Man Without Qualities

Wednesday, August 14, 2002

Zombie Phone Home

WorldCom appears to have died long before its Chapter 11 filing. But its expiration was allegedly concealed by the black arts of accounting fraud applied to over Seven Billion Dollars in operating expenses. Through all that period of concealment, WorldCom's competitors - AT&T, Sprint and others - had to compete with the WorldCom zombie. WorldCom's banks say the company's accounting fraud allowed WorldCom to obtain billions of dollars in funds under its bank loans which should not otherwise been available, funds which WorldCom used as an operating subsidy. That is to say, the effects of WorldCom's fraud on its competitors has already been economically similar to - although not yet as damaging as - the effects of the decisions of Eastern Airlines' bankruptcy judge on competing airlines.

In some ways related to solvency considerations, the telecom industry resembles the airline industry. An interesting Wall Street Journal article today asserts:

Buyers have begun rescuing financially troubled fiber-optic telecommunications networks for cents on the dollar, but by giving these companies new life they risk perpetuating the world-wide capacity glut that sent the industry into a tailspin. ... [W]ith rescue efforts under way for a number of these troubled telecom providers, including the latest bankruptcy filer, WorldCom Inc., that capacity may be here to stay.

What's the solution? Well, Stephane Teral, identified in the Journal article as research director at telecom industry-tracker RHK of South San Francisco, California, is quoted as saying: "If you want to solve the problems with the telecom industry in North America, you better liquidate, period."

But if Ms. Teral or the authors of the Wall Street Journal article think that liquidating WorldCom is going to make excess capacity in any way disappear from the market, they are mistaken. [Actually, I don't think Ms. Teral is suggesting any such thing - although the Journal article presents her quote that way. Ms. Teral is probably suggesting that a liquidation would help solve the problems with the telecom industry without eliminating any real capacity. That is essentially the view advanced below.]

The real assets of WorldCom, Global Crossing and every other company that overbuilt telecom capacity will not be destroyed by a legal liquidation of any company. Liquidation will simply cause the sale of those real assets to some other person. That is what has happened to Global Crossing, whose capacity is still very much a part of the market. Industry assets and excess capacity simply exist as real, physical things, there is no good reason to destroy those assets or remove them from the market - and a legal and financial liquidation will certainly not have that effect.

Does that mean that a liquidation of WorldCom is ill advised or that WorldCom's competitors are doomed? The answer is probably "no" to both questions. Ms. Teral is probably right - but perhaps not for the reasons her quote is offered to support.

Worldcom may either be reorganized or liquidated. If WorldCom is the most efficient user of its own assets, then reorganization may be in order. But WorldCom's need to conceal huge operating losses over a period of years while its competitors did not have to do that strongly suggests that WorldCom is NOT the most efficient user of its own assets. Recent industry history therefore suggests that those assets would probably be better used by WorldCom's competitors, who should be allowed to purchase them in liquidation. The liquidation price for those assets would be low, so the purchase should be affordable. The capacity will not disappear, but much will remain unused and dark, probably for the next few years.

The Journal article suggests that WorldCom may emerge from bankruptcy as a fierce competitor:

As struggling companies are bailed out, and the massive debt they incurred to build their lines is wiped away, they "are in a much stronger position to compete on pricing," says To Chee Eng, a Singapore-based analyst with the U.S. market-research and consulting firm Gartner Inc. A revived WorldCom could be an especially nettlesome competitor for the likes of AT&T Corp. and Sprint Corp. Upstart companies such as Global Crossing or Williams still have to fight inch-by-inch to win the largest corporate customers. But WorldCom already has those relationships, and if it eventually slashes prices it will put the most direct pressure on big competitors such as Ma Bell.

But the capacity problem already exists - it is a problem of overabundant, real assets. WorldCom's competitors therefore probably don't have the choice of turning away from the market or this business. If WorldCom's only competitive advantage is financial, as suggested by Mr. Eng, then WorldCom's competitors will have to stay in the market, cut their prices and use their competitive advantages in operations to the extent possible - an advantage which has already been clearly demonstrated by their not having run up huge operating expenses they found necessary to conceal, unlike WorldCom. In the process, one or more of WorldCom's competitors may join it in bankruptcy. If so, once they are reorganized, WorldCom will have no advantage over them - it would be a battle of the zombies. WorldCom will probably simply be driven out of the business again, and require liquidation or further reorganization. In bankruptcy parlance, a WorldCom plan of reorganization based solely on the supposed financial advantage identified by Mr. Eng, and which does not correct the operating deficiencies which have driven WorldCom's losses, is almost certainly not feasible. Under the requirements of Chapter 11, no such plan of reorganization should be confirmed by a bankruptcy court.

But many such plans have been confirmed.

And worse could happen. If the WorldCom bankruptcy court were to adopt the "public service" approach to the case, WorldCom might function as a "reorganizing debtor" under Chapter 11 and court protection for a long time, all the while consuming its own assets the way Eastern Airlines did. That would tend to eliminate real capacity over time. But the effects of such an "elimination" on WorldCom's competitors would probably be even worse than those resulting from WorldCom's emerging from Chapter 11 as a reorganized, recapitalized zombie.

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