Monday, April 11, 2005

Is Qwest Over?

Ever since SBC announced its proposed acquisition of long-distance giant AT&T on January 31, Verizon and Qwest have been involved in an ongoing bidding war to acquire MCI so that they can remain competitive in an increasingly consolidated telecommunications market. On February 13, MCI accepted Verizon’s bid of cash and stock worth $6.75b and rejected Qwest’s substantially higher bid of $8b. Qwest consequently increased its bid to $8.4b on March 16 and Verizon responded with a bid of $7.5b ($23.10 per share, $8.35 in cash and $14.75 in stock). MCI once again accepted Verizon’s bid as superior on March 29. Refusing to concede defeat, Qwest increased its bid yet again to $8.9b ($27.50 per share: $13.50 in cash and $14.00 in Q stock). Both Verizon and Qwest have also been courting major MCI shareholders and Verizon has recently secured a 13.7% stake in MCI (subject to regulatory approval) by purchasing 43.4MM shares from Carlos Slim Helu for $1.12b. This purchase would make Verizon MCI’s largest holder.
During the course of the MCI bidding war, analysts have examined a variety of factors to determine their choice of ideal partner for MCI. First of all, analysts have compared the financial stability of both Verizon and Qwest. Analysts rationalized that MCI was willing to accept Verizon’s lower offer because it “appreciated the quality and stability of Verizon’s business, its financial condition, the dividend yield and the impact on customers”. Verizon has a more valuable equity currency and allows MCI an easier exit because MCI shareholders will represent under 5% ownership in Verizon, as opposed to an approximately 40% of Qwest. Analysts feel that Verizon’s large size also protects it from material dilution compared to Qwest, although the merger may help Qwest unlever its balance sheet.
Secondly, analysts examined the post merger synergies that would be generated and found that greater savings could be attained by merging with Verizon through reduced headcount, improved vendor procurement terms and network cost savings. In terms of network cost savings, Verizon noted that $3 billion of integration costs would need to be invested in MCI's systems and networks, which it is in a better position to fund than Qwest. On the revenue side, Verizon’s name could help bolster MCI’s tarnished image from prior accounting fraud and improve MCI customer retention. Smith Barney is skeptical of Qwest’s estimated synergies and argues that MCI would have the opportunity to increase share in Verizon’s region, which will help mitigate competitive pressures from the SBC-AT&T merger. Smith Barney also advocates selecting a financially sound partner since pricing across all segments of the telecommunications industry remains “fierce”. Although CSFB argues that the “MCI board will be hard pressed not to find [Qwest’s] bid superior given its ~20% premium to the current VZ bid”, Jefferies Equity Research has consistently backed Verizon as the preferred partner in this merger for all of these reasons. Jefferies believes that Verizon’s financial soundness coupled with “its local and wireless franchises will complement MCI’s long distance network and large enterprise client base”. In addition, Jefferies argues that Verizon will prevail because it has the resources to “make an all cash bid, if necessary”. Now that the feeding frenzy is coming to a close, a comparison of analyst recommendation trends over the last few months shows that MCI has gradually become a “hold” stock.
Verizon represents an attractive partner for MCI in spite of its lower share valuation. Verizon has a history of financial stability and is well respected in the analyst community. Verizon’s strong leverage ratios decrease the risk associated with its offer. In addition, Verizon is equipped to manage the impact of the need to repurchase MCI debt should bondholders choose to exercise the rights granted by a change of control provision. Verizon is a large company that posses a highly recognized and respected brand in local telephone, long distance, wireless, and DSL services. MCI currently does not have a strong wireless business and could gain from Verizon’s strength in the wireless sector. MCI also stands to gain from the local carrier business that Verizon offers and in return can offer its large base of corporate customers to the Verizon network. Finally, MCI will be able to offer its existing customers a DSL service through Verizon’s successful DSL business.
Shares of MCI and Verizon stock are more likely to retain their value during the transaction’s regulatory approval process. Since FCC approval will take at least twelve months, MCI needs to merge with a company that has demonstrated stability in its stock price over time. Verizon’s stock price should be more stable than the stock price of Qwest at the end of the regulatory review process.
Though Qwest has offered MCI shareholders a higher price for their shares, several aspects of the Qwest offer make it a less compelling proposal for MCI’s board of directors and shareholders. Qwest is currently burdened with $17.3 billion of debt, and spreading existing debt plus additional transaction financing over the increased revenue base of the combined firm may not generate improvement in leverage ratios. Qwest is also in the early phases of emerging from bankruptcy. As a transaction partner, it does not offer a strong reputation or a long history of robust financial performance.
The risk associated with the Qwest offer is greater due not only to the leverage ratios but also to stock volatility and ability to retain corporate customers. MCI argues that a proposed merger with Qwest poses a greater threat to the retention of valuable corporate customers. For this reason, MCI has asked Qwest for a less strict material adverse change clause. The clause allows an acquirer to adjust downward its valuation just prior to the close of the transaction in response to material changes in the performance of the target company. Thus far, Qwest has been unwilling to give MCI more favorable terms with respect to the structure of the transaction than those offered by Verizon.
Qwest could potentially address all of the concerns raised by MCI’s board by improving the terms of the agreement. There is one obstacle, however, that Qwest may not be able to overcome, the ultra conservative nature of the MCI board of directors. In the era of Sarbanes-Oxley, directors and executives have sought strategies that meet the highest of standards and win favor with the analyst community. MCI’s board includes a number of attorneys and accountants and meets far more often than that of other Fortune 500 firms on average. The board faces additional scrutiny generated by the legacy left by the board of MCI’s predecessor, WorldCom. The members have been extremely cautious in avoiding the perception that they merely approve all of management’s recommendations. Recent events reinforced that philosophy when former WorldCom board members paid a total of $24 million to settle a suit related to their roles in the firm’s accounting scandal. While Qwest may be able to exhaustively negotiate all of the finer points of its bid for MCI, it seems unlikely that with its tumultuous past it will be able to allay the worries of a board of directors focused on maintaining its image and preventing personal liability.

