Sanford Bernstein on WCOM-FON? Still Strikes Us as Powerful Combination
Tod Jacobs Carl Walker Jeff Halpern
September 27, 1999
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O - Outperform, M - Marketperform, U - Underperform
Highlights
1. Continue to believe that WCOM-FON combination is the right one to
solve WorldCom's wireless question; would also be a boon to Sprint relative
to its need for cohesive strategies in both international and domestic local
2. Assuming purchase accounting, creation of a tracker for PCS assets
could hold dilution to less than 10% year1, and under 5% year3; conservative
revenue synergy assumptions could make breakeven year3
3. Assuming pooling (and the tracker) which we think would be possible,
deal immediately accretive by 1-2%, moving up to about 3% year2
4. Deal could probably withstand regulatory scrutiny other than in
internet space; forced divestiture of Sprint Internet wouldn't poison
pooling, but could create taxable event and thus modestly higher price to
WCOM
Investment Conclusion: We continue to rate WCOM and FON outperform
Details
A. Overview
In May of this year, as the market expectations were growing in relation to
a WCOM-NXTL deal to solve the WorldCom wireless "problem," we issued a piece
suggesting that the more sensible merger was with Sprint, in part because
the addition of the wireline part of Sprint would also bring substantial
synergy and access to a large customer base in both business and consumer
markets, and in part because the PCS wireless assets have an easier
migration path into the future (3G, capacity; see below) than do the Nextel
assets. Current talk of a merger, though unconfirmed, nonetheless still
strikes us as reasonable and possible. In the piece we wrote, which we've
appended here for those interested in pursuing the wireless angle in more
detail, we made several assumptions that need to be updated. First off, the
numbers have changed: FON has had a stock split, and PCS stock has risen
substantially from its then-$45 level. Second, we modeled a consolidated
entity; talk today was for a tracker on the PCS business, which would
radically reduce dilution. Third, we modeled a pooling, and talk in the
recent articles was of a purchase, though for reasons we don't understand
(though the company may wish to preserve the right to sell off Sprint's ILEC
business). While we believe the chief regulatory risk of such a combination
is the overlap in internet assets, any Government-forced divestiture, even
if it triggered a taxable event for FON shareholders (which it presumably
would; thus potentially raising the price to WCOM by the amount of the tax
liability), wouldn't poison a pooling according to what we know. On the
other hand, if WCOM had in mind to divest FON's ILEC assets (the tradeoff
being a steady, if slightly less than sexy (not only based in Kansas City,
but an ILEC too!), cash generator for a more consistently growth-honed
(Jackson-based) company.
B. Logic
In our view there are four chief benefits to the concept of a WCOM-FON
combination:
1. WCOM's wireless problem gets solved with a first-resort solution.
Unlike Nextel, for example, PCS enjoys a single frequency, single
technology, capacity unconstrained, multi-vendor-supported wireless
technology which also comes complete with a path to 3G. The consumer
friendliness of the PCS product also allows for greater customer-base
penetration. The issue with business customers for WCOM comes down the road,
in our opinion, when business customers begin to demand integrated wireless
products from their vendors (e.g., for wireless remote access, etc). And
while wireless would not have been a prudent investment for WCOM to make to
support its consumer business alone, there's no question that having it
would greatly strengthen the company's rather anemic consumer bundle
(vis-à-vis T and RBOCs), as well as offer the company a vehicle to recapture
consumer LD minutes that are migrating to wireless. Moreover, the addition
of wireless would end a persistant overhang on WorldCom: namely, how long
can you go without wireless? At once, that negative would become a positive
in the sense that the company would now be exposed to every growth segment
in telecom. As exhibit 1 shows, by 2003E, voice revenue would drop from 44%
of the total corporate revenue mix on a stand-alone basis to about 38% pro
forma, with wireless making up 12% of the total.
Exhibit 1
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2. FON's international problem gets solved. That is, the company could
extract itself from Global One in favor of WCOM's existing and cohesive
strategy. The fate of G1 would be very much up in the air. According to our
understanding of the G1 agreement, upon a change of control in Sprint, board
and voting control would move to FT/DT. Sprint then has the right to offer
its shares to FT/DT at a price to be determined by a third party appraiser.
If FT/DT refuse the price the voting control is restored to prior levels
(prior to further fighting). For WCOM, FON's extraction simply becomes a
source of synergy, if not a source of cash from a sale.
3. FON's local connectivity problem gets solved, and WCOM/FON get scale
in MMDS. FON is currently subjecting itself and its shareholders to $0.30 a
year dilution from ION and an additional $0.18 from MMDS - all in an attempt
to build what in essence is a CLEC for both consumer and business customers.
Joining with WCOM would shorten the timetable dramatically for FON given
WCOM's large CLEC presence, thus helping to reduce customer churn through
bundling of more services. And both companies have recently embraced MMDS as
a local hi-speed access strategy; thus scale would come faster and for lower
combined R&D and deployment costs.
4. The combination would allow for significant cost and capital
savings, much as the MCI merger did and does, as we discuss below.
