SSB's take on merger. SSB acted on behalf of GBLX...
___________
QWST: FRO/USW UNDERSCORES NEED FOR SCALE & SCOPE
Salomon Smith Barney
Tuesday, June 15, 1999
--SUMMARY:--Qwest Communications--Telecommunications Services
*QWEST made a unsolicited offer for both FRO & USW (exchange ratios
detailed in note). We believe GBLX offers for FRO & USW are superior t
QWST offer given structure of respective deals.
*QWST bids for USW & FRO underscores validity of GBLX merger agreements & QWST understands virtue of putting together assets w/customers & strategic irtue of increasing scale & scope to become a global end-to-end player.
*QWST deal is dramatically dilutive to the growth rate of QWST & will be a currency that will likely not pay dividends. Proforma QWST EBITDA growth rate is roughly 15% vs roughly 40% standalone. Proforma rev growth will be about 14%, roughly half QWST standalone rev growth.
*Applying similar valuation metrics for WCOM to proforma QWST, fair value for QWST is $32-$35 range which is where the stock closed yesterday.
--EARNINGS PER SHARE--------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 12/98 EPS $(0.03)A $(0.03)A $0.00A $0.01A $(0.05)A
Previous 12/99 EPS $0.00A $0.00E $0.03E $0.09E $0.12E
Current 12/99 EPS $0.00A $0.00E $0.03E $0.09E $0.12E
Previous 12/00 EPS $N/A $N/A $N/A $N/A $0.40E
Current 12/00 EPS $N/A $N/A $N/A $N/A $0.40E
Previous 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Footnotes: Standalone eps estimates.
--FUNDAMENTALS--------------------------------------------------------------
Current Rank........:1H Prior:No Change Price (6/14/99).....:$34.13
P/E Ratio 12/99.....:284.4x Target Price..:$58.00 Prior:No Change
P/E Ratio 12/00.....:85.3x Proj.5yr EPS Grth...:50.0%
Return on Eqty 98...:N/A% Book Value/Shr(99)..:5.66
LT Debt-to-Capital(a)34.5% Dividend............:$N/A
Revenue (99)........:3750.0mil Yield...............:N/A%
Shares Outstanding..:762.0mil Convertible.........:No
Mkt. Capitalization.:26007.1mil Hedge Clause(s).....:#
Comments............:(a) Data as of the most recently reported quarter.
Comments............:
--OPINION:------------------------------------------------------------------
QWEST (QWST) has made a unsolicited offer for both Frontier (FRO) and US WEST (USW). The considerations are as follows. QWST will offer 1.226 shares of QWST plus $20 per share in cash for FRO and 1.783 shares of QWST for USW if they are successful in getting both companies. If they can only get one or the other the deal consideration goes to 1.181 shares plus $20 per share in cash for FRO and 1.738 shares of QWST for USW None of the stock components have a collar surrounding the QWST stock. To remind investors, the Global Crossing (GBLX) offer is $63 a share for FRO as long as GBLX stays between $34.56 and $56.78; at the high end of the collar it reverts to a fixed exchange ratio of 1.1095 shares and at the low end of the GBLX has the option to add cash or stock to maintain a
$63 value. The USW ratio will be set once the FRO deal with GBLX is
closed such that in the new USW/GBLX combination there will be equal
amount of USW shares and GBLX/FRO shares. At yesterday's close, a $63
value for FRO means GBLX will be issuing 227.6 million shares for FRO and thus, the ratio between GBLX and USW will be roughly 1.26. (Details of these calculations are provided in the "Detailed Valuation Mechanics" below.) It should also be noted that USW's tender offer for 9.5% of GBLX at $62.75 per GBLX share will be completed as planned this week.
We have displayed below a comparison of the QWST and GBLX offers based on yesterday's closing price. As can be seen, in all situations the GBLX offer for either FRO or USW is actually superior to the QWST offering thanks to QWST's dramatic drop in price (this is in addition to our view that GBLX's structure of two tracking stocks will unlock much more value than having one security which combines diverse assets together). In addition, based on an expected close of 3 months for GBLX/FRO the annualized return for FRO is 39.2% and thus, from a return basis FRO is a clear Buy.
