The Hindu Business Line : Two and two don't add up

THE telecommunications industry, specially in the US and Europe, lies in shambles with no immediate prospect of recovery. So, what is new about that, you may ask? Well, it is true that the last one-and-a-half years have seen a telecom meltdown of monumental proportions. Practically every major telecom player of the likes of Nortel Networks, Ericsson, Nokia, Cisco Systems, Motorola or Lucent Technologies, to name just a few, have seen their financial projections go awry and suffered a massive squeeze in valuation. With the economic downturn contributing to lowered infrastructure, almost all these companies have gone through an endless cycle of extensive layoffs, asset reorganisation and rationalisation of an unprecedented scale. The process of consolidation has not even begun.

However, the last few months have been qualitatively different for telecom companies. Primarily because, post-Enron, the focus of Corporate America has revolved around the accounting scandals and pathetic corporate governance track record of some of these telecom majors. For those who thought that the accounting improprieties of Global Crossing or SEC inquiries into Qwest International were a one-off event, the accounting fraud uncovered at WorldCom, the second-largest long-distance telecom carrier in the US has come as a major shock.

And Corporate America is fortifying itself for more such skeletons from tumbling out of the telecom/information technology cupboard. The series of accounting scandals in telecom have only underscored the severe loss of credibility for companies and the crisis of confidence for investors. At the same time, these scandals have highlighted the valuable lessons that can be learnt from these corporate debacles. And served to create the need for significant accounting and corporate governance reform:

Forecasting follies: It is a well-established fact that forecasting is an imperfect science. But for companies which kept growing without any hiccup between 1996 and 2000, demand growth was taken as a given and all forecasting models were predicated on that assumption. These forecasts started off on a more tempered note in the initial years, only to grow wild and unsustainable as companies kept achieving and even exceeding these forecasts during the late nineties. That in turn, emboldened research outfits (spurred on by companies in different industry segments such as bandwidth, servers, routers, database markets, PCs or the cellular market) to start issuing fancy projections. Soon, they were competing with each other to upgrade the forecasts on the firm belief that the information technology/telecom industry was not dictated by cyclical factors. However, this so-called virtuous cycle had to end somewhere. When the entire IT industry starting from semiconductors, PCs, cellular to optical networking went into a downturn almost lock-in-step, the cyclical effects brought the ugly face of forecasting to the fore. Obviously, the management guidance on revenues and profits predicated on demand forecasts also went for a toss. But these forecasting errors were only magnified by accounting irregularities which seem to be coming to light.

Accounting question marks: Doctored cash flows, failure to account for the actual cost of real stock options, swelling goodwill on account of an acquisition spree and manipulated "proforma" statements of profit and loss, specially arising from one-time/unusual items have raised questions over the reliability of financial statements presented by companies. Each of these loopholes has been exploited to inflate revenues and tamper with earnings (both operating and net) to the advantage of the companies involved. Instead of providing management guidance, companies need to offer better quality disclosures to shareholders. These disclosures ought to be a part of the financial statements rather than being tucked away as notes to accounts, escaping the attention of shareholders altogether.

New code of corporate governance: The corporate governance code for new economy companies has to be created on an entirely different footing compared to more mature old-economy counterparts. While addressing the question of corporate governance, four issues keep repeatedly coming to the fore. First of all, the CEO's pay. The outrageous sums doled out to CEOs over the past five years only serve to highlight that greed and power have overtaken sound reason in Corporate America. Secondly, the independence of directors has been repeatedly called into question. For new economy companies, the criteria for selection of independent directors have to be on probably a different footing. An understanding of the dynamics of technology is an essential pre-requisite for directorship in new economy companies. And until that happens, the tough questions which independent directors ought to have raised, specially on the growth front, will never be raised. Thirdly, institutional investors who have remained passive spectators will have to play a more active role in the management of companies. Unless that happens, scandals of this nature will always be waiting to happen. Finally, the "cosy nexus" between the management and investment analysts during the technology boom has to be broken quickly.

However, given the complex nature and pace of changes in technology, the analyst community will remain dependent on the management to provide them with guidance on future growth. As long as this trend persists, the scope for objective analysis may remain a mirage. The only lasting remedy seems to be to provide analysts with access to an independent board in these companies to whom tough question can be addressed.

Slowing technology spending: The chieftains of key corporates such as Cisco Systems, Hewlett-Packard, Intel and others have already warned technology spending is likely to remain sluggish till end-2002 and is poised to stage a recovery only in 2003.

To a large extent, the sluggish growth in technology spending is attributable to decelerated growth of the telecom sector, basically in the three key segments — telecom carriers, optical network and wireless. The slowdown in these three segments has already had and will continue to have a cascading effect down the entire telecom value chain. While the industry had not suffered a loss of credibility so far, the new revelations of accounting fraud in WorldCom and Global Crossing and SEC inquiries into Qwest International have dealt a devastating blow to the future of the IT sector. How the long-term effects of this blow will pan out is anybody's guess.

maverick@thehindu.co.in

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