WorldCom Inc.: survival at stake.

Gollakota, Kamala ; Gupta, Vipin

CASE DESCRIPTION

The primary subject matter of this case concerns management of mergers and acquisitions in a turbulent environment. Secondary issues examined include strategic, organizational, and competitive issues that push the companies to the brink of destruction, and that may induce them to breach the boundaries of ethics and accountability for remaining afloat. The case has a difficulty level appropriate for first year graduate level. The case is designed to be taught in 1.5 class hours and is expected to require 2 hours of outside preparation by students.

CASE SYNOPSIS

Accounting fraud issues have taken the center stage whenever there is a discussion about the bankruptcy of WorldCom. However, the fraud issues were just an outcome of a deep-rooted deterioration in the performance fundamentals of WorldCom. In this case, we discuss some of the strategic, organizational and environmental issues that led to the survival challenges, and hence precipitated ethical irregularities and downfall of the company.

INSTRUCTORS' NOTES

OVERVIEW

This case focuses on the growth and decline of WorldCom. The case traces the growth of WorldCom, till it filed for bankruptcy in 2002. Although accounting fraud issues have taken center stage when discussing the bankruptcy of WorldCom, the roots of WorldCom's decline lie in its turbulent industry, and strategic and management errors made. WorldCom shows meteoric rise and an equally meteoric fall. The case traces the developments in the telecommunications industry from the breakup of AT&T till 2002. Deregulation and technology have had major roles in shaping the industry. While deregulation increased competition in the long distance business, the local exchange business was not so transformed. Long distance business became increasingly commoditized and competition was price based. Technological advances allowed for massive increases in the transmission capability of networks, resulting in the expectation that there will be a convergence in data, voice and video. Many firms wanted to be the provider who would provide all these services to the consumer and greatly increased their network capacity by laying new lines. Unfortunately the demand boom expected did not happen and all that resulted was a gross mismatch between supply and demand.

WorldCom started as a small long distance reseller and by a series of acquisitions managed to become a national player, with a strong presence in the rapidly growing data business. WorldCom was the leader in the internet backbone business and was strong in the business segment of long distance telephony. WorldCom went on to buy MCI, a company much larger than itself. Various problems may be seen with the merger. The price paid was too high and the company took on a lot of debt. MCI was in a slow growing highly competitive segment--the long distance segment. By buying MCI, WorldCom was increasing its exposure to this segment. Whatever synergies and cost savings that this merger might have obtained were quashed with the poor implementation of the integration. Culture clashes and unreasonable cost cutting resulted in MCI executives leaving the company. Another problem with WorldCom was its lack of presence in the wireless business. WorldCom's attempt to correct that--by its bid to acquire Sprint--was defeated when the Justice department turned down the merger. This left WorldCom with strategic weaknesses, financial burdens, and with a large exposure to the slow growing long distance business. The situation came to a head with disclosures of accounting fraud that involved top management--right from the CEO. Failure to make payments resulted in WorldCom filing for bankruptcy protection.

DISCUSSION QUESTIONS

1. What are the major driving forces in the telecommunications industry? How have they affected the long distance business?

The major driving forces are: regulation/deregulation and technology.

Impact of Regulation/deregulation: Initially, the telecom industry was a monopoly and consisted of one firm: AT&T. AT&T controlled all aspects of telephony--it owned all the local and long distance networks in the US. Thus a call would travel from the home or business of a subscriber on AT&T lines.

Deregulation began when AT&T was ordered to break up. A distinction was made between the local and long distance businesses. Figure 1, shows the process of transmission. While local exchanges continued to be monopolies, the long distance business was opened up to competition. Local exchange was controlled by the creation of 22 separate holding companies (Regional Bell Operating Companies or RBOC's also called Baby Bells). The original company, AT&T, stayed in the long distance segment. Subscribers could now choose their long distance company (AT&T, MCI etc), but did not have a choice in who provided them local services--local service was provided by the RBOC controlling their geographical area. These RBOCs controlled a crucial component of the communication network--the "last mile" or the final connection to the consumer's home. A long distance carrier had to use these local networks to reach their subscribers and was charged an access fee by the RBOCs. The result was an entry of new competitors into the long distance business, which was becoming increasingly competitive. Prices for long distance calls dropped amongst allegations of high access fees pushing up costs.

