How could so many smart investors have been so foolish? What were they thinking? Martin Fridson, the chief junk-bond strategist for Merrill Lynch, says that already-hot Internet and telecom markets turned incandescent when money came flooding into the United States after the Asian financial meltdown started in 1997. “Ideas that you would have called ridiculous at other times got funded,’’ he says. Another major factor in “smart” money’s flooding into telecom start-ups was that the nation’s biggest telecom, AT&T, bought upstart Teleport, and No. 2 WorldCom bought MFS and Brooks Fiber, all at fancy prices. This encouraged others to rush out and start up telecoms that could then be sold quickly to hairy-chested, deep-pocketed phone companies that, it turned out, weren’t buying. So, you see, it wasn’t just callow twentysomething supposed geniuses who lost big time on the Internet-telecom bubble, but seasoned smart people, too.
And now, for our list of lessons that these investors learned the hard way. And, by the way, should have known in the first place.
Paul Allen, a cofounder of Microsoft, builder of the Jimi Hendrix museum and one of America’s richest people, rocked the telecom world when he wrote a huge check to little-known RCN, which sells broadband services to residential customers in competition with entrenched local phone and cable companies. Allen said RCN would be central to his wired-world investments. Timing is everything, and Allen’s timing was terrible. His check cleared just before the stock bubble began bursting. Alas for Allen, his high-profile investment guru, Bill Savoy, was also outbargained by low-profile David McCourt, RCN’s chief executive. Here’s how. Like many big investors, Allen didn’t buy plain old common stock. He bought preferred stock–which carries a dividend and ranks ahead of common stock in its claims on a company’s assets–that was convertible into RCN common stock at $62 a share. This means Allen can trade $62 of preferred for a share of RCN. That looked great when RCN soared into the $70s. It’s not so good now, with RCN kicking around at about $4. Normally, owning preferred stock rather than common offers some protection against such a price collapse. That’s because you collect cash dividends on your preferred, and you can get your original investment back in cash when your preferred matures. Not so with Allen. His dividends are paid in new preferred shares convertible at $62, not in cash. Worse, when Allen’s preferred matures in 2007, McCourt has the option to force him to convert it to RCN common at $62, rather than getting his $1.65 billion back. Barring some miraculous recovery, Allen will get 26.6 million RCN common shares, currently worth about $100 million, instead of getting his $1.65 billion back. Assuming, of course, that RCN (whose common holders include me) survives that long. Bonus lesson: read the fine print.
John Malone became the most successful cable investor in history by seeing investment opportunities before anyone else, then selling when everyone was buying. For instance, he sold Tele-Communications Inc. to AT&T for top dollar in 1998. Despite selling TCI, he managed to keep control of TCI’s high-octane investment arm, now called Liberty Media. But he made un-Malone-like investments in start-up telecom companies ICG and Teligent, classic examples of bubble investments. He bought with the herd instead of ahead of it. Both companies went into bankruptcy, wiping out their shareholders, though Malone managed to sell Liberty’s Teligent stake for about $40 million slightly before the fall. His European cable investments, made when everyone saw Europe as a hot broadband market, may ultimately work out. But for now, he’s way underwater. The value of his $200 million 1999 investment in United Pan-Europe, currently selling at about half a buck, is a rounding error. His subsequent $1.4 billion investment in UnitedGlobalCom of Denver, which controls United Pan-Europe, is way down, too. Liberty will have paid between $16.18 and $23.33 a share, depending on future developments. At UGC’s recent price of around $5, Malone’s hurting, big time. The real question is, has Malone lost his touch or is he just going through a slump?
It seemed like a brilliant stroke on Jan. 27, 2000, when the prestigious Janus mutual-fund family announced that on the previous day, it had bought 15 million shares of the health Web site Healtheon (now WebMD) directly from the company at $62 a share. That was a discount from the market price, and it helped Janus deal with a problem that it had at the time: how to invest the torrents of money pouring in from investors. Most of the Healtheon stock–11 million shares–was bought by the Janus Twenty Fund, then one of the hottest mutual funds on the planet. That private purchase let Janus Twenty add $682 million to one of its favorite holdings without running up the price by buying shares on the open market. Because the stock was restricted, Janus had to wait a year to sell it freely on the open market. But who cared? Janus was buying, not selling. Healtheon was hot. But not for long. The stock peaked the day the deal was announced, but wound up in the ER when the Internet bubble burst. The stock was under $10 by the time Janus could sell it without restrictions, and currently it’s about half that value (financial ICU, anyone?). For its part, the Janus Twenty Fund is down about 30 percent this year.
This seemed like a classic can’t-miss investment, albeit a pricey one. Verizon, a giant regional phone company, was hot to offer broadband services to customers throughout the country. Metromedia was building a network to deliver those services. How convenient. What’s more, Metromedia Fiber came from a prosperous, respected family–it’s affiliated with Metromedia International Group, which is owned by legendary billionaire John Kluge. So instead of building its own network, Verizon made a deal to use Metromedia’s network. To help Metromedia finish building it, Verizon bought $717 million of stock (at $14 a share) and made the company a $975 million loan convertible into stock at $17. That gave Verizon an insider’s look at Metromedia, and a leg up if it ever wanted to buy the whole company. But Metromedia ran short of cash, Kluge has been slow to open up his coffers and the stock languishes at less than a dollar. Last month Verizon wrote down the value of its investment to about $200 million. And even that may be too high.