Moreover, QWST will have to trade to roughly $35-$36 per share in order to have an offer competitive with GBLX for either FRO or USW. It should be noted in the FRO situation, since there is a collar with, at this stage, $16 downside protection for FRO shareholders on GBLX stock vs only $6 upside "give up" in terms of exchange ratio, the option value of that collar is, using a Black Scholes methodology, $4 per share. Thus, we believe QWST on the FRO transaction would need to be at close to $40 per share in order to break-even with GBLX for FRO. QWST would have to be at roughly $36 per share as we alluded to earlier to break-even with GBLX on
USW. We also provided a break-even analysis for the QWST offer at
different ranges of GBLX stock prices. Given GBLX's superior bid based on yesterday's closing prices, we do not believe GBLX will increase its bid for either FRO or USW.
balomon Smith Barney acted as an advisor to GBLX in its proposed mergers with FRO and USW./b
CURRENT VALUE OF GBLX vs QWST OFFER
At current GBLX price:
QWST price where QWST price where
GBLX GBLX offer offer for FRO equals GBLX offer offer for USW equals
Price FRO value of GBLX offer: USW value of GBLX offer:
6/14/99 Value w/o USW w/ USW Value w/o FRO w/ FRO
------ ----- ------- ------- ------- ------- ------
$50.38 $63.00 $36.41 $35.07 $63.57 $36.58 $35.66
Note: Since there is a collar in the FRO merger there is a value for
this option given that the downside potential is greater than the upside
"give up" which at current prices is worth $3-4. Thus, the break-even
value for QWST stock on the FRO deal is really roughly $38-$39 vs.
$35-$36.
QWST price where QWST price where
GBLX offer offer for FRO equals GBLX offer offer for USW equals
GBLX FRO value of GBLX offer: USW value of GBLX offer:
Price Value w/o USW w/ USW Value w/o FRO w/ FRO
------ ----- ------- ------- ------- ------- ------
$45-50 $63 $36.41 $35.07 $59-63 $34-36 $33-35
$51-55 $63 $36.41 $35.07 $64-67 $37-39 $36-38
$56-60 $63 $36-39 $35-38 $68-73 $39-42 $38-41
Note: Option value of collar not factored into analysis above.
Value Stock
of GBLX price Annualized
Offer 6/14/99 Upside Return Comments
------ ------- ------ -------- -----------------------------------
FRO $63.00 $57.38 9.8% 39.2% *Value based on collar; price is
fixed at $63 of GBLX for each share
of FRO if GBLX trades between $34.56
& $56.78; Above $56.78 the ratio is
1.1095 and below $34.56 the ratio is
1.8229 per for each share of FRO.
*Annualized return based on expected
close by the end of Q3'99 or 3 mos.
USW $63.57 $58.00 9.6% 9.6% *Based on exchange ratio of 1.26 due
to yesterday's closing prices for
GBLX, FRO, and USW; and the shares
issued in FRO transaction.
*Annualized return based on expected
12 month close.
------------------------------------------------------------------------
Value Stock
of QWST price Potential
Offer/a 6/14/99 Upside Comments
------- ------- --------- -----------------------------------
FRO $60.30 $57.38 5.1% 1.181 QWST + $20 cash per/sh of FRO
FRO w/USW $61.84 $57.38 7.8% 1.226 QWST + $20 cash per/sh of FRO
USW $59.31 $58.00 2.3% 1.738 QWST for each share of USW
USW w/FRO $60.84 $58.00 4.9% 1.783 QWST for each share of USW
/a Based on QWST closing price on 6/14 of $34.125
The salient point in all of this is which currency--GBLX or QWST--would
trade better going into these transactions and on an after market basis.
We reiterate that both GBLX and QWST are terrific new generation assets
run by CEOs that we have known for a long time and for which we have the
utmost respect. Both QWST and GBLX were companies we brought public and
which we have been unabashed bulls on since their public launches. We
think this fight over USW and FRO is indicative of a theme which we have
discussed many times. That is, in the new world order of telecom, there
is a mad rush to put together assets that allow one to be a global
provider of end-to-end integrated on-net facilities-based solutions. In
addition to scale and scope of these types of facilities, one also needs
distribution and connectivity to customers as well as product sets,
applications capabilities, and infrastructure for sales, billing and
customer care. Whether you are an older established company like an RBOC
or a European PTT who have customers but need new assets, especially
outside of your former monopoly territory, or a new age company with very
modern assets but in need of customers, product sets and other
capabilities, the name of the game is to attempt to leverage one's cu
rrency to bulk up in order to get to a size level that allows you to get
even bigger if one is going to be successful in being one of the handful
of megacarriers in the global telecom industry.
