comments out of Sanford Bernstein's Tod Jacobs this am (recirculation
of his analysis from last May):
WorldCom and the Wireless Question II: A Sprint Combination Could Work;
Lower Technology and Network Risk; Tougher Regulatory & Cultural Go
Highlights
1. A WorldCom-Sprint (including both FON and PCS to avoid prohibitive
tax and GAAP earnings consequences) combination could provide viable
alternative to a WCOM-NXTL merger and would likely meet company's expressed
dilution guidelines of less than 10% dilutive in year one; neutral by year
three
2. Combination would create lower network and technology risk; however
much tougher sell regulatorily (we think it would fly after a fight) and
culturally
3. Timing is everything: most ugly dilution would be avoided by
effecting 2H-2000 close - beyond peak PCS dilution period; cost savings
trace primarily to long distance side, CLEC, Global One and general overhead
4. Continue to believe company not compelled to act relative to
business trends for next couple of years; nor is Nextel - which may be a
viable choice - the only choice
Investment Conclusion: We continue to rate MCI WorldCom outperform. Better
levered than any large-cap telecom company to the growth areas of data,
internet, international and competitive local, WCOM should outgrow both its
major competitors and the market by a substantial and sustainable measure.
However, now that wireless lightening has struck at least twice (first
Airtouch, upon which cold water was thrown after 4 days of speculation, and
now Nextel, where the hot water continues to flow), we expect that the stock
may hold in its current volatile trading range until the company puts up or
shuts down the speculation. Once done, and assuming that the targets for
dilution/accretion fall as expected, we would expect a rapid recovery in the
stock as the market appreciates what would likely be a sounder long-term
operating structure (the last hole filled) and an improved long-term growth
rate. Sprint retains an outperform rating for the strategic value of its
wireless and wireline assets to a host of others and for its continued
double digit earnings growth and reasonable valation. PCS is rated market
perform on valuation.
Details
Strategic Rationale
As we indicated in a piece last week titled, WorldCom and the Wireless
Question (April 30, 1999), we believe that MCI WorldCom would benefit
long-term from having a facilities-based wireless solution that could
support voice and high-speed data services in a bundled offer. And while
that piece focused on the strategic implications of a Nextel merger, we
believe that a WorldCom-Sprint merger could provide a perfectly viable
combination. Key to the merger would be the acquisition of both parts of
Sprint: wireline (FON) and wireless (PCS). That's the only way to avoid
prohibitive tax consequences (relative to PCS; they don't go away prior to
November 2000 in a stand-alone purchase) and prohibitive GAAP earnings
consequences (ie the only way to effect a pooling and avoid goodwill). It's
also the only way to mask the otherwise substantial PCS dilution through
application of cost synergies derived from a combination with the wireline
company.
Beyond financial impact, we believe that Sprint PCS carries lower network
and technology risk than Nextel. This is primarily because Sprint's network
is based on the industry standard CDMA technology which already enjoys
widespread vendor support (for handsets and network equipment) and which
sports a more elegant evolution path towards the higher speed (e.g., greater
that 28.8 kbps) and third generation (3G) data services that we expect to
grow in importance to business customers over time. Moreover, Sprint PCS
has close to 30 MHz of spectrum, on average, across the country - and
therefore, much less capacity risk going forward -- and a great and largely
established distribution network (via Radio Shack and other retailers) to
boot. MCI WorldCom could thus deploy advanced bundled services off the
Sprint platform with much lower network/technology risk and less management
overhead than with Nextel.
That said, regulatory and cultural issues could hamper the deal.
Specifically, the long distance marketshare concentration engendered in a
combined WCOM-FON company would likely draw fire from competitors and
regulators alike. However, having spoken with several regulatory experts, we
believe that the following facts would combine to push the merger through:
* pending RBOC LD entry (especially given unanimous analyst estimates
of a fast march into the consumer LD market (we think 25% by 2003) and a
robust entry into the business LD market (estimated 8% by 2003 - effectively
15% of the small-medium business market and about 0% of multinational, which
will require the assistance of full-service networks, which they don't have
and can't build that quickly from scratch)
* growing CLEC (new entrant) market share
* exploding long-haul bandwidth (domestic and intercontinental), and
* relative ease of market entry by other would-be competitors
* consumer competition would actually increase as MCI WorldCom - which
on a standalone basis has little incentive to invest in the consumer space
(see our March research report for in-depth treatment) - would have a higher
stake in consumer, with a foothold in LD and wireless. The company would
thus be far more likely to enter the local market to complete the bundle.
The second issue is culture: MCI WorldCom seems to find an affinity with
high-flyers and upstarts, like Craig McCaw, the MFS guys, the UUNet guys,
the Brooks Fiber guys. Not that they're squares or anything like that out in
Kansas City; but the Sprint Local Division (not to mention product
distribution and directory publishing segment) might not walk the WCOM walk
(though there's very little strong and consistent cash flow can't cure with
time). And while it's somewhat difficult to imagine Art Krause and Scott
Sullivan or Bernie and Bill doing a lot of joint meetings on the roadshow,
we expect that in a take-out the most senior brass at Sprint could be
persuaded to spend more time with their families. At the end of the day,
WCOM has a way of incenting and keeping the folks they need and allowing for
graceful departures for the typically cashed-out folks they don't.
--more--
Financial Issues
Assuming a pooling (as indicated above) and a mid-2000 closing date
(reasonable, given the complexity and regulatory challenges of the deal, and
important given the higher dilution inherent in PCS' losses that would be
caused by an earlier close), we believe that a Sprint acquisition would
dilute WorldCom's 2000E earnings by 15%, or about $0.45, based on a 20%
premium to yesterday's closing price (Exhibits 1 and 2). Backing out the
losses from Sprint's CLEC and Global One businesses (assumed to be
discontinued operations after the deal; even if WCOM wants to keep the
development of ION going, it doesn't need the hard assets; and WCOM's
international division obviates the need for G1), shaves about another point
off dilution. And operating synergies - including cuts in overhead and
reduction of Sprint's wireline network and sales/distribution expense from
leveraging WorldCom's core operations ($0.14/share) and the D&A and interest
rate synergies related to the lowering of the combined company's total CAPEX
budget ($0.02) - dilution could drop to about 9%, or about $0.25 a share.
This falls within the "single digit" dilution target oft repeated by the
company and represents much less of a stretch than with Nextel's "reach"
NOLs that we described in our piece last week. Beyond 2000, we believe that
earnings dilution could decline to 7% by 2001E and to about 2% by 2002E. At
the same time, WorldCom's 2000E-2003E revenue growth would drop on the
inclusion of the slower growing FON revenue (which includes far slower
growing local, product distribution and directory publishing revenue and
which excludes, according to our expectation, the CLEC) - prior to any
expected revenue synergies, which we haven't counted (Exhibit 3). However,
the company's EBITDA growth rate would increase by about a point, to 12%,
and operating profit growth would increase by 300bp. The promise of
bundling would add the juice to the dilution and growth rate numbers
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