Hicks, Muse, Tate & Furst built itself into a leading leveraged-buyout firm by staying with its specialty: buying existing companies cheap and squeezing more profits out of them. But in 1999, it changed course and invested a total of $1 billion in telecom start-ups ICG, Rhythms NetConnections, Teligent and Viatel. Sure, their business models were a little different from one another, but hardly enough to qualify as diversification, as Hicks Muse thought. In fact, pouring so much money into broadband start-ups could only be called “diworsification.’’ All four went into bankruptcy, wiping out Hicks Muse’s investment. Part of the problem was LBO lifestyle disease. LBO guys typically get annual fees of 1 or 2 percent of assets, plus 20 percent of profits. If they don’t do deals, their investors get antsy. “You have to do transactions to support the LBO lifestyle,” observes Randall Curran, who was recently brought in as ICG’s new chief executive to help clean up its mess. Deals like these, though, make investors poor.
Like other leveraged-buyout firms, Ted Forstmann’s Forstmann, Little & Co. was horribly frustrated in 1999 when attractive conventional LBO investments were hard to come by for a variety of reasons, including lofty price tags. So Forstmann decided to join the telecom start-up stampede. He put $1 billion each into XO Communications, a company whose early investors include wireless pioneer Craig McCaw, and another $1 billion into McLeodUSA, a telephone upstart trying to compete with local phone companies, primarily USWest. Both XO and McLeod-USA foundered, partly because of heavy competition. But unlike Hicks Muse, Forstmann came to the rescue. This year he forked over an additional $250 million to XO and $100 million to McLeodUSA. In return, he got the desperate companies to sharply reduce the prices at which he could convert his earlier investments into common stock. The game plan is to hang on, keep XO and McLeodUSA afloat and hope enough competitors croak so these guys can make a go of it. Forstmann would have done better sticking to his M.O. of buying established businesses.
This is one of the rare examples of how smart Wall Street money bought into the Internet at sucker prices. The usual pattern was for early investors to make out well by buying at wholesale prices and selling at retail to the teeming masses who bought shares after a company went public. Here, Goldman Sachs ($100 million) and a slew of other Wall Street types put up half of the groceries-by-Net company’s capital, and never unloaded onto the suckers. To replace the perfectly fine practice of shoppers going to the market, Webvan decided to centralize everything in huge, automated facilities and then deliver the groceries to shoppers at home. In pursuit of much-ballyhooed “mindshare,” it tried to open everywhere at once. It was funded lavishly, but spent even more lavishly. The business seemed to be totally disconnected from reality–Wall Street’s version of Bush 41 needing to be introduced to a supermarket scanner in 1992.
When AT&T bought Telecommunications Inc., a giant cable-TV company, the deal included TCI’s majority voting stake in At Home. At Home has the exclusive right to carry broadband services over TCI’s cable systems, now AT&T Broadband. But even though TCI had voting control of At Home, two fellow At Home investors–Cox Cable and Comcast–had blocking power over certain transactions. This unusual structure unsettled AT&T. To get Cox and Comcast to give up their blocking rights, AT&T guaranteed them $48 a share–$2.9 billion–for their stock, starting this year. At Home was in the $30s when the deal was struck last year, but AT&T banked it would run up. That may explain why AT&T, led by CEO C. Michael Armstrong, didn’t limit how much it would pay if At Home’s stock stayed under $48. Dumb, dumb, dumb. At Home was in single digits as the year started, prompting Cox and Comcast to ask for their $2.9 billion. Belatedly showing some smarts, AT&T opted for a smaller after-tax cost (but a bigger embarrassment) by paying Cox and Comcast a total of $3.4 billion–and letting them keep their At Home stock. Those shares are almost worthless, and the $1 billion that AT&T saved on taxes more than covers the $500 million extra it paid. A second fiasco: in August 2000, AT&T paid $75 a share for $1.4 billion of stock in Net2-Phone, a bet on Internet long distance. Current price: around $4. Should have stayed at home.
The biggest debacle is the one least known to Americans, because it took place in Europe, mostly after the U.S. market bubble popped in the spring of 2000. Europe’s leading telecom outfits got into an insane bidding war for the right to offer3G (short for third-generation wireless services) in several European countries. By the time the dust settled, the companies had paid a total of $96.1 billion for 3G licenses to deliver things like wireless Internet. The total will no doubt rise above $100 billion by the time French licenses are sold. British licenses fetched $35.4 billion in April 2000; German licenses, $46.1 billion in August; Italian licenses, $10 billion in October. Paying for the licenses has so crippled the companies that they will have trouble raising the estimated $200 billion it will take to be able to offer these services. The bidders had been stricken with madness. The secret: the main selling countries hired consultants who played the bidders like violins. You can even make a case that the 3G debacle helped to finally burst the U.S. telecom bubble. Consider this–a year ago, prices of telecom companies in the United States had recovered somewhat from their sharp fall in the spring of 2000. But after the 3G dustsettled, it became obvious that the European telecoms had big problems of their own and weren’t in any mood to snap up fledgling American telecomcompanies. The key future question: will countries revert to typical government cluelessness and quietly give refunds to their stricken national telecom firms?
The overarching lesson here is an eternal one: markets can swing from being irrationally exuberant to being totally depressed in an instant. Heaven help you if you don’t see the switch coming. When even smart people start acting as if there’s some truth to the four most dangerous words on Wall Street–“this time it’s different’’–you can be sure it’s time to take the money off the table. And the one thing you can certainly bet on is that when the next investment mania strikes, that broader lesson–and, for that matter, all the dealmaking-for-dummies lessons wejust discussed–will have been completely forgotten.
