SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Date of Report (Date of earliest event reported): June 20, 2001
QWEST COMMUNICATIONS INTERNATIONAL INC.
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(Exact name of registrant as specified in its charter)
Delaware
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(State or other jurisdiction of incorporation)
000-22609 84-1339282
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(Commission File Number) (IRS Employer Identification No.)
1801 California Street Denver, Colorado 80202
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: 303-992-1400
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Not applicable
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(Former name or former address, if changed since last report)
Item 5. OTHER EVENTS
On June 20, 2001, Morgan Stanley issued an equity research report on Qwest
Communications International Inc. ("Qwest" or the "Company"), entitled "Qwest:
Listening to the 10-K." In this report, Morgan Stanley made a number of comments
on the Company's accounting in various areas, including accounting for the
merger of Qwest and U S WEST, Inc. ("U S WEST"), pension assumptions, and
software capitalization trends. Morgan Stanley concluded that these observations
have an important bearing on the sustainability of Qwest's future earnings
growth and capital needs.
The Company believes the report is misleading and inaccurate in its explanation
of generally accepted accounting principles ("GAAP"), includes several factual
errors, and has no bearing whatsoever on the sustainability of the future
earnings growth or capital needs of the Company. The Company's press release
regarding the same is attached as Exhibit 99.1 to this Current Report on Form
8-K.
Issue 1: Purchase Price Allocation
As stated in our Annual Report on Form 10-K, filed with the Securities and
Exchange Commission (the "SEC") on March 16, 2001, the June 30, 2000 merger
between Qwest and U S WEST (the "Merger") has been accounted for as a reverse
acquisition under the purchase method of accounting. Because the Merger is
considered a reverse acquisition, U S WEST is deemed the acquirer and Qwest the
acquired entity for accounting purposes. The total value of the consideration
was approximately $40 billion.
Morgan Stanley claims that certain of the Company's preliminary purchase price
adjustments are "unusual," that the Company has not fully disclosed the impact
resulting from its preliminary purchase price allocation and that the impact is
significant to reported results. In addition, Morgan Stanley implies that Qwest,
prior to the Merger with U S WEST, avoided an impairment charge related to its
assets on a stand-alone basis.
According to the Morgan Stanley report:
"The $3.1 billion write-down of tangible net assets strikes us as
unusual, given the apparent lack of disclosure of details concerning
the adjustment and the potentially significant impact on reported
results. In order for the write-off in PP&E to be adjusted in the
purchase price allocation, the fair values of Qwest assets and any
possible impairment (based on fair value) would have to been unknown or
not ascertainable at 6/30/00. This is because of the "reverse
acquisition" character of the merger. While Qwest was a stand-alone
entity it could avoid an impairment charge under current US rules (FAS
121) if the assets were in operation and generating any cash flow.
However, on the date of the acquisition any possible impairment should
be estimated and recorded, as the company should have been aware of a
need to write down the book value to fair value at 6/30/00. The full
fair value exercise was apparently only undertaken after the filing
date of the 6/30/00 10-Q.
Just as important for investors is the question of the true earning
power of the old Qwest assets, given that a substantial portion was not
written off even though it may well have been economically impaired at
6/30/00."
The Merger was closed on June 30, 2000. Because of the competitive nature of the
Qwest bid for U S WEST and uncertainty over the Merger closing, there was
limited interaction between Qwest and U S WEST prior to the closing of the
Merger. The original purchase price allocation recorded by U S WEST on June 30,
2000, largely represented a carryover of net book value for most acquired assets
because of the limited information available to U S WEST and the short timeframe
between closing of the Merger (June 30, 2000) and the due date of the Form 10-Q
(August 14, 2000). In the quarter following the Merger, the new management team
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reviewed the business of the combined Company and a preliminary estimate of fair
value was received from the independent appraiser. In the Form 10-Q for the
quarter ended September 30, 2000, the preliminary estimates of fair value were
recorded and disclosed. Recording the acquired assets and liabilities at fair
value resulted in the $3.1 billion "write-down" of tangible net assets described
by Morgan Stanley. The components of the "write-down" set forth in the Morgan
Stanley report are: (1) an approximate $1 billion reduction in property and
equipment; (2) approximately $1.1 billion in other liabilities and (3)
approximately $1.6 billion in deferred taxes.