More importantly, unlike much of the rhetoric we are hearing, we do not
believe that QWST nor GBLX are attempting to merge and/or acquire USW and
FRO as some indication of uneasiness about their business prospects. On
the contrary, we believe that Joe Nacchio and Bob Annunziata, given their
backgrounds understand the leverage one has in putting together new
assets with broad based customer bases and capabilities. Thus, we
believe the QWST bids for USW and FRO simply underscore the validity of
the GBLX merger agreements with both these companies and we believe that
QWST clearly understands the virtue of putting together assets with
customers and getting to a size level that then allows one to go up to
the next level in order to become a global end-to-end player as well as
the strategic virtue of increasing its scale and scope just as GBLX does
and neither move is a statement about their own view of their own
prospects. Let's face it, WCOM which clearly has the telecom industry's
broadest set of global network, data and IP assets, used its merger with
MCI to leverage these assets with MCI's customer base and other
capabilities.
Therefore, in our view the logic of GBLX was underscored by what is a
very smart management team at QWST. However, we believe that the
structure of the GBLX transaction is far more virtuous for unlocking
value transparency for all sets of shareholders whether you are a USW
income-oriented shareholder or a GBLX hyper-growth shareholder. The GBLX
deal is a pro-Choice deal which gives all types of investors choice as to
what type of currency they want to own vs the QWST transaction while
having similar industrial logic, nonetheless, forces a structure that
will suboptimize value.
QWEST DEAL STRUCTURE SUB-OPTIMAL RELATIVE TO GBLX DEAL
Having said that, however, we believe the structure that QWST has chose,
which is to smash all these companies into one currency, is sub-optimal
relative to the structure that GBLX has put forth, which is to create two
pure tracking stocks--one an income oriented company with local exchange
assets that will pay 75% of its earnings out in dividends and the other a
hyper-growth company that will have EBITDA growth in the 45%-50% range.
We believe that structure gives the entire class of shareholders of USW,
FRO and GBLX the best transparency of value since if one is an
income-oriented shareholder, one can elect to have the bulk of their
holdings in the L shares which will be a single digit-growth vehicle with
a very high dividend payout that will have a very predictable 10-12%
total return. On the other hand, if one is a hyper-growth investor, one
can elect to have the bulk of their holdings in the G stock which will be
a $6 billion entity with $1.4 in EBITDA growing at 45-50% per year.
GBLX + USW + FRO IMPLIED VALUATION
($ in billions, except per share amounts)
2000 EBITDA FV/EBITDA Firm 2000 Equity
EBITDA growth multiple Value Debt Value Comments
'00-'04
G Stock $1.4 46.3% 35.0x $49.2 $6.0 $43.2 35x EBITDA multiple
is
avg multiple of
emerging
growth network
stocks
2000 Payout Dividend Equity
Net Inc. Ratio Yield Value
L Stock $2.0 75.0% 4.0% $37.3 Based on avg total
return & yield for
income stocks.
------
TOTAL $80.5
Implied per share valuation $62.24
Current GBLX share price $50.38
Upside from current share price 24%
GBLX/FRO/USW Proforma shares 1,294
In contrast, the QWST structure which smashes together all of these
assets into one currency, creates a currency that is dramatically
dilutive to the growth rate of QWST which no doubt disappoints the
hyper-growth investors and will be a currency that will pay no dividends
which we believe eliminates the attractiveness all together for any USW
shareholder. More specifically, the proforma QWST/USW/FRO will have
roughly $22 billion in revenues, $8 billion in EBITDA and cash earnings
per share (net income plus amortization of goodwill) of $1.20-$1.25 in
year 2000. QWST on a standalone basis had an EBITDA growth rate of
roughly 40%. We believe the 5 year compound annual growth rate (CAGR) of
EBITDA will be roughly 15%. If one smashes all the companies together it
is actually 12% but factoring synergies and acceleration post-271 LD
entry we can get to a 15% or so 5 year CAGR. We believe the revenue
growth of this proforma company will be about 14%, roughly half what QWST
standalone revenue growth would be.
