QWEST(QWST) LEGG MASON ,RAISING RATING TO OUTPERFORM
***LM*** LEGG MASON WOOD WALKER, INC. ***LM***
06/24/99
Danny Zito
Bradley Wilson
QWEST COMMUNICATIONS INTERNATIONAL INC. (OTC-QWST)
QWST: Raising Rating to Outperform
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* Raising rating to Outperform from Market Performance and establishing a $40
target price.
* Revised offers for FRO and USW include a collar ($30.50 - $43.50) within
which FRO is valued at $68 per share and USW at $69 per share.
* Collar addresses major concerns of target boards, increasing the likelihood
that QWST will prevail, in our opinion.
* Acquisitions of USW and FRO would enhance QWST's strategic position and
improve its ability to create long-term economic value through greater
network utilization, a lower cost structure, and access to a lower cost of
capital.
* USW and FRO also provide attractive ways to enter the shares, trading at a
12% and 16% discount, respectively, to their in-collar valuations.
* Our preliminary analysis of the combined company suggests a value of
approximately $38-$40/share assuming a 10-11x multiple on our 2000
estimated, pro-forma EBITDA.
Investment Summary. We are raising our investment opinion on QWST shares to
Outperform from Market Performance and establishing a $40 target price. Our
* Raising rating to Outperform from Market Performance and establishing a $40
target price.
* Revised offers for FRO and USW include a collar ($30.50 - $43.50) within
which FRO is valued at $68 per share and USW at $69 per share.
* Collar addresses major concerns of target boards, increasing the likelihood
that QWST will prevail, in our opinion.
* Acquisitions of USW and FRO would enhance QWST's strategic position and
improve its ability to create long-term economic value through greater
network utilization, a lower cost structure, and access to a lower cost of
capital.
* USW and FRO also provide attractive ways to enter the shares, trading at a
12% and 16% discount, respectively, to their in-collar valuations.
* Our preliminary analysis of the combined company suggests a value of
approximately $38-$40/share assuming a 10-11x multiple on our 2000
estimated, pro-forma EBITDA.
Investment Summary. We are raising our investment opinion on QWST shares to
Outperform from Market Performance and establishing a $40 target price. Our
above average-risk rating remains unchanged. The churn in QWST's shareholder
base and removal of a near-term takeout premium (due to a misconception of
QWST as a near-term target, in our opinion) have depressed shares 27% from
predeal levels and 38% from their highs in mid-April. Frankly, we believe
QWST's shareholder base held views that were inconsistent with a realistic
assessment of QWST's business situation. While shareholder churn and the
remaining uncertainty surrounding the bids will likely keep QWST shares in the
penalty box in the near term, we believe the acquisitions strengthen the long-
term viability of QWST's business. Specifically our more favorable view is
based on the following:
* Improved Strategic Position. To date, our Market Performance rating on QWST
has been predicated on the argument that the company had two critical holes in
its business plan. Specifically, the company needed customers to fill its
network and local access facilities to reduce its operating cost structure and
provide end-to-end broadband connectivity. In the bids for USW and FRO, QWST
is signaling it recognizes these issues. If successful with the bids, QWST
would improve its position dramatically in these areas, in our opinion.
* Enhanced Economic Value Creation Potential. We believe the jockeying and
discussions surrounding the two competing complex offers and the virtues of
one stock over another mask the economic rationale and positive impacts to
QWST's business model going forward. Simply put, adding USW's traffic improves
network utilization, while local access facilities reduce access fees paid to
ILECs, improving margins. These two factors, combined with QWSTs access to a
lower cost of capital due to USW's strong balance sheet, should significantly
enhance QWST's potential to create economic value in the long run.
* Increased Attractiveness as a Target. While many QWST investors have believed
QWST was an imminent takeout target and, hence, the premium in the stock prior
to the bids, we have consistently maintained that without a significant retail
customer base and revenue stream, QWST was not that attractive to a larger
suitor. Paradoxically, while the market appears to be eliminating any takeout
premium, we believe that with a successful acquisition of USW acquisition and
the BLS relationship, we believe QWST's attractiveness to other players as a
takeout or a U.S. partner, actually increases.
