Read Confessions of a Wall Street Analyst Online
Authors: Dan Reingold
Joe was uncharacteristically quiet. I suppose he was trying to act gracious and authoritative, as he’d seen other chief executives act in the past. Or perhaps he knew what was coming.
He deferred to Cy Harvey, who was president of the Anschutz Corporation and, at least for today, was the designated stand-in for Phil Anschutz. A round, quiet man who had seemed rather gentle until this point, Cy didn’t waste any time by describing his latest elk hunt. Instead, he sat down and immediately launched into a diatribe against a very stunned analyst—me. He explained that he had just read my most recent report, in which I argued that the long distance industry was headed for an increasingly competitive period given the entry of the Bell companies and low-cost startups like Qwest. I had, indeed, written this; it was, and had been, my basic position for the past few years. At risk, I believed, were the incumbent long-distance players, not the startups or the Bells. But Cy failed to see the distinction. He thought I was bearish on the long distance market and, by extension, on Qwest.
“I don’t understand how Merrill could be a lead underwriter [of the coming Qwest IPO] with a research opinion that is so negative on long distance,” he said menacingly. I stopped eating my muffin, mid-bite, and swallowed anxiously. What the hell was going on here? I sneaked a look around the table to see Middleton and Allison equally frozen, smiling thinly, forks in air. A guy we’d never heard of named Cy Harvey was telling us that Merrill wouldn’t—and shouldn’t—underwrite Qwest’s IPO because of my research opinions. Not only was this a breach of social decorum—these “meet and greets” were supposed to be
light
—but it was a naked attempt to corner me, or at least intimidate me. And the irony was that I was actually bullish on Qwest.
I tried to look unruffled as I planned my response. I looked over at Allison, who, although normally pretty hard to faze, seemed startled. I hoped this was no big deal for a former naval officer. I had never had a run-in with Allison about my research or opinions, even though there had likely been many complaints from AT&T and MCI, two of telecom’s largest fee genera
tors. Tom Middleton, the banker, and I had a mutual respect for each other, so I felt that I’d have some backup there, though he certainly wouldn’t have complained if I suddenly turned into a screaming bull on all the companies that needed banking help.
I waited for Cy to finally stop haranguing me, and when he took a breath, I jumped in. I told him, as calmly as I could, that my report was about AT&T, MCI, and Sprint—the incumbent long-distance companies—and that I thought the Baby Bells were, as a result of the Telecom Act, going to take considerable market share from them. But to do so, the Bells would need to lease or buy long distance capacity from other companies such as Qwest. “That would be very good for Qwest,” I said. Cy didn’t seem to register what I had said.
Middleton, trying to defuse things, suggested that we set up a meeting with Joe and Qwest’s CFO, Robert Woodruff, to develop some models. This was a normal course of action for an analyst: dig in deeply and work up a range of valuation possibilities and an estimate of what price the market might pay for the IPO. This was a guessing game, affected by macroeconomic events, industry trends, investor psychology, and a million other factors, but ultimately we all had to make a call. I said my final view on Qwest would come after my team and I had completed our forecasting and valuation analysis, which likely would take a month or two. I promised to dig deeply into Qwest’s business plans and its financials.
But Cy would have none of it. He repeated himself a few more times, hammering the point home just in case we’d missed it (we hadn’t): How could Merrill expect to underwrite the offering when its research analyst was so negative? (Believe me, Merrill didn’t expect to win the deal by this point.) I wondered if Salomon had lobbied for the banking by contrasting Jack’s more bullish reports with mine. Another explanation that crossed my mind as I sat there was that Merrill’s bankers, my own colleagues, had set me up in order to cover their own asses and show Herb that the reason this IPO wouldn’t be won was not because of any failure on the banking side, but because of my research opinions. Maybe I was getting a bit paranoid, but it wasn’t hard with this crowd glaring at me. I took solace in the realization that I was still the top-rated analyst on that silly poll and that I still had another year left on my three-year contract.