[FIGURE 1 OMITTED]

Increased deregulation took place with the passage of the Telecomm Act of 1996. Under this Act, long distance companies were allowed to provide local services by setting up their own facilities if they did not want to pay access charges. Local exchange carriers were required to open their networks and provide access at wholesale prices. This opened up the door for long distance companies to set up their own facilities to reach their customers and avoid the access fee. Two dominant business models emerged--facilities based operators (companies that invested in laying down lines and networks) and resellers (companies that bought access to networks from facilities based competitors at wholesale prices and sold it to customers for a markup).

Impact of Technology

While deregulation opened the door for competition, technological changes amplified trends and created turbulence in the industry. Digital technology allowed for longer transmissions without signal losses, with better quality at no big cost increase. Developments in the carrying capacity of fiber and increasing substitution of fiber for traditional cable resulted in big increases in bandwidth (volume of data that can be transferred through a network). Towards the end of the 90's there was considerable euphoria as to the potential market size in telecom. This euphoria was fuelled by increased bandwidth that was available that would potentially allow the same provider to provide a subscriber access to the internet (data), entertainment (video) and telephone (voice). The opportunity to provide data, video and voice with the same network is referred to as convergence. The potential of staking a leadership position in a converged telecom industry, the rapid growth of the internet, and the easy availability of capital during the stockmarket boom resulted in huge capital investments in networks. Industry transmission capacity increased 500-fold between 1998 and 2001 (when we account for the technological evolution of carrying capacity of the fiber optic cable). Thus there was a massive increase in supply of telecommunication services, both in number of firms offering the services and total volume of transmission capability. Unfortunately, the exponential demand growth expected from converged networks did not happen. Further, technological progress in wireless networks resulted in a switch from wired to wireless networks further dampening the demand for all the additional capacity. Demand growth during the period when supply increased 500-fold was only 4-fold. Thus we see a huge mismatch between demand and supply and an industry moving rapidly from one of great promise and opportunity to one with tremendous overcapacity.

These changes may be summarized as given below:

Demand

Wireless (-)

Price decrease (+)

Convergence (?)

Supply

New entrants (+)

Capital availability (+)

Fiber capacity (+)

2. What is WorldCom's corporate strategy till 1997? Did it add value?

WorldCom's corporate strategy can be classified as one of related diversification. WorldCom started out as a reseller, but by acquiring companies with facilities it increased its geographic coverage, became a facilities based provider and increased its market power. Later on, with the belief that networks would converge, Worldcom opted to diversify into related products. Many of the early acquisitions were small, entrepreneurial companies--similar to WorldCom.

A strategic shift occurred when WorldCom started to acquire companies not in the telephone business, but firms in related businesses. The goal of these acquisitions seems to be to establish a leadership position in the converged networks. To this end, WorldCom acquired MFS, the parent of UUNet to give it a major presence in the internet/ data business. IDB Communications, gave WorldCom fax and data connections, television and radio transmission services, and mobile satellite communications potential. A gap in WorldCom's portfolio was the absence of a strong wireless presence.

Overall, WorldCom's corporate strategy can be seen mostly as growth by acquisition, versus building up what it had. In the early years, WorldCom's strategy of acquiring other long distance companies to increase its geographical coverage and market power added value. Integration of these firms was also easier since most were small entrepreneurial startups like WorldCom. During this period, WorldCom's shareholders saw their stock price go up.

3. Discuss WorldCom's acquisition of MCI. This deal was hailed by the media as "the deal of the century". Why did it fail to live up to expectations?