Summing it up, the acquisition of USW would enhance QWST's strategic position
and improve the company's ability to create long-term value for shareholders
while increasing its attractiveness as a viable takeout candidate. Finally, if
Symbol(s) QWST & Services Date
QWST is not successful in its pursuit, we think the shares would likely enjoy
a relief rally, given current shareholder dissatisfaction with the proposed
deals.
While we are increasing our investment opinion on QWST, we recognize
significant regulatory and operational concerns remain. Further while we
believe QWST shares are attractive at these levels, USW and FRO may provide
more attractive ways to enter the shares. USW and FRO currently trade at a 12%
and 16% discount, respectively, to their in-collar valuations with projected
deal closures of mid-2000 and year-end 1999, respectively.
New Bids Summary. Qwest restructured its offer for both FRO and USW including
a collar ($30.50 - $43.50) on both deals and topping GBLX offers by roughly $1
billion for FRO and $4 billion for USW. Specifically, the FRO proposal is
valued at $68 per share ($48 of QWST stock and $20 cash) within the collar.
The USW deal is valued at $69 per share in QWST stock within the collar. The
added kicker of $2 per share in the previous deals, if both USW and FRO agree
to merge with QWST, has been removed. Under both proposals QWST has the right
to mix cash and stock within the collar, to manage the ownership structure of
the combined entity. While the revised offers provide some downside protection
for FRO and USW shareholders, they also curtail the potential upside reward.
See the table below for comparison of the new offers to QWST's previous
offers.
QWST Share Price $25 $30 $35 $40 $45 $50 Crossover
New USW Bid Valuation $56.56 $67.87 $69.00 $69.00 $71.38 $79.31
New FRO Bid Valuation $59.34 $67.21 $68.00 $68.00 $69.66 $75.17
Difference between offers
Old USW Bid 27% 27% 11% -3% -11% -11% $38.70
Old USW Bid w/ FRO 30% 30% 13% -1% -9% -9% $39.70
Old FRO Bid 17% 18% 8% -2% -7% -8% $39.15
Old FRO Bid w/ USW 20% 21% 11% 1% -5% -5% $40.65
Although the lack of a guaranteed dividend will likely continue to concern
USW's traditional shareholder base, QWST's revised offers have addressed USW's
and FRO's primary concern-downside protection. By our estimates, QWST's share
price would need to fall to approximately $27, or 16%, for GBLX offer to be
financially superior given yesterday's closing price. Additionally, by
instituting the collar and, thus, decreasing the potential upside QWST may end
up paying less for USW and FRO, if its shares rebound.
Valuation. Our standalone DCF for QWST yields approximately a $34 per share
valuation. Our preliminary analysis of the combined company suggests the
equity is worth $37-$40 per share. We arrive at this by applying a 10-11x
multiple to estimated pro-forma 2000 EBITDA. As a frame of reference, AT&T
trades at 10.3x and WCOM at 13.2x our 2000 EBITDA estimates.
Key Risks. While we are upgrading our opinion at this time, we recognize
significant risks remain. Key risks in our opinion, include the following:
* Regulatory. In-region interlata services will have to be suspended/divested
until USW gains 271 (long-distance) relief. While QWST estimates this
represent 6% of its current revenue and 1% of the combined companies' revenue,
in our opinion this also puts at risk some of QWST's and FRO's nationwide
wholesale contracts. Wholesale customers of QWST and FRO would have to find
alternatives in the USW region, which could jeopardizes the entire contracts.
While this is a drastic view of the potential outcomes, wholesale revenue
represents 25% of QWST's revenue.
* Integration. While QWST has previously merged with LCI, the size of the
proposed transaction with USW and FRO dwarfs its previous integration
activity. The size of the transaction, the established operating history at
USW, and fact that it's a three-way integration will increase the complexity
of integration.
* May Need to Raise Bids. GBLX has not admitted defeat, and may raise the bid
for either or both companies, potentially causing QWST to raise its offer
further. With a $4 billion premium on USW, we feel it is unlikely GBLX will
respond. However, the premium of only $1 billion for FRO could trigger a
response from GBLX, as we feel the FRO assets are more important to GBLX's
story at this time.
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