QWEST PROFORMA VALUATION
Thus, if one attempts to value QWST on a proforma basis, the only way to
do it is to compare it to other integrated large cap companies such as
WCOM. WCOM, which has by far, the widest array of assets around the
world, in particular, the largest IP backbone on the planet and more
fiber into more buildings than any carrier on earth, trades at roughly
13x 2000 EBITDA or about 70% of its EBITDA growth rate and WCOM trades at
roughly 26x 2000 cash eps. If one applies similar valuation metrics to
proforma QWST, one gets a fair value in the $32-$35 range which is
essentially where the stock is after yesterday's close. In contrast, as
noted in the table above, we would argue that the proforma valuations of
the G and L stocks for GBLX sum to $62 per GBLX share or 24% above
current prices.
We should point out that QWST will have to divest or at least churn away
its existing long distance customers within US WEST's territory which
generate roughly $200 million in revenues for QWST today probably growing
at a double-digit rate. QWST is assuming that USW gets 271 approval for
entry into long distance on January 1, 2002. We believe that this
estimate is aggressive since we have not seen USW make much if any
progress towards meeting the 14 point checklist spelled out in the
Telecom Act of 1996.
We believe while the strategic merits of the QWST proposed bids for USW
and FRO have foundation as vertical integration can boost margins
significantly, nonetheless, smashing all of these assets into one
currency we believe is problematic for valuation, whereas in the GBLX
transaction, where the structure is in place for realization of value for
both the value and growth components of the combined asset base of the
companies in question, that structure we believe allows for an
instantaneous valuation at least 25% above the current GBLX share price
with more potential value creation with two separate tracking stocks on a
going-forward basis.
QWST + USW + FRO Proforma Valuation
5 YR CAGR EBITDA & Cash EPS Implied
2000 '00-'04 Multiple* Value Per Share
EBITDA $8 billion 15% 10.5x = $35.00
Cash EPS $1.25 18% 26.0x = $32.50
(NI + Amort. of Goodwill)
Fair Value $32.50-$35
QWST's current price (6/14/99) $34.13
Implied Upside to Current Price -2.5% to 5.0%
*Valuation of 10.5x is 70% of EBITDA growth (in line with WCOM's
multiple/growth rate)
*Valuation of 26.0x is P/E on cash EPS (in line with WCOM's P/E on cash
EPS)
FRONTIER's VALUE TO QWEST vs GBLX
The other thing we would point out is, unlike GBLX which clearly has a
real need for the FRO network given GBLX's lack of a US network, QWST on
the other hand does not really need the FRO network and we believe that
the reason for going after FRO is simply a way to break-up the GBLX
transaction. Thus, while there are certainly synergies to be gleaned on
the part of QWST by also owning the FRO network, since neither network is
particularly full of traffic and since the FRO network by definition is
virtually identical to the QWST network, there does not seem to be the
type of off-net/on-net synergies one would normally get by combining two
long haul networks. On the other hand, the synergies and opportunity
benefits in terms of time to market that GBLX can glean by owning the FRO
network are, in our mind, much more tangible than is the case for QWST.
Also, if QWST believes that owning FRO somehow disadvantages some of
those companies that may be using the FRO network now until they build
their own, LVLT in particular has tons of cash in the bank and is
partially owned by one of the world's best construction companies,
therefore they will in fact complete their network and thus any
collateral benefits of QWST owning FRO will be rather short-lived. We
find it somewhat odd that QWST would essentially be buying back their own
network at a very significant premium to what they sold the original 24
strands of fiber to FRO, especially since it is not obvious to us that
QWST needs that network given the macro-capacity embedded in their 48
strands not to mention the spare conduit they have. Again, from a GBLX p
erspective, they had a deficiency in the US which FRO solves, so to us
that is a much more straight forward and seamless fit than FRO with QWST
which to us is somewhat superfluous.
US WEST's VALUE TO QWEST vs GBLX
On the USW side, we certainly would argue that whatever virtues there are
in having access to the USW customer base and technological expertise on
the data side should accrue to either QWST or GBLX. Our view, though, is
that the value creation from that will be much more transparent in the
GBLX structure than in the QWST structure.
The other interesting side effect of all of this is BLS' interest in QWST
which up until this week was 10% of QWST for $47.25 that they paid.
