NOT SO LONG
You know the routine: The narrator explained that Janus didn't buy into this company merely because the Internet was hot. It invested only after its analysts went out and saw for themselves that the company was well ahead of schedule on its installations. The spot's tagline: "Proof that tuning into the details can turn up sweet opportunities."
What Janus didn't tune into but probably could have was that it was walking into quicksand with this stock. The company in the ad looks very much like Winstar Communications, the ailing competitive local exchange carrier, or CLEC, that filed for Chapter 11 bankruptcy protection on April 18. Winstar was a major holding in two big Janus funds the Orion fund and Strategic Value fund and the filing was the culmination of a sickening slide into insolvency that saw the stock plunge from a high of $65 a share in late March of 2000 to less than five cents a share today.
But Janus, a unit of Stilwell Financial, is hardly the only casualty of the Winstar train wreck (see table). In fact, some of the best and brightest on both Wall Street and Main Street put their faith in this profitless, cash-burning CLEC Putnam Investments, Munder Funds and Fidelity Investments are among the other mutual-fund companies that made big bets. Brokerage titans Credit Suisse First Boston and Salomon Smith Barney were both principal investors in the company's various securities and boosters of its stock. Among equipment makers, Lucent Technologies and Cisco Systems dumped hundreds of millions into the company in the form of vendor financing. And both Microsoft and Compaq Computer invested in Winstar preferred stock.
The damage, in fact, was so well distributed among successful, highly sophisticated investors that Winstar is beginning to look a lot like one of those emblematic disasters that comes to define an era on Wall Street much as the battle for RJR Nabisco came to represent the excesses of the corporate takeover frenzy of the 1980s, or the Long Term Capital Management debacle epitomized the risks of high-tech financial instruments in the 1990s. As Winstar heads for both bankruptcy court and a $10 billion civil trial against Lucent (which on March 30 precipitated the Chapter 11 filing by pulling the plug on a crucial $90 million in vendor financing), the true complexity of its capital structure is only now coming to light. But this much is already clear: Winstar is a prime example of the tightrope financing, shameless stock promotion and blind faith in the future that ran rampant across Wall Street over the past few years.
Perhaps Winstar's biggest champion over its final months of solvency was Jack Grubman, the well-known Salomon Smith Barney telecom analyst and dealmaker. It's no secret that Grubman has been roundly criticized in the past for promoting companies with which Salomon had investment-banking relationships most notably WorldCom. But his opinions are well distributed by Salomon's brigade of 12,500 brokers. And in 2000 he won First Team honors in the annual Institutional Investor popularity contest.
At the beginning of 2001, Winstar had just finished burning through more than $1 billion in cash. And, like all CLECs, it was caught in a capital crunch as Wall Street soured on telecom investments. Grubman was pushing Winstar management's position that the company had a relatively comfortable $1.2 billion in liquidity, which could be counted on to fund its capital-intensive operations into 2002. This sum included $315 million in cash and short-term investments and $700 million in vendor financing from Lucent, Cisco and Compaq. In other words, the vendors supplying equipment to Winstar were largely propping up the company.
That didn't seem to bother many on Wall Street not even after it became clear as 2001 rolled on that Lucent was running into deep liquidity and cash-burn problems of its own. Winstar was still burning through cash to the tune of $1 billion a year, partly because it faced interest expense for the year of about $450 million (not including payments that could be made in stock). But the widely held belief among investors was that as long as Lucent kept writing out checks, Winstar would be OK. With the stock at $20 (or one-third of its March 2000 high), Grubman put out a research note on Jan. 25 urging investors to ignore sporadic speculation that the company was close to running out of money. "Winstar remains one of our favorite CLEC names," he reassured, calling upon his following to "take advantage of any weakness in stock." He reiterated his Speculative Buy rating and $50 price target on the company's shares, which were then commanding a respectable $3.5 billion market cap.
Grubman was even more effusive a few weeks later when Winstar's fourth-quarter earnings report beat Wall Street estimates and strengthened the case that management's operating prowess would eventually rescue the company from its negative cash-flow position. On Feb. 27, with the stock at $10, Grubman wrote, "We have often said that if Winstar's 'pedigree' in the telecom business equaled that of some of its rivals, the sheer results it is producing would alone result in a stock price quite a bit higher, even before accounting for the fact that we think Winstar is severely undervalued."
