from acquiring more companies and issuing more debt. WorldCom appeared to have its ambition set on AT&T in the long-distance telephone market. In its ambition, WC might have failed to fully account for the bankruptcy risk of issuing $6 billion in bonds in order to finance the $37 billion acquisition of MCI. Furthermore, investors and the market as a whole failed to take into account the risk.

It was widely believed that WC’s bond rating would be upgraded from BBB+ to a low single-A category in the next year. Considering the increases in debt issues and loans that were occurring for WC, this upgrade does not make much sense, at least in hindsight. The failure here was that the market and investors relied in WC as a great company that couldn’t fail. They didn’t see that WC had likely overextended itself in the telecommunications market, in acquisitions, and in issuing debt. There seemed to be a bandwagon effect in line with WC’s attempt to compete with AT&T. The market was assuming that WC would be able to safely finance the acquisition of MCI. When the deal to buy MCI was announced, WC’s stock price, the S&P 500, and the industry all increased by 72%, 22%, and 40% respectively.

It might have helped to look at the key ratios for WC as compared to the long distance telephone industry. Many ratios for WC were lower than the industry average. WC’s profit margin was 2.3%, compared to industry’s 5.1%. WM return on equity was 2.8%, compared to industry’s 8.3%. And the other key ratios were less than the industry, including return on assets, revenue/assets, interest coverage ratio, and current ratio. In particular, the interest coverage ratio for WC war only 3.5, compared to 9.3 for the industry. The bonds ratings companies could have used a better process in rating WC’s bonds. They might have done well to look at the ratios as described above.

WC also may have overestimated the synergies with buying MCI. They reasoned that their high bid price of $37 billion reflected the synergy value. But synergy can be hard to calculate and estimate, so WC should have scaled down its synergy estimates. It can be very difficult to integrate synergies in large companies with large infrastructure. The market and investors in turn overestimated the synergies as was shown by the positive results of the stock, industry, and bond prices.

Finally, the market and investors should have looked at WC’s (later known as MCI-WorldCom) management. The long-time CEO Bernie Ebbers seemed to drive a lot of the financial, accounting, and managerial irregularities that occurred. A closer look on Ebbers and the other relevant managers might have shed more light on the situation.

In conclusion for this section, we believe that the market did fail to some degree in this case. But “market failure” is a complicated concept, which would require us to define what the market was in this case, and how that specific market failed. There were many relevant aspects to the eventual bankruptcy of WorldCom and the events leading up to it. In terms of the market, the telecom industry was certainly not a “free” marked absent of government regulation. Though there was a lot of deregulation during the 1990s.

Responsibilities – Yanchao Wu

On 21st July 2002, WorldCom Inc filed bankruptcy to the awe of many considering that it is the second largest telecommunication provider company in the US. The collapse was heavily noted in the world because of the network of people it affected, besides its employees. This included outside people like the retailers, the government and bankers having direct attachment to the company. The failure of the company is sourced from the poor business decisions made by the top notch officials who manipulated the earnings with inappropriate entry in the books account. Apart from the executives, three key participants facilitated market failures and they include investment banks, rating agencies and the investors (United States, 2004). This paper presents an analysis of the case study to find how these three key participants can be related to the failure.
Investment banks

Investment banks are considered key participants in the failure since they were responsible for aiding the company in selling its cooperate bonds to the public. In which case, the major responsibility of the four investment banks featuring in the case was to ensure that the company sold the bonds to as many investors as possible. The selling of the bonds was just two years behind the company’s bankruptcy filing. Instead of the investment banks conducting adequate examination of the company’s financial status, they blindly entered the deal of selling billions of bonds. In which the investment banks failed because they did not undertake full responsibility of investigating financial position of the company before acting as the company’s agent in selling the securities. However, the investment bank supported their decision as most appropriate by stating that they relied upon the financial statement released and vetted by the company’s editor. They solely lay their claim that they were duped by fraud witnessed in accounting procedure of the company.

The rating agencies can also be considered as major participants considering that they ignored their responsibility of assigning appropriate credit ratings to the company. They rated WorldCom bonds as investment grade, while failing to flag problems exhibited within the company’s operation. However, the agencies supported their actions by asserting that they could not pinpoint fraud done by the company.

The investors are important part of any large corporation, especially with their contribution to the operation therein. The sole responsibility of investors in this case was to ensure corporate governance system of the company was up and running well. This could be through their involvement in providing legal protection to the company to ensure that the company is not affected by the market failure. However, the case of WorldCom presents a situation whereby the investors ignored their responsibility thereby leading to the failure of the company to balance short terms gains with prospects of long term. On the brink of failure, the company was not attractive to the investors thereby making them to shrink their contribution to the operation of the company. The books of accounts were no longer attractive and the investors had to make a choice of quitting their responsibility in order not to invest on undervalued stocks of WorldCom.

References
United States. (2004). The WorldCom case: Looking at bankruptcy and competition issues : hearing before the Committee on the Judiciary, United States Senate, One Hundred Eighth Congress, first session, July 22, 2003. Washington: U.S. G.P.O.