WorldCom's debt financing strategy and acquisition risks in telecommunications

WorldCom

1. Strategic Analysis WorldCom\\\\\\\'s aggressive strategy was based on its vision of massive growth in the telecommunications sector. The Internet came online in 1994, and by 1997 it was apparent that there was a tremendous opportunity in telecom, as the critical infrastructure driving the growth of the Internet. WorldCom saw an opportunity at this point to be a leader in the industry. In order to capitalize on this opportunity, WorldCom leadership felt that it was of utmost importance to grow rapidly, in order to earn market share. This is where the move to acquire MCI came into play – it was seen as WorldCom\\\\\\\'s ticket to the big leagues of telecom, something that would allow it to grow rapidly with the growth of Internet traffic. There were definitely going to be risks with this strategy, the massive debt load notwithstanding. Normally, a company growing this rapidly will struggle. It might be able to bring the acquired technology online, but an acquisition like that of MCI would also come with thousands of employees, an organizational culture and other things that will challenge such an acquisition to work. WorldCom felt that this would be worth it in order to build market share, or otherwise it simply did not consider the operational risks that it was undertaking with such a rapid expansion strategy. WorldCom had been increased the pace and size of its acquisitions for several years at this point, so it felt that it would be able to easily absorb MCI, even though that deal with highly complex. The response of WorldCom, therefore, was to adopt a gung ho strategy of simply going ahead with increasingly large and complex acquisitions, of which MCI was just the latest.

2. Situation Analysis The bond market conditions were such that there was strong demand for US issues at the time. This would have significant implications for WorldCom. First, it allowed WorldCom to think that it could issue the large amount of bonds at once. Second, it meant that WorldCom might be able to offer the issue at a lower rate. High demand should push yields down, in the sense that there are a lot of buyers and the issuer can set terms more favorable when demand conditions are high. WorldCom was doubtless also trading on the fact that the Internet was the big hot thing in 1997, and bond investors would trust that the infrastructure underpinning the Internet would be a fairly safe bet, despite being a relatively new business. Stress in international conditions, however, might have the impact of lowering demand for international investors. However, there are two things to remember here. First, if international investment is lower, but American investment can make up for that, then the state of international investment doesn\\\\\\\'t matter for an American issue. The second factor is that tough conditions in international markets usually means a flight to quality, which not only means money flowing into US issues, but also the US dollar. High demand for the US dollar could push interest rates higher as a means to controlling inflation. So there is a risk that while high domestic demand would lower the interest rate, rates could increase at the macroeconomic policy level in response to a surge in demand for the USD. Whichever of these factors was stronger would influence the spread. Stronger demand for domestic issue should tighten the spread, even if the baseline interest rate goes up. WorldCom might benefit from these conditions in terms of issuing, and be able to extract more favorable terms, but it would also be at risk for rising interest rates in the near future, should the strength in domestic issues start to wane. 3. Bond Ratings Bond rating agencies are important for the issuance of debt. While most bond investors have a high level of knowledge about debt products, the reality is that they do not have time to do a full evaluation of each issue. That is a niche filled by the bond rating agencies. They examine each company, and each issue, and then issue a rating. The ratings have been so well-established that they are trusted by investors. An institutional investor might use a bond rating in conjunction with proprietary insight, but more casual investors are more likely to put a lot of faith in the ratings. Therefore, it is important for an issuer to receive a favorable rating, based on its financial condition. Better ratings means lower coupons, which is favorable for the issuer. With higher ratings, issuers also receive the ability to set more favorable terms for their issues. Additionally, a better rating gives the issuer more flexibility with regards to innovative issues. Having the biggest issue of all-time is certainly innovative, if not creative, but it is something facilitated by having a superior rating. Moody had rated WorldCom a Baa2 at the time. This reflects a bond that has speculative characteristics, and is neither highly protected nor poorly secured. This seems an accurate reflection of WorldCom. While the company\\\\\\\'s financials are worse than the industry averages, they are not unreasonable. But there is significant operating risk associated with having grown so rapidly in recent years, which is reflected in growing pains like having losses for two of the past four years. WorldCom was definitely not an A but was probably a little stronger than Ba, which has a fairly high degree of uncertainty. 4. Financial Strategy WorldCom\\\\\\\'s strategy would essentially double its debt, and increase its leverage substantially. It would not maintain the current capital structure, but might bring the company closer to the capital structure it has had historically, including in 1995. However, there were other options on the table for WorldCom. Many observers felt that the company would issue a number of smaller issues. However, there is something to be said for the splash of the biggest debt issue of all time, which might have been perceived by WorldCom management as announcing themselves to the world and making the company a household name. However, the company\\\\\\\'s equity was highly valued, with a P/E ratio of 242.2, about five times higher than the industry average. The company was being overvalued, relative to its actual performance, because of the growth rate it promised through acquisitions and because of excitement about the Internet boom. WorldCom could definitely have used more equity to make the MCI acquisition – there was no need to do the largest debt issue in history, especially not all at once. I believe that a more appropriate strategy would have been to leverage the high stock price to make equity purchase, or at least 50% of the purchase via equity. It is normally good practice to leverage on outsized stock price for acquisitions, and most companies also prefer to maintain a reasonably stable capital structure. There is risk with the strategy that WorldCom undertook with respect to having too much debt on the books, distorting the capital structure. One of the things that was less known at the time was just how short the cycle is for new telecommunications infrastructure. Bond issues longer than a few years are actually inappropriate at this point in the technology development cycle, but I\\\\\\\'m not sure that would have been a well-known thing at the time. Still, taking advantage of sky high equity valuation would have made more sense than going with a bond issue of this size, all at once. 5. Financial Structure WorldCom’s bond tranches are as follows:

$1.5 billion in 3-year notes $1.0 billion in 5-year notes $2.0 billion in 7-year notes $1.5 billion in 30-year bonds

These issues would all carry annual fixed coupon rates, which is standard, and interest would be payable semi-annually, also standard. There were no specific assets or collateral pledged on the bonds, and “only a few standard covenants appeared in the indenture.” There were standard limitations on taking on more debt (subject to EBITDA parameters) and on asset sales and payment of dividends. There was nothing unusual or onerous about these covenants. The case does not specify what yields were being offered in this issue, which makes it difficult to compare. The case does specify other current conditions, relating to similar issuers and terms. It does not appear that there are any special protections within the covenants, such as obligations to maintain a specific current ratio, or other such covenants that might be used to protect creditors. WorldCom is clearly optimistic about its ability to place these bonds, and earn a reasonable spread, and therefore has not incorporate special considerations into the issue. Despite the size of the issue, it might not be necessary to do so, given that the final debt ratio would probably still be within the bounds of reason, and WorldCom is still not junk status. While there is some speculative element to the WorldCom issue, the reality is that there is not enough to justify any strong covenants, and those sorts of covenants might make it more difficult for WorldCom to realize the growth that it intends to realize with the MCI purchase.

6. Investor Approaches The investor view of the WorldCom issue was enthusiastic, indicating that management had read the market correctly. The appetite for corporate bond issues at the time was related to a couple of factors. The flight to quality and safety of US corporates was reflective of the Asian financial crisis, which stimulated a flight to quality, and corporates reflect a need to retain yield. In this type of market, an issue like WorldCom might work. Furthermore, the bond rating is indicative of an investment-grade security with some speculative properties. The Internet was entering into a boom, and WorldCom was definitely seen as a way to get involved in that. It is not difficult to imagine an investor looking favorably upon this issue, despite its size. However, given how much bigger the MCI purchase was compared with other purchases that WorldCom had made, there was definitely more risk here than the market might have realized. The fundamental objectives of investors is to maximize return on a risk-adjusted basis, and that is true for both debt and equity investors. A debt investor here might have looked at WorldCom as a company that was aiming to be a blue chip company, but at this point had a little bit lower rating. So an investor looking at this issue might have been aiming to get a little bit of extra reward, thinking that they were not taking on a substantial risk. For the bond investor, this may have been a little bit irrational, in the sense that WorldCom did not provide any additional coverage with its terms and covenants. Some investors were clearly looking at this more through an equity frame than a debt one, and willing to take on extra risk here, and not seeking to cover this risk.

7. Outcomes It is a little bit unfair to criticize the investors here for failing to anticipate WorldCom’s failure. First, the failure was the result of fraud, not leverage. The fraud was committed by Ebbers and a few others, and these people had to this point been running WorldCom in an ethical manner. The fraud had not yet occurred in 1997, and was actually several years away. When one looks at the fraud triangle, those conditions did not yet exist at WorldCom or for Ebbers personally. The result is that the fraud was not so easy to anticipate at the time. The second element is that the dot-com business was booming at the time, and had not yet reached bubble status. The bubble had burst by the time that WorldCom started the fraud. If this debt issue had occurred mid-bubble, that might have been easier to predict. The reality is that such a bubble had not occurred in a while, and therefore was not going to be that easy to predict in 1997. The one thing that might have been a red flag was investing so heavily in the Internet, at a point in time when the technology was still just emerging. Emerging technologies often post challenges for investors because the rapid pace of change could leave a company like WorldCom leapfrogged by someone else, and losing market share rapidly. Investing in the 3-year bond would have made a lot more sense than investing in anything longer term, at least without additional protections. That said, it cannot be stated enough that WorldCom failed because of fraud, not because its business wasn’t working, or because it had too much leverage. So investors in 1997 cannot be tagged with a failure to anticipate – overeagerness maybe but predicting fraud without the key elements of the fraud triangle in place is honestly not that easy.