The Corporate Pyramid Scheme How WorldCom Lost Billions in the Biggest Pyramid Scheme of All Time
by Bob Hiler
The headlines are starting to come out about how WorldCom cooked its books to hide nearly four billion dollars from Wall Street:
The New York Times: WorldCom Says It Hid Expenses, Inflating Cash Flow $3.8 Billion Wall Street Journal: WorldCom Internal Probe Uncovers Massive Fraud The Financial Times: WorldCom fires CFO after $3.8bn fraud claim
What a story: WorldCom's CFO - working together with Enron accountant Andersen - systematically hid billions of dollars of expenses by reclassifying them as capital expenditures. The sheer magnitude of fraud by WorldCom's accountants is breathtaking, further shaking our faith in what should be our high priests of finance.
But accounting fraud is only half the story. Finding the rest of the story means following that old journalism adage: Follow the Money.
You can't understand the fall of the WorldCom empire without understanding its rise. At its height, WorldCom and its telecom peers generated billions in revenues in the 1990's. After studying its financials, I now believe that these revenues were generated by nothing less than a corporate pyramid scheme. It is the collapse of this pyramid scheme that triggered the fall of WorldCom - and the subsequent rejiggering of financials by desperate management and their complicit accountants.
In other words, accounting fraud is often just the last act of desperation by companies frantic to prop up a collapsing pyramid scheme. The core problem is not generated or caused by accounting fraud - it's caused by something entirely different, and entirely legal.
These days, Fraud is most often a symptom of a new disease on Wall Street: Corporate Pyramid Schemes.
THE RISE OF THE WORLDCOM EMPIRE
WorldCom began life as a real company with real revenues: Long Distance Discount Services (LDDS), a long distance company born after AT&T's federally mandated breakup in 1983.
But WorldCom really took off in the 90's, as it started to acquire telecom networks: IDB's burgeoning communications network in 1994, Williams Telecommunications Group's 10,000 miles of fiber in 1995, and MFS's owned and leased network capacity in 1996.
These network acquisitions allowed WorldCom to enter the lucrative and growing "Carriers' Carrier" market. Here's how it worked: WorldCom leased its long-haul transmission capabilities wholesale to other telecom carriers who didn't want to build out their own expensive global networks.
At first, the strategy worked brilliantly: as the world got more global and the Internet grew, the wholesale market in global transmission began to boom.
But behind WorldCom's rise lay the seeds of its eventual collapse: the perfect conditions for a Corporate Pyramid Scheme.
WORLDCOM STARTS TO PYRAMID
As long as customers are paying real money to a company, a pyramid is unlikely to emerge. All that changed with the birth of a new product called Dark Fiber.
Dark Fiber is dirt cheap to build. That's because the majority of the expense of laying fiber comes from digging holes and hiring submarines. Once I've dug my hole, it doesn't cost me much extra to bury more cables right next to my original. I can bury a cable or two for me, and a couple more to sell. Since I don't plan to use this fiber, I won't even have to attach expensive machines to "brighten" the fiber optic cable with laser-encoded messages. In industry parlance, I've just made "dark fiber."
Dark Fiber became the growth engine for most Carrer's Carriers, as they sold this dark fiber not to customers, but to their competitors.
Take Global Crossing for example: at first, their only asset was Atlantic Crossing 1 (AC-1), a 14,000 km cable connecting the US to Europe. In most industries, Global Crossing's competitors would want AC-1 to be a dismal failure.
Instead, competitors like Deutsche Telekom, Level 3, and Qwest paid Global Crossing huge sums of money to tap into AC-1's dark fiber. Why? Because no one company had an entire global network, they all had to trade and buy from each other to cobble one together.
Telecom became a giant game of Monopoly, with each company trading properties to build the equivalent of hotels. But there was one twist to Telecom Monopoly: if I have Boardwalk and you have Park Place, we can trade and both build hotels.
In most industries, that's not true: once you sell a product, it's gone. But in the world of Dark Fiber, I can sell you access to my network and I still keep the network. I book the revenue, my financials look great, and I run out to build some more Dark Fiber to keep the pyramid going. And to complete my network, I'll buy some Dark Fiber from you - and you can do the same.
In other words, Dark Fiber enabled nothing less than the biggest pyramid scheme in corporate history.
COMPETITION BECOMES GOOD?
Most competitors do annoying things like introduce better products, undercut your prices, and steal your market share. But in the wholesale capacity market, competitors became a good thing. And with Dark Fiber fueling the explosive revenue growth of the industry, more and more companies lined up to play Telecom Monopoly.
Companies started networks in droves:
Qwest originally buried cable for WorldCom and Frontier, but by 1996, began to build its own network in earnest. Williams had sold its network to WorldCom in 1995, but by 1998, began building a new network from scratch. Also in 1998, Canadian construction company Ledcor started 360networks, while a Nebraskan construction company named Peter Kiewit Sons', Inc. morphed into Level3. And let's not forget venture capitalists, who spawned Global Crossing to build a high-speed transatlantic cable in 1997. Some industry players tried to spin this pyramid scheme as part of a new economy. Listen to Michael Mahoney of now-defunct Viatel explain his $150 million investment in competitor Global Crossing: "Welcome to the new world of 'co-opetition,' where telecom companies both compete and cooperate with each other."
But as we've all learned from the recent collapse of the tech economy, you can't repeal the laws of economics. Co-opetition wasn't a consequence of the new economy, it was the cause - creating the pyramid scheme and the IPOs that put so many tech companies on the cover of Fortune.
Continued here: http://www.beyondvalueinvesting.com/articles/worldcompyramidscheme.htm