In 1997, WorldCom made its largest purchase--MCI. MCI was the second largest long distance company and WorldCom was the 4th largest. By purchasing MCI, WorldCom would be a major player in the long distance business. WorldCom beat the next best offer of $28 billion, by offering $37 billion. This is in contrast to British telecom which after having worked with MCI for many years, dropped its offer from $23 billion to $17.9 billion. WorldCom justified its premium by the expected synergies from sharing networks and reducing costs. Further, they expected to use MCI's strong marketing skills to enhance their other businesses. In concept there was potential in these arguments, but numerous problems emerged in implementation (discussed below).

The effectiveness of corporate strategy could be evaluated in light of the value added to shareholders.

Porter (1987) suggests using three criteria:

* Attractiveness test: The attractiveness of the industry being entered into

* Cost of entry test: Cost should not overshoot future profits

* Better off test: Either the new unit or the corporation must be better off

In the MCI-WorldCom merger, none of these three criteria were met. By 1997, the long distance business was not attractive--it had excess capacity, severe price competition, and was viewed by customers mostly as a commodity--giving firms little opportunity to differentiate. Regarding the cost of entry, it might be inferred that WorldCom paid a premium for MCI. British Telecom had worked closely with MCI for the previous few years actually dropped its offer from $23 billion to $17.9 billion based on MCI's performance and the potential of future revenues. This deal also required WorldCom to take on a lot of debt to pay British Telecom its 20% share in MCI.

Regarding the better off test, Bernie Ebbers, the CEO, referred to a large number of potential cost savings and synergies. It was hoped that WorldCom could cut down the costs of MCI in the price sensitive, increasingly commodity type long distance business, while MCI could strengthen the marketing of WorldCom's high growth data businesses. However, not much was actually realized. There were major problems of culture clash between WorldCom and MCI. WorldCom was a smaller, newer, lean company, while MCI was a more established, larger company. While WorldCom's growth was by acquisitions and cost cutting, MCI grew internally through innovation. The sort of culture and skills needed for a strategy based on cost leadership is quite different from that needed for innovation. What resulted was a major clash in cultures making integration of operations essential for cost savings elusive. Moreover, the austerity measures taken by Ebbers to cut costs went overboard (eg., removing water coolers) and some 70% of MCI executives left the firm. One can presume that with their exit, some of the marketing skills that WorldCom wanted also left MCI.

Adding to these strategic and implementation problems, the long distance business continued to deteriorate, with increased price competition. By 2000, just 3 years after acquisition of MCI, WorldCom decided to partition the two companies and created a tracking stock for MCI to allow focus on its faster growing data business.

4. How do you explain the poor performance leading to the bankruptcy of WorldCom?

Although the media has focused on the ethics issues as the cause of failure of WorldCom, there are many other equally important issues.

Problems in the Long Distance Business: Deregulation increased competition in the long distance segment of the telephone business, not the local exchange. Local exchanges were still monopolies and long distance companies had to pay large access fees to reach their subscribers. Since 1996 when local exchanges were opened for competition, it was possible for long distance companies to lay down lines to reach their customers, but this was very capital intensive and took place mostly in the densely populated areas.

Unforeseen Industry Shifts: In the mid 90's the telecommunication business was seen as an extremely high potential industry. Rapid technological advances in carrying capacity of optical fiber and internet, led to the expectation that entertainment, access to the internet and telephone service could be offered by one firm. Unfortunately, while the capacity of optical fiber to transmit information lived up to its potential, the boom in entertainment delivery and convergence did not occur. Other than densely populated urban areas, many areas did not have high speed access from their homes as the local exchange companies continued to keep the copper lines rather than update them. This acted as a bottleneck in data and video transfers through the network (even if the long distance companies had optical fiber lines, the local exchange did not, therefore slowing delivery). This resulted slower than anticipated demand contrasted with massive overcapacity since many firms had laid down networks in the hope of being the firm of choice in a converged environment.

