[MS Investor: Jubak on telco merger targets]
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Jubak's Journal: Mega-mergers or major mistakes?
The big combos keep on coming! Here's how to avoid the turkeys and find the next targets.
By Jim Jubak
I've decided to call them "junk stock" deals.
SBC Communications' $62 billion bid for fellow Baby Bell Ameritech, Banc One's $30 billion deal for First Chicago, and Daimler-Benz's $35 billion proposed purchase of Chrysler, to name just a few recent blockbusters, remind me of the junk bond-financed buyouts and restructurings of the 1980s. Stunning prices, loud claims of future "synergy," almost universal praise from Wall Street -- I've heard this all before.
There's one big difference, though, between this wave of deals and the junk-bond financings of the previous decade. This time around, the deals are being driven by fear -- not greed. In industry after industry, CEOs seem to have decided that the supply of the critical assets needed to assure the survival of their companies is dwindling fast. Buy now, and at any price, the logic goes, or watch your company forever be shut out of the game.
Now, I don't have anything against fear in the executive suite. The emotion can really motivate a manager to get out and do something.
Great. But it's then up to investors to evaluate that something. And not all deals that add assets to the company's balance sheet add value for investors. Let me use the recent proposed acquisition of Ameritech (AIT) by SBC Communications (SBC) to illustrate how I decide whether an acquisition increases the value of a stock or dilutes your holdings.
SBC's rich bid easily topped Bell Atlantic's (BEL) August 1997 purchase of Nynex for $25 billion, which at the time seemed like a pretty steep price to pay for 19.2 million phone lines. That deal worked out to two times Nynex's annual revenues, while SBC's $62 billion bid comes to about 4.2 times Ameritech's estimated 1998 annual revenue. And the deal looks even pricier if you just count phone lines -- SBC is getting 21 million Ameritech phone lines, or about the same number that Bell Atlantic bought for half the price.
Or look at it another way. SBC is coughing up about 24 times trailing 12-month earnings for a company projected to grow earnings by 8.6% in 1998 -- that's a P/E-to-earnings-growth (PEG) ratio of 2.8. By contrast, BellSouth (BLS), a Baby Bell projected to grow earnings at 10.7% in 1998, trades at a price-to-earnings ratio of just 19.5 -- a PEG ratio of 1.8. So an investor on the open market can buy growth at BellSouth for about 38% less than SBC is paying. SBC wanted Ameritech so badly that it offered the company's shareholders a 27% premium over the current market price of their stock -- even though Ameritech's stock had already climbed 48% in the year before the deal.
But the price of a deal like this is never about the value of the acquired company as a stand-alone business. It's always about the synergies that the acquisition will create between the two companies. Combine two companies and you can cut costs by eliminating duplication and buying more efficiently, the theory goes. Join two companies, each with substantial market presence, and squeeze additional sales from the heightened visibility with consumers. In this case, SBC has told analysts that by 2003 it expects to see $1.4 billion in annual enhancement and savings from cost-cutting. (The benefits would phase in gradually, with synergies amounting to $560 million in 2001, increasing to $1.26 billion in 2002, and hitting the full $1.4 billion in 2003.)
I think SBC might be able to get most of the way to that target -- though I'm not sure it makes that much difference to investors, anyway.
SBC made similar promises in its 1997 acquisition of Pacific Telesis. While not ruling out eventual success, its performance against those promises since then is mixed. A year after closing the acquisition, for example, SBC still hasn't managed to completely integrate the two companies' network structures, since SBC uses Newbridge (NN) switches and Pacific Telesis used Ascend (ASND) switches. (SBC faces a similar integration problem with Ameritech's wireless business since it uses the CDMA standard instead of the TDMA technology employed by SBC.)
The picture is brighter on the revenue end. By the end of their first eight months of combined operations, for example, 6.4% of customers in the region served by Pacific Telesis subsidiary Pacific Bell had signed up for Caller ID. That's up from 1.5% of users in the year before the acquisition.
