Lessons from Bernie Ebbers' acquisitions spree

Ebbers, who stood at six foot five and weighed 200 pounds, bullied his employees. But, he had a charming demeanour with investors. He captivated Wall Street with his vision of dominance of the booming telco landscape.

WorldCom’s dazzling rise under Ebbers was built on two pillars – acquisitions and earnings growth. It grew by gobbling up over 75 companies. In 1998, Ebbers’ purchase of MCI for US$47 billion made it second only to AT&T in the US telco field.

Earnings growth was squeezed out of the acquisitions through cost-cutting and aggressive accounting. The market was fixated on the ever-increasing EPS numbers. He slashed thousands of jobs and even banned free coffee in an effort to hit the earnings growth target.

The music eventually stopped. WorldCom’s undoing was its foray into fibre optics at the turn of the century. The fibre optics industry was viewed as the magic platform for the growth of the internet. WorldCom overstretched itself by excessive investment in fibre optics. The dotcom collapse in 2000 paralyzed the sector and exposed WorldCom’s frailties.

Within a year, the stock lost almost 90% of its value. WorldCom had accumulated US$30 billion in net debt from its buying spree. Crucially, the mood had turned hostile towards fibre optics. The streets were littered with insolvent tech companies.

The spotlight turned on Ebbers. It turned out that WorldCom had loaned him $408 million to buy stock. It was found that he had improperly exaggerated profits by treating operating expenses as capital expenditure.

Ebbers was eventually sentenced to 25 years in prison in 2015 for 11 counts of accounting fraud – the largest white collar conviction.

Asia is in a similar position to the US in the 1990s. There is a massive capital expenditure boom in the telco sector, as 5G looms.

In the 1990s, the US was the centre of the telco boom. Today, the world’s leaders in the field are Huawei, Xiaomi and Samsung, which are in Asia. The low interest rates have spurned a debt binge. The boom is funded by the largesse of the banks. In Asean alone, net debt levels have nearly doubled in the last decade.

There are some traps that Asian investors should be alert to:

First, acquisitive companies could be dangerous investments. Once WorldCom acquired a company, the principal focus was to cut the costs to provide a post-facto justification for the deal. Half of the headcount was axed in several cases.

WorldCom was a roll-up, which is a company that adds value by acquisition. A roll-up company is risky, because the expectation of further success rises with every deal.

Second, complicated accounting practices could be designed to mislead investors. WorldCom aggressively treated operating expenses as capital expenditure to exaggerate its earnings. Capital expenditure is typically deducted from earnings in small chunks.

Third, inflated balance sheets can be problematic when the market turns. After the dotcom collapse, WorldCom had US$30 billion in debt, which was more than twice its market cap.

Wilmar International, a commodity trader, is one of the region’s most indebted. It is carrying US$18 billion of net debt, after spending about US$5 billion in capex in the last five years. The market is ignoring its leverage risk, because its net interest rate is only 2%. This comfortable cost of funding may not be sustainable if the exchange rates move against them.

Ebbers’ lawyers pleaded his innocence by citing his poor grasp of finance. They stressed his roots as a basketball coach, where he often yelled at his players to keep their eyes on the ball. But investors in Asia’s high growth companies should instead keep their eyes out for accounting tricks.

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