Kate Hacker, Anita Arbogast and Aarti Patel

3 Comments:

Blogger luke piestalker said...

thorough analysis, but the interesting aspect of this deal is not the technology. most people would not argue that qwest is a better suitor than verizon for mci. the critical issue here is the responsibility of the board: should it go for the higher $ per share offer from qwest (greater immediate payout), or the potentially greater $ per share offer from verizon (greater long-term potential)? many institutional investors are clamoring for mci to take the qwest offer, especially in light of the premium that verizon recently paid for carlos helu's stake in mci. so is the board obligated to take the "better" offer, and appease these shareholders who want to see the money? personally, i think qwest would have better luck directly appealing to the shareholders rather than to the board. there's really no right answer to this, but i would have liked to read your thoughts on this issue. ~pjan

8:58 PM  
Blogger Rachel Soloveichik said...

As, an economist, I find it very interesting when courts allow companies to turn down the highest offer. Legally, companies are allowed to turn down high priced offers if they believe the high priced offer is not the best. But, the stock market already contains complete information about a company's prospects. So, if a company offering a high price is about to collapse, then their stock market price should go down, lowering the offer. In effect, courts are rejecting the efficient markets hypothesis.

11:49 AM  
Blogger strat_blogger said...

The deal with Carlos Helu was an interesting development that arose as we were writing over the weekend. Given Verizon's working relationship with Helu in Mexico and perhaps other parts of Latin America, it was not surprising.

MCI has a large number of hedge fund and other short term investors who would favor the Qwest offer. Many speculated that Qwest would take advantage of the opportunity to thwart Verizon's efforts by appealing to those shareholders to either delay the vote to approve the Verizon offer or vote to reject the offer. Verizon's acquisition of Helu's holdings will help to neutralize the threat of Qwest's pursuit of that strategy. Helu, in turn, could command a premium for his block of shares.

This development indicates that if Qwest were to implement a bear hug or hostile bid strategy, Verizon would be ready to counter those efforts. Its strategy would likely be focused on a select block of shares to minimize the additional investment required.

Kate Hacker

4:46 PM  

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