We strongly disagree with Morgan Stanley's assertion that the purchase price
allocations described above are "unusual." Accounting Principles Board ("APB")
Opinion 16, "Business Combinations," provides relevant guidance for recording a
purchase business combination. Paragraph 88(d) of APB Opinion 16 requires that
plant and equipment to be used in operations be valued at current replacement
costs for similar capacity unless the expected future use of the assets
indicates a lower value to the acquirer. The $1 billion reduction in property
and equipment is thus neither "unusual" nor unexpected given the declining cost
of network equipment. Qwest has consistently disclosed the declining cost of
procuring network equipment and has provided revised guidance on capital
expenditures resulting from these price reductions.
Further, we believe that Morgan Stanley's description of GAAP relating to the
need for Qwest to take an impairment charge on or before June 30, 2000 is
inaccurate and misleading. The ability to write-down an asset from its net book
value to its fair value is not elective. Statement of Financial Accounting
Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of," permits such a write-down only
when the sum of future cash flows (undiscounted and without interest charges) is
less than the carrying amount of the asset. Because Qwest fully expected to
recover the carrying amount of its long-lived assets prior to the Merger, it
could not write-down its assets to fair value as was suggested by Morgan
Stanley. The fact that the assets have a current replacement cost less than
their historical book value does not "question the true earnings power of the
old Qwest assets" as suggested by Morgan Stanley. It simply reflects the normal
reduction in the cost of new technology that will benefit Qwest in the future
vis-a-vis reduced capital expenditures.
According to the Morgan Stanley report, the $1.1 billion in other liabilities
"...[r]elates to various contracts and other legal accruals." Further: "...to be
part of the purchase price adjustment the economic obligations or losses had to
exist at 6/30/00 but Qwest had to be either unaware they existed or unable to
estimate any value for them." Paragraph 88(i) of APB Opinion 16 requires a
company to record other liabilities and commitments, including unfavorable
leases, contracts, and commitments and plant closing expense incident to an
acquisition, at present values of amounts to be paid determined at appropriate
current interest rates. We believe such accruals are required as part of the
allocation of purchase consideration and are not "unusual." Similar to
prohibitions against writing-down plant and equipment to fair value prior to an
acquisition, these fair value adjustments to recognize assumed executory
contracts and obligations cannot be recorded prior to an acquisition. Given the
constraints on preparing the Form 10-Q for the period ended June 30, 2000, and
the significant number of contracts, commitments and leases that needed to be
reviewed and valued, we do not believe it is unusual that the initial purchase
price allocation did not include these fair value adjustments.
In their report, Morgan Stanley acknowledges that the $1.6 billion in deferred
taxes are appropriate and required under GAAP. We take issue to the
characterization of this $1.6 billion liability, representing over 50% of the
amount questioned by Morgan Stanley, as a "write-down" of tangible net assets.
No tangible assets were written down. A deferred tax obligation was
appropriately recorded in purchase accounting for the difference between the
fair value of net assets recorded in purchase accounting and their historical
tax basis.
Finally, we believe our disclosure of the Merger with U S WEST and the purchase
accounting is adequate. The Staff of the SEC (the "Staff") has reviewed the
Qwest Form 10-K as of December 31, 1999, and the Qwest Form 10-Q for the quarter
ended September 30, 2000. The review resulted in various comments by the Staff
regarding our accounting for the Merger and related disclosures. The Company has
responded to those comments in its Form 10-K filed with the SEC on March 16,
2001, and the issues raised have been cleared to the satisfaction of the Staff.
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Issue 2: KPNQwest Valuation
Morgan Stanley speculates that the Company may write down our investment in
KPNQwest given the current trading price of KPNQwest's stock, and that there
will be a significant impact to unnamed balance sheet ratios.
As a result of the final appraisal of the assets acquired in the merger, a
downward revision of the estimated fair value of the Company's 44.4 % equity
interest in KPNQwest at June 30, 2000 will be made. The Company's investment in
KPNQwest is subject to restrictions on its disposition specified in the
agreements with KPN Telecom B.V. and KPNQwest. At the time of the Merger, the
Company originally estimated the fair value of its investment in KPNQwest to be
approximately $7.9 billion. Based upon an independent third party appraisal that
has recently been completed, the estimated fair value of the Company's
investment in KPNQwest was approximately $4.8 billion on June 30, 2000 (the
Merger date). We are not aware of any significant balance sheet ratios that will
be adversely affected by a reduction in the carrying value of the KPNQwest
investment
As a result of the adjustment to reflect the appraised value of our investment
in KPNQwest and a revision to the estimated useful life of the goodwill related
to the investment from 40 years to 10 years, we expect amortization to increase
approximately $79 million per quarter.