Manny the Short Seller
A couple of blocks away, Manuel Asensio was apoplectic. The head of New York-based Asensio & Co and a well-known short seller, Asensio had been warning investors to steer clear of Winstar for years. He himself had profited handsomely by betting on Winstar's demise. And he saw a new opportunity to agitate. The former investment banker was so annoyed by the refusal of Grubman and some of his other CLEC-industry peers to ask management tough questions that he issued his own press release on March 8 questioning Winstar's viability and accounting methods. This wasn't exactly a surprise, as the short seller has drawn the ire of the National Association of Securities Dealers, or NASD, in the past for his aggressive stock-deflating tactics.
|Holding the Bag|
|Equity funds with the largest Winstar holdings,
as % of portfolio
|Provident Inv Couns Mid Cap A||2%||01/31/2001|
|Equity funds with the largest Winstar holdings, $ million||Date Reported*|
|* Funds' stakes as last reported to Morningstar||Source: Morningstar|
But Asensio seemed to be onto something. He pointed out that Winstar's $30 million in earnings before interest, taxes, depreciation and amortization, or Ebitda, would never come close to covering its annual interest expense. That meant financing from the ailing equipment vendors was all the more critical. Moreover, he made the point that Winstar had been funding operations by issuing a particular kind of convertible preferred stock known on Wall Street as "toxic preferred." It's considered poisonous for common shareholders because management has the option to pay interest not in cash, but in new shares of stock. That dilutes the value of shares already outstanding which is what makes such stock "toxic" to existing investors.
Winstar sold six different preferred issues to investors ranging from Credit Suisse First Boston to Microsoft. The coupons on the different issues assumed a steadily rising stock price, and if the stock hit that price on the day Winstar repaid them, common investors could count on a set level of dilution. But the lower the common-stock price, the more shares that would have to be issued to pay off a given obligation. And since the stock was falling like a rock, the amount of dilution was essentially unknowable. Some $100 million of the preferred obligations were due within a year.
"We believe that Winstar's beleaguered common-stock holders are embarking upon a dangerous gambit with a far greater probability of losing their entire investment than they realize," Asensio concluded. "We see no reasonable financing or restructuring that can provide [them] with any value."
In a rare sell-side rebuttal to a short seller, Jack Grubman on March 9 issued a detailed, five-page research note accusing Asensio of "lacking an understanding of the CLEC industry" and "reiterating our belief that Winstar is well funded into 2002." Winstar, Grubman explained, was like any CLEC in its growth phase cash-flow negative. What counted was whether it had the resources to build out its network so it could get to a position where it could generate cash. "We believe that if Winstar continues to perform as they've been doing, there will be no issue with [the company] being able to obtain the needed external financing over the course of the next four to five quarters," Grubman said. Never mind the well-publicized turmoil shaking the telecom industry and troubling questions about overcapacity.
As for Asensio's beef about the toxic-preferred stock, Grubman said the dilution could be estimated by simply calculating how many shares would be needed to pay off each of the classes of preferred stock at the given conversion price. He made no mention that if the stock never reached the conversion price, more shares potentially a lot more would have to be issued. For instance, he claimed that Winstar's Series G preferreds would dilute the outstanding common stock by only 25.1 million new shares, assuming a year-end 2003 price of Winstar stock in the mid-40s. But since the price that day was about $10 a share, that assumes the shares would more than quadruple by then a fact Grubman didn't feel compelled to note.
But suppose instead that Winstar shares trade with the market. If you assume the S&P's historical average annual growth rate of around 10%, the shares would be trading at $12.10 a share at the end of 2003 and Winstar management would have to issue more than 93 million shares, or roughly half again as many as the total number of shares outstanding on the day of Grubman's refutation. All that, of course, still assumes a price of $10 on March 9 (the date of Grubman's note), and not the March 30 price of $2.28. In that case, the stock would grow to only $2.27 at the market's growth rate, and Winstar would have to issue 400 million new shares, or roughly two-and-a-half times its March 9 float.
a unit of Citigroup), had a strong economic interest in Winstar's health and the ongoing buoyancy of its common stock. Salomon enjoyed important investment banking ties to the once acquisitive and always capital-hungry CLEC, helping to underwrite secondary offerings and many of the preferred issues. Sources also say that Salomon had a large stake in Winstar's ultrahigh-yielding junk bonds. And high-yield debt will often piggyback off the momentum of the common shares especially as Winstar common stock figured so prominently in the servicing of future preferred issues. Salomon, like Grubman, refused to comment on its relationship with Winstar, or to confirm or deny any stake in its debt.
