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LVLT could be a key player in the process; positive for stocks of all emerging
carriers. In our view, LVLT’s core competencies and long-term competitive advantage will lie in being a more horizontally focused, long-distance company. LVLT has the highest firm value of the emerging carriers and a relatively higher market capitalization. These factors combined with covenant-light debt, an uncanny ability to access credit markets and
Sprint/Qwest’s general disinterest in their LD operations (and in becoming consolidators), make LVLT the most likely candidate to drive consolidation, in our view. Indeed, the company has been a force in CLEC consolidation in the past, which we believe helped it to survive the debt crisis, but in many ways has compounded its current strategic problems (too much vertical integration, channel conflict, etc.).
Positively for the sector, the period 2005-2007, when LVLT acquired over 5 major CLECs, marked the last instance when its stock (and the stock of most emerging telecom companies) had solid performance (see Exhibit 3 below). We believe the shares of the emerging telecom sector could do well again if consolidation reignites. Should LVLT merge with one of its LD peers, we would expect the transaction to be highly accretive.
Subsequent to a successful LD transaction, we would expect LVLT to continue on its consolidation raid and seek to acquire Qwest’s LD network (and possibly Sprint’s as well), and to likely spin out its CLEC and data-center businesses (which can be better operated by pure-play providers). While we remain skeptical of LVLT’s stand-alone FCF-generating
capacity, we see massive potential operating and capital synergies in consolidation. We believe that combining two major long-distance networks could result in a relatively easy $300-$400 million in expense savings per year.
Management comments, improved credit and removed covenants point to M&A.
The impetus for this report is two-fold: 1) consistent management comments from LVLT/Qwest/Sprint and others in the industry on the need for further
consolidation/restructuring, and 2) the much improved high-yield markets (albeit somewhat volatile as of late). LVLT has retired its 12.25% notes and hence removed restrictive covenants now allowing the company to use pro-forma metrics in estimating acceptable leverage levels for any transaction. Absent debt restrictions, we believe LVLT will manage to achieve leverage of around 5x debt/EBITDA on a pro-forma basis in most of these hypothetical scenarios. This makes most of the hypothetical transactions
highlighted in Exhibit 4 possible, particularly using 2011 estimates, and even more likely if LVLT’s stock goes over $1.80, whereby some of its convertible debt changes to equity (a good thing, in our opinion). Our forecasts for Qwest and Sprint are highly contingent on
the potential merger terms/conditions (essentially a sale and lease-back of future transport services).
In our view, LVLT-GLBC is the most likely transaction. We believe a larger
transaction (Qwest or Sprint) would drive the highest synergies, but it is unlikely to be the first one announced. LVLT tried to consummate a deal with Qwest (and we believe Sprint-Nextel, too) last year, and could not come to terms. The complexity appears to have been driven by disagreements over management control, relative valuations and
access to capital markets. In our view, the most attractive transaction would be Global Crossing, followed by XO Communications, mostly due to: 1) manageable transaction size; 2) modest relative leverage; 3) minimal channel conflict on the wholesale front; 4) high synergy potential; 5) owners of these assets having limited strategic rationale for keeping an underperforming operation, and 6) both are stand-alone companies that would
not require the extra legal/corporate work of spinning out debt/assets as would a transaction for the LD assets of Sprint/Qwest. As a reminder, XO Communications is already using LVLT fiber/conduits, making for a potentially quick and accretive transaction.
Potential “win-win” scenario from LVLT-GLBC combination. We show the pro-forma
results of our hypothetical M&A scenarios in Exhibit 4 below, with our estimated purchase price for each of the four largest target companies. We guesstimate that LVLT could offer close to a 100% equity premium to acquire GLBC in a combination of stock and cash that would yield substantial free cash flow accretion with a lower overall EBITDA multiple and
lower leverage. More specifically, we believe that a combined GLBC and LVLT could achieve annual synergies of around 10% of GLBC’s revenues, and $80 million in cap-ex savings. The incremental $350 million in cash flow could be used to start paying down debt. XO also makes a good candidate, especially given how disruptive its pricing has been for the industry in the last three years. We also believe that its tax NOLs have been successfully separated from the operating business. There are other providers in our
sector that could be targeted as well (e.g., Cogent and many regional players), but we believe that the four we have addressed in our analysis are the most willing sellers and largest facility-based long-distance companies.
FCF generation is key for LVLT. The key driver for LVLT’s search for consolidation alternatives is to generate free cash flow. It seems that LVLT is unlikely to be FCF positive on its own in the next 2-3 years (especially given its CLEC expansion plans), and it has substantial debt maturities coming due in 2013-2014.
A restructuring transaction in LD would likely yield substantial cost and cap-ex synergies, allowing LVLT to start generating cash, paying down its debt and lowering its cost of debt. Another positive
byproduct (for the industry as a whole) of such a transaction would be pricing stability, which is absent in the current oversupplied market.
Consolidation to drive stock appreciation and further M&A. Positively, LVLT’s stock on a pro-forma basis would be much more valuable given potentially improved balance sheet and lower valuation multiple. With these critical synergies, at LVLT’s current valuation and paying close to 100% equity premium for GLBC, LVLT’s multiple would drop from 9.2x EBITDA to below 7x, and leverage would decline from 6.6x to below 4.5x. |
