WorldCom Dashes Street's Love Affair with Cash Flow

Cash flow in recent years increasingly became the holy grail among companies seeking Wall Street's approval of their financial performance.

Analysts used cash flow -- a measure of the money coming in and leaving a company -- as the basis for their complicated charts and models for forecasting corporate performance. Investors were trained to rely on cash flow because it was seen as being immune to accounting tricks.

But cash flow is no virgin to scandal anymore.

WorldCom Inc.'s disclosure late Tuesday night that it had improperly booked routine expenses as capital expenditures to the tune of $3.8 billion to boost cash flow and profits, shocked even the most skeptical of investors.

What Wall Street found even harder to swallow was how effortlessly WorldCom, the No. 2 U.S. long-distance company, was able to manipulate its cash flow.

"This isn't even the sophisticated one -- like offshore partnerships we saw at Enron," said Robert Willens, a veteran accounting analyst at Lehman Brothers, referring to the murky partnerships that brought down the energy company.

Willens said he was taken aback that a scandal would center on so fundamental an accounting issue.

"This is like, Oh, I'm going to misclassify a bunch of stuff. What're you going to do about it?" he said.

Capitalized expenses, or the spending on assets such as plants and equipment on which the company expects to generate a return, only show up in a separate section of the cash flow statement -- cash flow from investing activities. That's a figure that doesn't receive much attention, said experts.

"How do you fake cash flow? You simply move the negative things -- the cash outflows -- out of the operating section and you move it into the investing or financing section. It's exactly the thing that WorldCom did," said Howard Schilit, who heads the Center for Financial Research and Analysis, which flags corporate accounting irregularities.

In addition, capitalizing expenses allows items to be entered as an asset on the balance sheet and depreciated or written off over a period of time, experts said. As a result, WorldCom would have been able to take routine expenses and spread them over a period of several years, they said.

Depreciation of capital expenses affects a company's net profits, but does not impact cash flow, while booking routine expenses decreases the amount of available cash.

"I think Wall Street is too in love with cash flow," said veteran short seller David Tice. "Investors should be reading financial statements like a mosaic. There's not just one holy grail of accounting."


Understandably, WorldCom's disclosure already has some analysts throwing the towel in on their reliance on cash flow, which is often expressed as a company's earnings before interest, taxes, depreciation and amortization, or EBITDA.

The measure of cash flow, which also doesn't include capitalized expenses, has been a key barometer for bond investors dealing with debt-laden companies like WorldCom, especially in the high-yield bond market.

In once-hot sectors such as telecom and wireless, companies that posted losses after spending lavishly to build networks could still find willing investors as long as they had prospects for positive cash flow.

"The whole premise of lending you money to build out your business was that you would be EBITDA positive," said Margaret Patel, high-yield portfolio manager for Pioneer Investment management in Boston. Positive cash flow has been seen as key to a company's ability to meet its debt payments.

Cash flow also mattered because bond investors thought it was a more reliable than earnings, which could be manipulated, she said. Net income, for example, can vary widely depending upon arbitrary issues such as the rate of depreciation or amortization a company chooses to adopt.

Still, some investors had become skeptical.

"You have to worry about these companies that were completely dependent on the financial markets," said Tom Parker, high-yield portfolio manager for Barclays Global Investors in San Francisco. "These companies were desperate for financing and had to keep the financing game going, so there were high incentives to manipulate EBITDA."

WorldCom was able to raise almost $12 billion last year, in the biggest dollar-denominated bond sale ever by a U.S. company, because investors believed it was stronger than many telecom startups, with real assets and healthy levels of cash.

"Worldcom was in a different league because it was a huge established company that was cash flow positive," said Patel. "Nobody ever questioned that."

WorldCom's revelations already have high-yield investors looking for new ways to value companies, analysts said.

"EBITDA may disappear as a benchmark for valuing companies," said Joe Galzerano, senior high-yield analyst for CIBC World Markets. Instead, free cash flow, which subtracts capitalized expenses, will gain momentum as the operating gauge, he said.