As I outlined in Hunting for Value, one of my favorite places to look for undervalued opportunities is among bankruptcy survivors, like MCI and Hidden Gems pick AlderwoodsGroup
What attracted me to MCI
Not every value pick is for the long term. Some, like MCI, had the whiff of one of Benjamin Graham's "cigar-butt" companies - buy way below intrinsic value and sell just before it reaches full value. Back in June and July, when I was turning over literally hundreds of companies to select just two for the first issue of Inside Value, I was particularly struck by MCI because:
- It was in a completely out-of-favor industry, with predictions of worse to come.
- The company still bore the distinctly unsavory aroma of the WorldCom fraud.
- It boasted a completely new management team and board of directors.
- It was fresh out of bankruptcy in April 2004, with $41 billion in WorldCom debt wiped clean off the slate.
- It enjoyed strong assets, including a global network of 98,000 miles, 130 data centers serving 150 countries, and loyal enterprise (big business and government) customers.
- The company was producing a lot of cash.
Since the heady days of the 1999-2000 telecom stock price bubble, the industry has crashed and burned. Incredible capital expenditures on infrastructure, 3G licenses, and overpaying for acquisitions led to a massive destruction of shareholder value. The excess capacity still exists and has resulted in wicked price wars among the remaining participants. For AT&T
The WorldCom hangover
WorldCom was the largest corporate bankruptcy in the United States, crushed under the weight of $41 billion in debt and the fraudulent understatement of $9 billion of expenses.
Ex-CFO Scott Sullivan pleaded guilty in March 2004 to three conspiracy and securities fraud charges and is cooperating with authorities. Former CEO Bernie Ebbers is on trial and so far has claimed that he had no knowledge of the understatements.
When a company like WorldCom comes out of bankruptcy, investors generally aren't lining up to invest. The memory of losing large sums of money is etched in the brain, and there is a very real antipathy toward the new company. The name change and new management cannot erase the loss.
A new management team
No board director and only one executive survived the bankruptcy; all the rest resigned or were fired. The key appointments were CEO Michael Capellas, who turned around a failing Compaq before its acquisition by Hewlett-Packard, and CFO Robert Blakely. Both Capellas and Blakely had a reputation for conservative cash management. The board of directors was similarly revamped with former U.S. Attorney General Nicholas Katzenbach as chairman, and former FASB Chairman Dennis Beresford as a director. These management changes were a major key to my investment decision.
The slate wiped clean
Coming out of bankruptcy with "fresh-start accounting," MCI had an enormous advantage over its competitors in that its $41 billion in debt was erased. Former shareholders got very little for their shares -- just a small share in a penalty imposed on MCI by the SEC and some cash from Citigroup as part of a $2.65 billion settlement for its involvement with MCI. The new MCI shareholders were almost exclusively the former debt holders of WorldCom. MCI still had $2 billion in liabilities related to back taxes, but its net debt (debt - cash) was just $1 billion.
MCI still had a lot of strong assets, particularly its worldwide network, which is attractive to multinational companies. Major U.S. companies and government departments did not ditch MCI during the bankruptcy proceedings. In fact, I would say that this and MCI's cash position is what is most attractive to suitors Qwest and Verizon. The consumer division is the weakest asset, particularly with the new FCC ruling on local access.
Cash, lovely cash
MCI was unprofitable back in August, but its units were producing a ton of cash. The cash was being used for ongoing bankruptcy charges, hefty severance charges as the company drastically reduced its workforce, and other one-time charges. Without these short-term commitments, MCI would have produced $700 million in free cash flow in 2004, and I estimated a further improvement to approximately $1 billion for 2005. At zero growth, I put the value of the company at $25 per share.
Fast forward to today
Capellas and his team have executed their plan very well. The revenue declines, particularly in the consumer division, have been outpaced by cost-cutting measures to the extent that cash production has actually increased. The agreed acquisition of rival long distance company AT&T by SBC made it only a question of time before suitors came knocking at MCI's door. The current bidding war will see shareholders amply rewarded for that puff on MCI's cigar butt.
Want some more investment ideas like MCI? Philip Durell is the Advisor for the Motley Fool Inside Value newsletter service and invites you to take a 30-day free trial. He owns shares in Alderwoods.