While the above industry pressures acted on all firms in the telecommunications industry, WorldCom was hit very hard. MCIWorldCom had invested a lot of money in laying down long distance networks, and owned the largest chunk of internet backbone. By owning MCI, WorldCom increased its exposure to the hard hit long distance business.

Lack of Presence in the Wireless Business: WorldCom lacked a strong presence in the fast growing wireless business. Although WorldCom tried to address this problem by making a bid for Sprint, the failure of the Justice department to allow the merger, resulted in a conspicuous gap in its product offering. Most other long distance companies had a stronger presence in the growing wireless segment. This not gave them a strategic advantage in allowing them to offer a complete line of communication offering to customers, it kept them out of benefiting from the growth of the wireless segment.

High Acquisition Price for MCI: The high price paid for the acquisition of MCI seems more a result of managerial hubris than based on careful research into costs and benefits. Prior successes with acquisitions, and the easy availability of capital during the stockmarket boom are likely to have reinforced feels of bravado. As suggested in the research on reasons for high premiums paid for acquisitions (Hayward & Hambrick, 1997), the past success with acquisitions, the media blitz surrounding the CEO might have lead to the high price paid for acquisition. The resulting debt weakened WorldCom's balance sheet in comparison to other telecom firms.

Managerial Errors: There seem major problems in both choice of MCI as the firm to acquire as well as in attempts to integrate the firm. The obvious differences in culture should have warned WorldCom about the potential problems in realizing synergies from MCI. Further, it seems that cost cutting went too far. The report that 70% of MCI executives left following austerity measures indicates serious managerial problems. It is quite likely that the most promising executives left as it was probably easiest for them to find jobs. This drain on talent from MCI further decreased the benefits WorldCom was counting on--that MCI's marketing executives would help WorldCom with their marketing.

Failure of Ethics: Worldcom has been charged with overstating accounting irregularities of $9 billion. Studies on failure of ethics point to some underlying features--pressure to deliver results that are probably unachievable, leadership and culture of the company. Initial investigations suggest that fraud in WorldCom started from the top. The CFO of WorldCom has been accused of being directly involved in misrepresenting accounts. The CEo, Ebbers, involvement in this fraud is also being investigated. In any case, it is not likely that Ebbers will emerge as a role model for ethical behavior in the company. Ebbers, it is alleged has personally benefited from various transactions with the firm . For example, he received low interest loans from the company to cover personal margin calls made on company's stock. In addition to the failure of leadership, we should note the tremendous pressures faced by the company. The turbulence in the telecommunications industry, unforeseen negative events especially in the long distance sector, in which WorldCom had high exposure, coupled with high debt and shrinking capital availability obviously put tremendous pressures on WorldCom to improve performance.

EPILOGUE

In the last quarter of 2002, WorldCom's MCI unit sharply raised many of its domestic and international rates, in some instances by as much as 80 percent, marking a departure from its previous role as an industry leader in cost cutting. MCI sought to shed its least-profitable customers and focus on its most-profitable plans, such as the Neighborhood with flat-rate pricing. "In the past, they had focused on every customer," "Now they are focused on customers that are the highest value." (Wallack, 2002)

In April 2003, WorldCom filed a reorganization plan that changed its name to MCI, and shifting its headquarters to Virginia from Clinton, Mississippi, the town associated with disgraced co-founder Bernie Ebbers. According to the new Chairman and chief executive Michael Capellas, the company "wanted a new name that would make us proud". "With established brand equity and a name that stands for integrity, innovation and value, we're ready to regain our leadership position in the marketplace." (Dalton, 2003)

In July 2003, new allegations were uncovered against MCI: schemes apparently designed to defraud its competitors that stretched back into the 1990s and that were still in place. Secret schemes to reduce the charges that the company paid to rival telecoms groups to complete long-distance calls. Mr Krutchen told investigators about schemes to reroute long-distance traffic via small independent telecoms operators in an attempt to disguise the origins of the calls and thereby avoid paying network access fees to local operators such as Verizon and SBC. MCI responded that just 8 per cent of its traffic is directed to least-cost routing companies.