The room was thick with tension, and everyone in the room sensed it and wanted to avoid it, even Joe Nacchio, who would normally be the first to jump into the fray. But it was one of his first days on the job, he barely knew
Cy, and he probably understood that the worst thing would be to have a big bank like Merrill, with so many retail investors, as an enemy when he was personally holding millions of Qwest stock options. So he decided to try to calm the waters.
“I think Robert and I should meet with Dan and his team and explain our plans, our opportunity, and the assumptions underlying our forecasts,” he said, far more calmly than the argumentative man I remembered from AT&T. “I’m sure that will help.” Perfect, I thought. Bring me up the learning curve, show me why your assumptions are what they are, and I’ll go back and analyze it, forecast it, put it into my strategic view of the industry, and come up with a fair valuation.
At this point, Allison chimed in for the first time, trying in his measured way to calm everyone down. “You know,” he said, looking at Cy, “there are many similarities between the long distance industry and ours, investment banking. Many analysts have alleged that our business has overcapacity too. Yet investment banks’ stocks have been soaring for the past several years despite the caution of many analysts.” In other words, in a market like this one, it might not matter what any research analyst thought. Cy just grimaced. Whatever was up his butt wasn’t going away.
Finally, the meeting ended. Mark Kastan and I went back down to our offices on the 20th floor. “Boy, did we just get ambushed or what?” I fumed. “That’s pretty embarrassing to have a client attack our research in front of Herb. Who is that Cy guy anyway?”
“I don’t who he is, but he must be Phil’s hatchet man,” Mark replied. Yeah, I thought: knows nothing, hears nothing, just delivers the final blow and moves on. The whole thing unnerved me, especially when banker Tom Middleton called me later that day to needle me a little bit.
“Quite a meeting, huh, Dan?” he chuckled. “How’s it feel to be the guy that Herb Allison will remember for losing one of this year’s biggest IPOs?”
The answer was that I felt incredibly pissed. Pissed because some jerk who knew next to nothing about telecom was trying to do what Bernie had joked about two years earlier: make investment banking fees contingent on bullish research opinions. Pound the table, win the business. Simple as that. And Tom turned out to be right: in February 1997, Qwest made its selection for the lead underwriting slot for its IPO. It was…Surprise! Salomon Brothers.
Much to the chagrin of every telecom banker on the Street, Salomon and its star analyst-cum-banker, Jack Grubman, were increasingly dominat
ing the telecom banking business. There was no joint lead underwriter on the Qwest IPO, which was tantamount to a loss for us and every other serious investment bank out there. No, the whole enchilada went to Salomon, along with the power to determine how many shares various clients got, called allocation. Merrill and everyone else were relegated to a co-manager role, which meant nothing other than that we’d all be thrown a very cheap bone to be sure some shares went through each of our firms. I was hardly surprised.
Despite the Qwest debacle, I was feeling quite pleased with the way the industry was shaking out. The Bells were advancing and AT&T was struggling, as I had predicted; many of the merger and acquisition deals seemed to support my arguments; and my clients seemed more than pleased with my research. But not everyone thought I was heading in the right direction, least of all when it came to WorldCom, which continued its pattern of aggressive growth and acquisitions—with Jack cheerleading all the way.
Fidelity Investments, the world’s largest mutual fund manager, wasn’t a big fan of mine. Or more accurately, the new telecom analyst there, Nick Thakore, wasn’t. Nick was a young, very smart MBA from Wharton who a year earlier had replaced Abby Johnson as Fidelity’s telecom specialist. Abby, the daughter of Fidelity’s founder, Ned Johnson, became president of Fidelity Management & Research Co. in 2001 and is now worth roughly $12 billion, thanks to her dad’s astute estate planning. Not bad for a former telecom analyst.
In the spring of 1997, I went to visit Thakore during one of my Boston marketing trips and found myself being ripped a new one by this 20-something man-child. Mark Kastan remained the lead analyst on WorldCom, rating it Neutral. I agreed with Mark’s caution about WorldCom. Mark also felt strongly, as I did, that the Baby Bells’ entry into long distance was going to hurt all the existing long distance players, including WorldCom. And, embarrassingly, neither he nor I yet understood how radically the Internet would change the dynamics of the telecom industry.