The current market value of the Company's investment in KPNQwest is
approximately $1.6 billion. The Company believes insufficient evidence exists to
reach a conclusion that the investment value is permanently impaired. Therefore,
the Company does not believe it is appropriate to write down its investment from
the June 30, 2000 appraised value of $4.8 billion to the current market value at
this time. If, in the future, a determination is made that such a diminution in
value is other than temporary, any reduction in the carrying amount of the
Company's investment in KPNQwest would result in a charge to income.
Issue 3: Changes in Pension Assumptions
Morgan Stanley implies that the Company has significantly increased the discount
rate (from 6.75% to 8.0%) used to measure pension obligations in order to reduce
the present value of our future obligation. In addition, they assert that the
increase in return on plan assets from 8.8% to 9.4% in 2000 may not have been
warranted given 2000 actual returns experienced by the fund.
According to the Morgan Stanley report:
"For 2000 Qwest (via U S WEST) revised the discount rate used to
discount the value of future obligations from 6.75% to 8% (versus a
Bell average of 7.75%). This has the effect of reducing the present
value of the future obligation. The new discount rate is based on a
representative corporate bond rate. At the same time, Qwest raised the
expected return on plan assets from 8.8% to 9.4% (vs. a Bell average of
8.9%) despite the recent turmoil in the markets. While other telecom
companies have similar assumptions, Qwest (U S WEST) has moved from
having the most conservative assumptions used by the phone companies to
among the least conservative."
We believe the Morgan Stanley report is misleading with respect to the effect of
the Company's change in discount rate assumptions. While a decrease in the net
present value of the pension obligation is the mathematical result of a higher
discount rate, the amount of discretion exercised by the Company to establish
the rate is limited. The Company's policy in establishing the pension discount
rate is followed consistently from year to year. Each year, the company measures
and discounts its future pension obligations using a rate based on the then
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current rate for Moody's AA-rated corporate bonds. The SEC has established
Moody's AA-rated corporate bonds as a reasonable standard upon which to base
discount rate assumptions, in accordance with SFAS No. 87, "Employers'
Accounting for Pensions." The increase in the discount rate resulted from
significant increases in interest rates in the last quarter of 2000. According
to a Credit Suisse First Boston Equity Research Report dated June 13, 2001, S&P
companies used a discount rate that ranged from 4.75% to 8.5% in 2000.
We also believe the Morgan Stanley report omits significant information
necessary to understand the Company's selection of its expected return on plan
assets. First, according to the Credit Suisse First Boston Report, Qwest's plan
was one of the top twenty overfunded plans in both 2000 and 1999. Second, the
Qwest plans have a net unrecognized actuarial gain of $2.9 billion indicating
that historical estimates of expected return on plan assets have been
conservative. Third, the Morgan Stanley report fails to mention that Qwest
utilizes a five-year smoothing mechanism in recognizing investment performance.
This smoothing mechanism dampens the effect the selected rate of return on plan
assets has on the Company's income. Based upon the Company's review of other
similarly situated companies with large pension plans, we believe our expected
rate of return on plan assets is comparable. Of the 50 public companies with the
largest pension asset trusts, the median expected return on assets was 9.5% for
2000. Based upon the Credit Suisse First Boston Report, companies within the S&P
500 used expected rates of returns ranging from 5% to 11.5%.
The conclusions drawn by the Morgan Stanley report are as follows:
"The recent changes in assumptions put Qwest's rates above those of the
other three Baby Bells. In 2000, Qwest recorded a net pension credit of
$405 million (or $0.15 per share (after tax), a dramatic swing from the
$8 million pension cost recorded in 1999 (by U S WEST). As with the
other Baby Bells, we do not expect similar income accretion in the
future, particularly if markets remain difficult. Indeed, the pension
fund at Qwest actually recorded a negative return in 2000, as did other
Baby Bells. Next year, the 2002 salary increase will also put
additional pressure on earnings."
We believe the information provided in the Morgan Stanley report and the
conclusions drawn are inaccurate. The net pension credit, as reported in our
Form 10-K, was $319 million in 2000 (versus the $405 million provided in the
Morgan Stanley report) and $151 million in 1999 (versus the net pension cost of
$8 million provided in the Morgan Stanley report). Further, the conclusion drawn
about the lack of similar income accretion in the future ignores the overfunded
status of the Qwest plan ($4.1 billion) and the smoothing mechanisms adopted by
the Company.
Issue 4: Incremental Software Capitalization
According to the Morgan Stanley report:
"One of the important changes in accounting in recent years has been
the requirement to capitalize software costs. This is very important to
telecom companies, which spend hundreds of millions of dollars every
year on software. In the first years, applying this policy has the
effect of enhancing net income as items previously expensed are
capitalized. Longer term, the positive effect on net income is
neutralized, as higher depreciation expense is recorded."