As a result, in late July 2003, WorldCom was banned from bidding for US government contracts, worth about $1 billion a year. The General Services Administration, the body that hands out government deals, said: "It is important that all companies and individuals doing business with the federal government be ethical and responsible." (English, 2003) In response, MCI decided to hire a chief ethics officer to improve its image. Michael Capellas observed, "We are in the process of rebuilding our ethics program and understand that there is still more work to do." (English, 2003)

In August 2003, WorldCom proposed changes in how the board would govern the company, as part of its reorganization plan. It accepted 78 recommendations by the court-appointed monitor reflecting specific weaknesses exposed by WorldCom's collapse. The changes aim to give the new MCI overwhelmingly independent and extremely active directors. The company will have 8 to 12 directors, with the chief executive as the only insider. The changes required the board to meet at least eight times a year, visit company sites and undergo annual training. The role of chairman will be turned over to an outsider who would run the board. It barred directors and auditor from serving more than 10 years, and mandated departure of at least one director each year. Strict standards for defining independence of the directors eliminated virtually any dealings with MCI. Most significantly, to give shareholders a bigger voice, an Internet site was to be created where MCI investors could bring concerns to the attention of the board and other shareholders. The site would allow investors to have resolutions voted on without having to gain approval to do so at the annual meeting. No employee will be paid more than $15 million a year without shareholder approval and severance packages will be limited (Feber, 2003).

In October 2003, WorldCom's reorganization plan was approved, and it looked forward to doing business as MCI starting 2004. MCI repaid most creditors just 36 cents on the dollar and wiped out all its former shareholders. MCI now had $2.3 billion in cash and $5.8 billion of debt, down from $41 billion when it filed for bankruptcy in July 2002. The work force was reduced by more than a third to 55,000, down from 85,000 before the bankruptcy. WorldCom had fired the executives responsible for the fraud and replaced the CEO, CFO and entire board of directors. The new policies and procedures--including state-of-the-art board of directors' guidelines, and an extensive corporate ethics program--make MCI a model of corporate governance. The federal judge overseeing the litigation against WorldCom recently opined that never has a company "so rapidly and so completely divorced itself from the misdeeds of the immediate past and undertaken such extraordinary steps to prevent such misdeeds in the future." (Garn, 2003)

In Jan 2004, the government ban on MCI bidding for government contracts was lifted. The representative of the government agency, General Services Administration, stated that "Now you have a company that has corrected the way it does business, and it's safe for the government to do business with it." (Young, 2004)

REFERENCES

Dalton, R. (2003, April 16). WorldCom is dead, long live its clone. The Australian, 26.

English, S. (2003, February 8). WorldCom barred from government contracts. Daily Telegraph. http://www.telegraph.co.uk/money/main.jhtml?xml=/ money/2003/08/02/cnworld02.xml

Feder, B.J. (2003, August 27). WorldCom plans sweeping changes. Barnaby J. Feder. International Herald Tribune, August 27. 11

Garn, J. (2003, September 22). Destroying MCI; How to manipulate the bankruptcy code. The Washington Times. A23

Hayward, M.L & Hambrick, D.C. (1997). Explaining the premiums paid for large acquisitions: Evidence of CEO hubris. Administrative Science Quarterly. 42(10), 103-127.

Porter, M.E. (1987). From Competitive Advantage to Corporate Strategy. Harvard Business Review. 65(3), 43-59.

Wallack, T. (2002, December 4). MCI plans additional rate hikes; MCI plans to raise its rates. San Francisco Chronicle. .B1.

Young, S. (2004, January 8). Ban is Lifted on MCI's Bidding for US Government Contracts. The Wall Street Journal. A20.

Kamala Gollakota, University of South Dakota Vipin Gupta, Grand Valley State University