Under the terms of QWST's offers for USW and FRO, BLS owns roughly 3.5%
of the new QWST with QWST's stock $13 below where BLS paid for it. Not
having had any discussions with BLS, we doubt that they are necessarily
pleased with this turn of events.
TRANSACTIONS UNDERSCORES GLOBAL TREND
The bottom line here is that the QWST bids of FRO and USW as well as the
GBLX merger agreements with both these companies underscore the
undeniable trend towards creating globally-based providers of on-net
facilities-based end-to-end services. We think both QWST and GBLX are
right in trying to take advantage of their currencies based on
well-deserved views of the assets they are building in order to increase
their respective size and scale in this industry. We believe those
companies, most notably WCOM, but others such as Bell Atlantic (BEL) and
SBC who are all pursuing the same idea are on the right path to creating
shareholder value. We also believe that this industry consolidation will
continue to highlight the value of assets that are being built on one
hand and companies that have customer bases on the other hand. Clearly,
many of the CLECs, many of the European networks being built and
obviously companies like Sprint (FON) all represent attractive assets for
those companies that are vying to being the half dozen or so major global
players.
DETAILED VALUATION MECHANICS
In our "CURRENT VALUE OF GBLX vs QWST OFFER" table above we compare the
two offers. Here we provide more detail regarding the calculation of the
offers. At yesterday's closing prices the GBLX offer provides a higher
premium than the QWST offer. Based on yesterday's closing prices, FRO is
worth $63 per share and we estimate USW to be worth $63.57 per share
under the GBLX offer, providing for 9.8% and 9.6% upside respectively
compared with 5.1% for FRO if only FRO agrees to merge and 7.8% for FRO
if USW also agrees to merge with QWST. The terms of the GBLX/FRO deal is
as follows: if GBLX trades between $34.56 and $56.78, FRO shareholders
will receive $63 worth of GBLX stock for each share of FRO that they own,
thus the exchange ratio will fluctuate depending on GBLX's share price.
Above the collar, the exchange ratio is 1.1095 shares of GBLX for each
share of FRO and at the low end of the GBLX has the option to add cash or
stock to maintain a $63 value. Thus, FRO is worth $63 per share given
that GBLX is trading within the collar of GBLX's offer representing 9.8%
upside to FRO's closing price.
To determine the GBLX/USW exchange ratio, one first needs to determine
the number of shares issued from the FRO merger. Given yesterday's
closing price the exchange ratio for FRO is 1.2506 or $63 divided by
GBLX's closing price of $50.375. Based on fully diluted shares for FRO
of 182 million the number of shares issued from the FRO merger at current
prices would be 227.6 million. These shares added to the GBLX fully
diluted shares of 458.4 million and less the 39.2 million shares from
USW's tender offer results in 646.8 million GBLX/FRO post-tender offer
shares. Consequently, the USW exchange ratio is 1.2620 (646.8
million/512.5 million USW fully diluted shares outstanding) shares of
GBLX for each share of USW given that GBLX/USW merger is a merger of eq
uals with an equal number of voting shares. Using this exchange ratio
and GBLX's closing share price of $50.375, USW's per share value is
$63.57, representing 9.6% upside to yesterday's USW closing price
compared with 2.3% for USW if only USW agrees to merge and 4.9% for USW
if FRO also agrees to merge with QWST.
The value of QWST's offer is more straight forward. For FRO without a
USW agreement too, FRO is worth $60.30 or 1.181 shares of QWST plus $20
in cash for each share of FRO ((1.181 x $34.125) + $20 cash). If USW
agrees to merge with QWST as well, the exchange ratio increases to 1.226
shares of QWST plus $20 in cash for each share of FRO or $61.84 ((1.226 x
$34.125) + $20 cash). QWST is offering 1.738 shares of QWST for each
share of USW if FRO does not agree to merge for a value per USW share of
$59.31 (1.738 x $34.125) or 1.783 share of QWST for each share of USW if
FRO does agree to merge too for a value per USW share of $60.84 (1.783 x
$34.125).
NET/NET: As we speak, the GBLX offers are in fact mathematically
superior to the QWST offers. One day does not make a trend but we
believe given that both QWST and GBLX are reputable companies run by very
proven management teams that the better structure for value transparency
of the GBLX transaction is likely to be increasingly evident to all the
various shareholder bases. |