But others found this obvious conflict hard to fathom. "I was absolutely amazed at how stark the Grubman example was," says George Haywood, a former investment banker and hedge-fund trader who now invests his own capital. "It's one thing to be wrong on stocks and he's not the only analyst and I've even come to expect the usual investment banking [conflict of] interest. But what was absolutely flagrant and unforgivable to me was that he clearly misstated facts especially where dilution was concerned." Grubman discontinued coverage of Winstar a week ago.
Enter Mark Kastan
Salomon wasn't alone in this Winstar intrigue. Across town, Credit Suisse First Boston was also up to its neck in exposure to the bankrupt CLEC. Mark Kastan, the firm's highly regarded CLEC analyst, picked up coverage of Winstar on Jan. 4 with a Strong Buy rating and a $79 price target. This came about a month after Credit Suisse's private-equity arm signed on to a $111 million investment in the Series H tranche of Winstar's toxic preferreds and less than a year after the investment bank participated in the $400 million sale of Series G preferreds alongside strategic investors Microsoft and private-equity house Welsh Carson.
In fact, as a 5% beneficial owner of Winstar, Credit Suisse First Boston earned the right to appoint Hartley Rogers, the co-head of its equity-partners unit, to the service provider's board of directors in early 2000. All told, the investment bank accumulated several hundred million dollars' worth of positions in different Winstar preferred issues.
Kastan, a highly respected analyst and an Institutional Investor 2000 Runner-Up, was prescient enough to reduce his ratings and price targets on a whole group of questionably funded CLECs. Yet he resurfaced following Winstar's seemingly impressive February earnings report to say that "the very strong 4Q00 results clearly give us even more confidence in our bullish outlook for both the stock and continued strong fundamental momentum." Even though the shares slipped to under $8 by March 14, Kastan reported that a Winstar senior management meeting hosted by Credit Suisse First Boston's high-yield analyst "effectively laid to rest many of the recent concerns that we have been hearing from investors, including the quality of Winstar's balance sheet as well as the company's funding status." Once again, he reiterated his Strong Buy and $79 target which implied a tenfold surge in the company's catatonic stock. On April 6, the analyst suspended coverage of the imminently bankrupt company.
Kastan would not return phone calls for comment, but it's worth noting that the analyst has disclosed that he personally has "an economic interest" in Winstar's Series G and H preferred issues and therefore had a strong reason to hope against hope that Winstar stock would somehow find its footing. Never mind that if Winstar went bankrupt Kasten's clients and all other common shareholders would be subordinated to the preferred holders essentially rendering their holdings worthless.
And that, of course, is exactly what happened. In March, under extreme pressure from Wall Street and its banks, Lucent did a spring-cleaning of its books and on March 30 refused to provide Winstar with a critical $90 million in financing it was expecting to help cover a $75 million interest payment coming due. Winstar had no choice but to file for bankruptcy shortly after. The CLEC has since filed a $10 billion civil suit claiming that Lucent reneged on contractual obligations to provide the financing and other aid for building out Winstar's network.
Winstar may prevail; the validity of those obligations is for a judge to decide. But that's beside the point where investors are concerned. After all, vendor financing is supposed to be a tightly limited attempt by an equipment company to help a customer buy new equipment not an open checkbook to pay off debt obligations. When vendors (especially shaky vendors like Lucent) become bankers, it's usually a red flag. At a time when clearer heads on Wall Street had shut off the financing spigots for all manner of CLEC's, the hope that Lucent could somehow prop up Winstar for a better future was nothing more than blind faith something few professional investors would openly admit to as a guiding portfolio strategy. No wonder none of the investors mentioned in this story would comment.
All told, roughly $6 billion in shareholder value was wiped out since Winstar's all-time high in March of 2000, with a stunning $4 billion of that snuffed out since last January alone. The stock now trades on the pink sheets for pennies a share. Not surprisingly, Credit Suisse First Boston and Salomon are still scrambling to salvage something from their investments. After Winstar filed for Chapter 11, a consortium including those two firms committed at least $75 million in debtor-in-possession financing to help the company begin its climb out of a deep fiscal hole.
Both brokerages, after all, have a clear vested interest in greasing the skids to an orderly liquidation. Too bad their clients can't say the same.