But Thakore had bought the Jack Grubman pitch, hook, line, and sinker, and told me that I had it all wrong. He parroted the lines I’d heard before: WorldCom would achieve even higher earnings and revenue growth
rates than investors were expecting. Thakore was focused entirely on short-term earnings-per-share, rather than on the longer-term, industry-wide events and trends I thought would have a negative impact.
Thakore’s argument was reasonable, but it was also one he had to make. That was because he—and Fidelity—had made a huge bet already on WorldCom following its acquisition of MFS. It had been a smart bet, as WorldCom shares had already risen from $18 to $25 since the MFS deal was announced. But his recommendation was, in large part, a self-fulfilling one: WorldCom continued to rise in part
because
Fidelity, the largest institutional investor in the world, had purchased so many shares. Companies like Fidelity moved the market all on their own, creating momentum that usually proved them right after the fact. Trying to mimic Fidelity’s stock purchases was a good strategy, one that many individuals and companies employed, but it had a major downside: if you were still in it when “Fido” started selling, you were toast.
Thakore clearly wanted Mark and me to turn bullish on WorldCom’s shares, pushing Merrill’s retail customers into the stock and propelling its price further upward. That way, I thought to myself, Fidelity could sell its shares at an even higher price. But he couldn’t say that. He had to argue the merits of the stock as earnestly as he could.
To be fair to Thakore, I had no way of knowing if he truly believed WorldCom shares were undervalued or if he was just bluffing. I didn’t know if he saw me as the old guy who just didn’t get it or as the old sage who cut through the hype. What I did know was that our difference of opinion was bad news for me; because of Fidelity’s size,
I.I.
counted Thakore’s vote as four times the vote of smaller institutions. This meant, in a survey in which even one or two votes can make the difference, I might be losing four votes just because of my (and Mark’s) caution on Thakore’s favorite stock. Although my job was to give advice to my clients, to have a strong difference of opinion with them wasn’t always a winning strategy.
Nor was it a winning strategy to have a difference of opinion with the companies I covered. Although my research had lost Merrill the lead manager spot for Qwest’s June IPO, the fact that we had been selected as lowly co-managers meant I still needed to come up with a valuation for the stock,
which was going to go public in June. I asked Megan and Mark to meet with Robert Woodruff, Qwest’s CFO, and to dig deeply into the numbers.
On March 27, we had another meeting with Joe Nacchio and Cy Harvey, but this time, the tone was altogether different. All smiles, Joe led the discussion, telling us all about his latest hires from AT&T and offering to answer any questions we had about Qwest’s plan. We interrogated him about the technology, industry pricing trends, traffic and cost trends, spending plans, key executives, and a host of other subjects. Joe was charming and as forthcoming as I’d ever seen him. Cy was quiet, looking bored. Maybe this Mr. Nice Guy stuff was no fun for him.
But the charm offensive would melt away as soon as they heard the numbers I’d come up with. By April 2, after a five-day marathon of creating different scenarios and models for the company, using a variety of assumptions, Mark and Megan came to me with a preliminary valuation for the company that averaged all of their scenarios: $1.5 billion. After reviewing their work and adjusting some of the variables, I was comfortable with their conclusions. We told Tom Middleton, who in turn, told Bob Woodruff and Cy Harvey. It turned out that our number was much lower than the valuation the Anschutz folks had modeled internally, $1.8 billion, and the whopping $2.2 billion Salomon had predicted. The reaction was not positive, to say the least.
I knew Qwest would try to pressure us to raise our valuation. Did they know something we didn’t? Once we had come up with our model, it was typical for us, or any other analyst, to go over the assumptions with the company to make sure we hadn’t missed or misinterpreted anything. This was another opportunity for the company to try to convince us that we were too conservative and that a higher valuation was in order. We expected that, and came dressed in our finest suits of skepticism.
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 assumptions. 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 15–25 percent below their theoretical value, also known as “private market value.”