But here's the rub: Even if SBC can deliver synergies in these deals as promised, the numbers won't blow investors away. According to Lehman Brothers, the Ameritech acquisition will cut SBC's earnings per share in 2000 by about 7%, since the company will issue more shares to finance the deal. In fact, earnings per share don't rise at all until 2002. Averaging the pluses and minus over the next five years, Lehman's analysts figure that the combined company would show an average annual growth rate of just 10% or so. And that's assuming SBC doesn't buy anything else, Lehman notes almost casually.
SBC shareholders are being asked to sit through at least two years of dilution in earnings per share in order to reach the promised land of double-digit earnings growth per share in years four and five.
That's an interesting comment, since SBC has already promised Congress and federal regulators that it will enter at least 30 new markets where it will compete with Bell Atlantic and BellSouth, thus increasing consumer choice in those areas. If this is more than posturing, SBC will have to buy competitive local exchange companies (CLECs) in these markets, build its own local offerings from scratch, or partner with existing CLECs in each market. The first alternative means more dilution; the second means a hit to earnings.
And look at what the SBC-Ameritech combination fails to accomplish. The combined company certainly isn't an Internet powerhouse, for example. To catch up to competitors like WorldCom (WCOM) in areas such as Web-hosting, security and electronic commerce, SBC would have to make other acquisitions. Nor, despite the principals' existing non-U.S. operations, is the combined company a real player as yet in the global voice and data long-distance market. Only hours after news of the acquisition hit Wall Street, analysts were already openly speculating on what long-distance company SBC should buy to supply that missing piece.
So here's the bottom line of the SBC-Ameritech deal as I see it. SBC shareholders are being asked to sit through at least two years of dilution in earnings per share in order to reach the promised land of double-digit earnings growth per share in years four and five. Any other acquisitions by SBC will push the promised earnings growth per share even further into the future. And four years -- or more -- is an incredibly long time in the phone business these days. By that time, technologies for putting phone calls over the Internet, for delivering the Internet over cable modems to the home, and for connecting home phones to the long-distance network using wireless local loops will have radically reshaped the market. I can't predict how. But if you buy or hold SBC or any other acquirer, you're betting that the management at your company can.
If I read the lessons of SBC/Ameritech, Daimler-Benz/Chrysler, and Banc One/First Chicago correctly, investors will have a lot more opportunity to do this kind of analysis. These deals aren't the last wave of big acquisitions. In fact, I think they are likely to speed up the pace of consolidation in the telephone, auto and financial-services industries. For example, SBC's move requires a response from BellSouth, BellAtlantic, and U S West (USW) -- as well as AT&T (T), Sprint (FON) and GTE (GTE). And prices in these deals are going to continue to climb. With fewer candidates for acquisition and with the need to acquire even more pressing, how can prices help but reach new heights?
For the next few months, I think the action will focus on the few remaining big plums. With the stock market at record highs, finding financing to do any deal isn't a problem, so no company is too big to be an acquisition target. Remember that SBC already took a run at AT&T. I'd say that Sprint, GTE and AT&T are all in play in the phone industry. American Express (AXP) and Wells Fargo (WFC) are clear targets in the financial-services field.
After the landmark deals, expect a second wave of acquisitions as the combined companies try to fill relatively smaller holes in their product lines. For example, in the phone industry, the buyouts among the big guys will actually turn out to be good news for the much smaller CLECs. At the worst, these companies will have more big partners knocking on their doors, offering to pay for access to the local customer base these companies have built.
Look to the recent deal between McLeodUSA (MCLD) and AT&T for an example. The CLECs could also become acquisition candidates themselves -- several own an enticing combination of local access lines, long-distance fiber networks, and Internet services. ICG Communications (ICGX), for example, offers local phone service in California, Colorado, Ohio and the Southeast, and supplies Internet access through its NETCOM division, purchased in 1998 for just $284 million. Other CLECs that combine good geography and critical assets are Electric Lightwave (ELIX) and Intermedia Communications (ICIX). I'd expect the same kind of filling deals in financial services once the last round of big deals gets done in that sector.
Don't wait too long to stake out some positions among the remaining acquisition candidates, however. Fear can drive even the slowest and biggest company to move really, really quickly.
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