As to Qwest, Morgan Stanley's report contends that there was a significant
increase in software capitalization in 2000 versus 1999 and concludes:
"During periods of high software capitalization, expenses are
understated relative to the cash spending, with the reverse as the
depreciation catches up. This is part of the reason for the rapid
increase in depreciation expense we are seeing. We believe that most of
the software capitalized is written off over a five year period. The
increase in EPS is equivalent to about $0.30 per share after tax if
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looked at from a cash perspective, or $0.06 per share each year if
amortized over 5 years."
We believe the Morgan Stanley report is incomplete and potentially misleading.
The $1.173 billion net capitalized software costs reported in the Company's 2000
Form 10-K reflects U S WEST and Qwest cumulative net, capitalized software
costs. For 1999, the $618 million net, capitalized software costs represent U S
WEST only. Therefore the numbers are not comparable. Assuming the two companies
merged at the beginning of 1999, the amount of software capitalized would have
been $453 million in 1999 and $642 million in 2000 on a pro forma basis. This
increase is primarily attributable to growth in internal software development
associated with our 271 long distance re-entry. These higher capitalized
software costs related to 271 will be amortized over five years. We have
previously provided guidance on the level of depreciation and amortization
charges and that guidance has factored in our increase in software development
activities.
Issue 5: Incremental Capitalization of Interest
Morgan Stanley indicated that capitalized interest increased from $27 million in
1999 to $151 million in 2000. They noted that an increase in capitalized
interest reduces reported interest expense in the current period and increases
depreciation in future periods.
We believe the Morgan Stanley report is inaccurate and potentially misleading.
The $151M of capitalized interest costs reported in the Company's 2000 Form 10-K
reflects US West results for a full year and Qwest results since the Merger. For
1999, the $27 million capitalized interest costs represent the results for U S
WEST only. Therefore the numbers are not comparable. Assuming the two companies
merged at the beginning of 1999, the amount of interest capitalized would have
been $71 million in 1999 and $200 million in 2000 on a pro forma basis. This
increase is primarily attributable to growth in capital expenditures in 2000 and
changes in our borrowing rates. The increase in our capital spending is in line
with guidance previously provided and was necessary to support growth
initiatives and improve local service quality. On a pro forma basis, capital
spending increased from approximately $6 billion in 1999 to approximately $9
billion in 2000.
Forward-Looking Statements Warning
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This Current Report on Form 8-K contains projections and other forward-looking
statements that involve risks and uncertainties. These statements may differ
materially from actual future events or results. Readers are referred to the
documents filed by Qwest with the Securities and Exchange Commission,
specifically the most recent reports which identify important risk factors that
could cause actual results to differ from those contained in the forward-looking
statements, including potential fluctuations in quarterly results, volatility of
Qwest's stock price, intense competition in the communications services market,
changes in demand for Qwest's products and services, dependence on new product
development and acceleration of the deployment of advanced new services, such as
broadband data, wireless and video services, which could require substantial
expenditure of financial and other resources in excess of contemplated levels,
rapid and significant changes in technology and markets, adverse changes in the
regulatory or legislative environment affecting Qwest's business and delays in
Qwest's ability to provide interLATA services within its 14-state local service
territory, failure to maintain rights of way, and failure to achieve the
projected synergies and financial results expected to result from the
acquisition of U S WEST, Inc. timely or at all and difficulties in combining the
operations of Qwest and U S WEST. This release is based upon the best
information available at this time, but does not necessarily include all
information that would be available at a quarterly earnings announcement. The
information contained in this Current Report on Form 8-K is a statement of
Qwest's present intention and is based upon, among other things, the existing
regulatory environment, conditions in the industry and economy generally and
market conditions and prices. Qwest may change its intentions, at any time and
without notice, based upon any changes in such factors, in Qwest's assumptions
or otherwise. This Current Report on Form 8-K includes analysts' estimates and
other information prepared by third parties for which Qwest assumes no
responsibility. Qwest undertakes no obligation to review or confirm analysts'
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expectations or estimates or to release publicly any revisions to any
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
By including any information in this Current Report on Form 8-K, Qwest does not
necessarily acknowledge that disclosure of such information is required by
applicable law or that the information is material.
ITEM 7. Financial Statements, Pro Forma Financial Information and Exhibits
Exhibit 99.1 Press release dated June 20, 2001.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, Qwest has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
QWEST COMMUNICATIONS INTERNATIONAL INC.
DATE: June 20, 2001 By: /s/ Robin R. Szeliga
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Robin R. Szeliga
Executive Vice President and CFO
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