INVESTORS WILL BE SPOOKED BUT WILL NOT STRAY FAR

Despite the moral outrage and indignation spewing in the wake of WorldCom's revelations, many in the financial community and the telecom industry believe the scandal will be short-lived in the eyes of investors.

In the immediate aftermath, though, money will continue fleeing the industry. In the first day after the scandal broke, the North American Telecom Index, which tracks large carriers and vendors and includes WorldCom, dropped 14.6% before recovering slightly the following day.

WorldCom's fraud forces investors “to throw everyone in that bucket and say ‘telecom is bad,’” said Scott Ford, president and chief operating officer of Alltel.

“Our sector has been discredited in just about every way possible,” said Dave Schaeffer, CEO of Cogent Communications, suggesting that WorldCom CEO John Sidgmore start the healing process by transitioning to easier-to-understand accounting. “Investors no longer have confidence in any numbers large corporations are putting out. A switch to cash accounting would be seen as a proactive move that would rebuild confidence.”

Concerns over the veracity of financial reports haven't smeared every big player, though. While AT&T and Sprint shares took big hits the day after news of WorldCom's deception spread, BellSouth, Verizon Communications and SBC Communications actually saw their shares hold steady or make slight advances last week. And long term, investors will continue to be attracted by the stability of incumbent carriers, notably the Bell companies, said Blaik Kirby, a vice president at Adventis.

“The incumbents have been regulated and have been under more scrutiny all along concerning how they spend money,” he said. “The more established players are more conservative and generally are seen as a safe investment.”

Investors could be expected to paint all of telecom with the same broad brush, but it would be unfair to do so, said Bill Daley, president of SBC. “WorldCom racked up $30 billion in debt and then gave their CEO a $400 million loan,” Daley said. “Someone should have been asking, ‘What is going on there?’”

WorldCom was viewed as having aggressive accounting methods even before the revelations of last week, Kirby said.

For investors who choose to tough it out, ILECs are doing their best to portray themselves as refuges in the storm.

“We just didn't fall out of the trees. SBC has been around in some version for 100 years,” Daley said. “Investors will always look for stability, and on that basis they won't be able to avoid telecom.”

A more serious issue for those without a Bell system heritage, though, will be access to cash. “This sector is toxic for capital,” and will remain so until its profits stabilize, said Scott Cleland, CEO of Precursor Group.

Currently only the highest-rated companies have any access to debt markets. Similarly, commercial paper, already difficult to access, will become even harder to issue.

Venture capital activity is also expected to slow even more because of the news. According to Bob Pavey, general partner with Morgenthaler Ventures, some of the firm's limited partners are questioning its exposure to telecom. Even more disquieting is the attitude of some venture capitalists, who are swearing off what were until very recently promising industry sectors, such as optical networking, he said.

Perhaps the biggest asset the industry has now is time. Because every big telecom player is expecting greater scrutiny, those that pass this test should once again become acceptable to the skeptics.

Pavey predicted a cyclical phase with more investor activity in telecom as other industries begin struggling. A few years ago, many investors swore off biotech, but that sector has seen a resurgence centered on the surviving companies, he said.

But in the meantime, VCs expect plenty of pain. “Our current companies, especially the ones we expect to start delivering products about now, are really struggling. We will lose some companies that will pain me deeply.”

The downfall of many telecom stocks also will attract value investors, said Mike Robinson, chief financial officer for US LEC. What will separate telecom shares from the rest of the market, which is giving those investors more choices than ever, is the need to be even more selective.

“Right now a lot of telecom companies are at rock bottom, and if you pick the right ones you can do really well,” Robinson said. “But people are going to take their time and do more due diligence. They used to want just sound bites. No more.”

Dana Tardelli, analyst with Aberdeen Group, said he believes telecom might be better off over the long term if the investment community turns its back on the sector.

Carriers are under “unrealistic pressure” to beat expectations and perform, he said. With voice revenues in decline and data's potential largely unfulfilled thus far, 5% growth rates simply aren't possible. Companies desire to meet that goal, though, is forcing them to do things they might not under different circumstances.

“The pressures WorldCom was under are wrought throughout the industry,” Tardelli said. “Less money coming into the sector might not be a bad thing because it would force carriers to refocus on existing assets and customers. Telecom needs a wakeup call.”