research today from Bernstein's Tod Jacobs (institutional call tomorrow):
HIGHLIGHTS:
1.WCOM-FON deal expensive but worth doing; company would have premium
assets in all growth areas of telecom; all the complaints over assets, scale
and capabilities for both sides are ended
2. At current share price, cash EPS dilution believed to fall around
8%; number gets cut to 3% if WCOM nears $81 (upper collar) and nears 11% at
lower end of collar ($62)
3. Primary changes relative to our published expectations: higher
synergies (credible) and shorter amortization schedule for goodwill (doubles
the amortization and increases GAAP dilution)
4. Goodwill choice a smart one: investors will be forced to look at
cash EPS (EPS+GW) as only viable way to measure company's value and earnings
power
5. Regulatory will provide an overhang on the consumer-benefits issue;
but we expect the combined company's consumer-small-business broadband
strategy (MMDS and DSL) to provide the appropriate cover
INVESTMENT CONCLUSION: While WCOM has clearly paid top dollar for Sprint, we
believe that the deal's strategic sense is powerful, and represents - as
we've believed all along - by far the most propitious solution to the
wireless issue. Even if the deal closes with WCOM at its current level (and
thus dilution runs 6% on cash earnings) the stock would be trading at about
17.5x 2001 estimates despite strong double digit earnings growth and the
most powerful set of global assets in telecom - a situation we find
untenable and very likely to unwind in WCOM's favor. The times that
investors have made significant money with WorldCom have always come on
deal-related (post MFS and MCI announcements; probably here as well) or
sentiment/fear-related issues (the great LD scare of '99). We continue to
rate both WCOM and FON (which will likely prove a cheap way to buy WCOM)
outperform.
DETAILS
1. Changes from our piece last week:
Primary changes are the price of the deal assumed (though structure is
exactly as we'd discussed, with premium paid for both FON and PCS pieces),
the size of the synergies (both cost and capital) and the amortization
period relating to the goodwill. First on deal structure, Exhibit 1 lays out
the basics: a $76 price per share of FON within the collar, which is set at
$62.15/WCOM share at the low end and $80.85 at the upper end. The exchange
ratio thus floats from a low of 0.94 WCOM shares per FON share to 1.228 at
the high end. Goodwill of $56b on the wireline side will be amortized over
20 years rather than the 40 we'd assumed, and for two reasons: 1) it will
play better with the SEC; 2) it will force most investors to disregard GAAP
earnings by effectively rendering them meaningless as a gauge of company
value and cash generating power.
Exhibit 1
<<...>>
Exhibit 2 lays out the company's expected pro forma earnings on a cash EPS
basis. With $1.35 in pro forma goodwill, the new company at current WCOM
stock price levels would produce about 8% in cash EPS dilution. At the upper
end of the collar ($80.85 share price), dilution on our estimates drops to
about 3%, while dilution at the lower end of the collar ($62.15) rises to
about 11%. Relative to GAAP EPS, the 20-year amortization schedule creates
huge dilution (29% going to 23% by year 3 at current share price levels; 3-4
points better and worse at the collar ends.
Exhibit 2
<<...>>
Exhibit 3 lays out the company's expectations for synergies. Relative to our
initial attempts, the company added a $100mm a year cost synergy at ION
(lower cost of switching and transport by using WCOM facilities rather than
RBOCs), and, in our way of thinking about it, added about 2 points of
overhead reduction (as % to total FON cash cost) and about 4 points of LD
cash cost reductions in year one, and grew the numbers to a very similar
level to our initial forecast for the latter years (2003). The company also
has identified larger capex synergies than we'd assumed, coming in at about
$1.3b versus (nearly double our attempt), and in turn driving higher
depreciation and interest expense savings. On a pro forma basis, synergies
thus are expected at about $0.41 in 2001 and $0.57 by 2003 - numbers that we
expect analysts will believe credible given the company's successful
experience in the MCI transaction in its first year.
Exhibit 3
<<...>>
2. Shape of the New Company
Exhibit 4 lays out the 2003E revenue expected revenue mix for various WCOM
permutations relative to both the wireline company (WCOM + FON) as well as
the consolidated company (including PCS) - both with and without Sprint's
internet business, which we expect will have to be sold. The reason
consolidated needs to be tracked is that starting in November 2001, WCOM
will have the option (as FON does now) to buy out PCS at a 10% premium. On a
consolidated basis, voice drops from an expected 44% to either 39% or 38%
depending upon inclusion or exclusion of FON internet. On a wireline basis,
voice stays virtually the same as WCOM standalone. Thus the deal is clearly
neutral to positive to business mix however you count it.
Exhibit 5 traces our forecast for the company's revenue growth rates under
the various scenarios. Our current WCOM standalone forecast calls for 12%
compound growth from 2000-03. The combined wireline company would see that
growth come at about 9.5% given the much slower growth of FON's non
long-distance operations, with less than half a point in growth dilution if
FON internet is excluded. On a combined basis, with PCS, growth appears to
be about 11.5%. And clearly if the company later divests the local business
(and directory publishing), the growth rate would accelerate further.
Exhibit 4
<<...>>
Exhibit 5
<<...>>
3. Regulatory
The clear issues here are internet concentration and consumer benefit. On
the former, we expect the company to divest the Sprint internet business
(which we believe would be neutral to accretive to eps given what we believe
is that business's currently not-too-profitable picture). On the latter
issue, we expect the company to make a big deal about the fact that it will
be the third broad-band pipe into the home and small business (T has cable;
BOCs have DSL) given the company's combined 55%-of-US-homes footprint in
MMDS (which we expect to actually get larger given the simultaneous
xDSL-related ION strategy). Ultimately we expect the deal to pass muster,
with closing anticipated in about a year (company says 2H'00; Ebbers says
3Q'00).
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