C. Synergies and Earnings Impact
We essentially modeled four scenarios to assess potential dilution and
earnings impact from a Worldcom-Sprint deal: a purchase transaction with PCS
spun out as a tracking stock (our base case scenario), a pooling transaction
with PCS spun out as a tracker, a purchase transaction without a tracker,
and a pooling without a tracker (our original, May 4th scenario). These are
discussed below.
Exhibit 2 lays out our base case scenario, a Worldcom purchase of Sprint
(FON and PCS) with PCS spun off as a tracking stock, and highlights the
incremental goodwill and shares required.
Exhibit 2
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Assuming a 20% premium to the September 23rd closing price for both FON and
PCS, current owners of FON would get 0.806 shares of WCOM for each FON share
and current owners of PCS would get one share of the new wireless tracker
and 0.196 shares of WCOM. In total, WCOM would have to issue 819mm new
shares -- 715mm to FON shareholders and 103mm to PCS shareholders (= value
of premium to closing PCS stock price; PCS shareholders would also get the
new wireless tracking stock). The transaction would create $43b of
incremental goodwill in the wireline stock and $46b of incremental goodwill
in the wireless tracker, and we've assumed a 40-year amortization. Based on
a year-end 2000 close, we believe that first year dilution in the wireline
stock (WCOM plus FON wireline operations) could be less than 10% after
expense and capital synergies (Exhibit 3).
Exhibit 3
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Base case synergies include a 5-15% reduction in FON LD cash expense to
reflect combined operations with WCOM, a 3-5% reduction in overheads at FON
and lower D&A and interest expense to reflect lower capital expenditures on
the LD and data networks and IT and in Sprint's C-LEC operations. More
specifically, we are assuming that the combined company would keep ION
(especially given its MMDS bias), but could nonetheless reasonably cut the
ION CAPEX in half by reducing the co-location and facilities costs by
leveraging WCOM's broadly deployed local C-LEC assets, while continuing
development costs and incremental (success-based) network capital and
associated software. All told, we believe that these synergies could be
worth nearly $0.30 per share in 2001, rising to $0.43 in 2002, and reaching
nearly $0.54 in 2003.
Out year (2003) dilution for the purchase transaction (assuming the PCS
tracker) would be less than 5% after synergies. Moreover, WCOM could make
the deal neutral to EPS by 2003, if it could capture 5-6% incremental
revenue from bundled services and other offers (we think this could be
attainable, give the combined company's marketing might). If the purchase
premium were 30% on both FON and PCS, first year dilution would be 14% and
third year dilution would be 9%, with 11% incremental revenue required for
break-even in 2003.
Divestiture of Sprint's internet assets could add modestly to this dilution,
given the high growth rate of revenue and what we think would be an
increasing profit impact on the business, though to be sure this would be at
least partially offset by returns driven on the the cash received on sale of
the assets.
Exhibit 4
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Exhibit 4 shows WCOM dilution for the deal under pooling accounting (still
assuming a PCS tracker). This would limit the firm's flexibility for
further asset sales (e.g., the FON ILEC business) but could cut out year
dilution (pre-synergy) in half, to 7-8%, and make the deal accretive from
year one post synergy, without assuming any revenue synergies. And, as
Exhibit 5 shows, on a cash EPS basis (= EPS + D&A), the deal looks even
better (Exhibit 5), with out year dilution 1% before synergies and accretion
6-7%, after.
Exhibit 5
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A straight purchase transaction, without a tracker, is a non-starter with
first year dilution of more than 40% and out year dilution of over 20%,
while a straight pooling transaction without a tracker (our May 4th
scenario) is somewhat better (see Exhibit 6): 21% dilutive in year one and
9% dilutive in year three, but still about 10 points higher than we forecast
in May on the higher assumed PCS purchase price.
Exhibit 6
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D. Risks
There are several risks to the deal, the most obvious being regulatory. On
that front, we've talked to several attorneys over the past several months;
most hold the opinion that the deal could pass muster, largely in light of
exploding LD capacity (here the pricing problems of recent months would be
helpful), imminent RBOC entry and general consolidation trends globally. The
stickiest point revolves around internet, where MCI was forced to divest
prior to the WCOM merger; that would likely happen here as well (though some
attorneys believe that the entry of T and QWST and soon BEL into the
internet space may make it possible to retain the assets). Sale of the
business would likely be a taxable event, and thus would generate a tax
liability that WCOM would have to cover. In our May piece we also noted
culture as a risk; though we expect that WCOMs desire to own PCS could
outweigh its desire to only buy high-fliers. And of course, as with all
deals, this would bring execution risk, though we expect that the MCI
experience has well prepared WCOM to digest a company this size with this
much overlap.
Following is an appended copy of our May 1999 note of a possible WCOM-FON
combination:
WorldCom and the Wireless Question II: A Sprint Combination Could Work;
Lower Technology and Network Risk; Tougher Regulatory & Cultural Go
Tod Jacobs 212-756-4607 & Carl Walker 212-756-4379 & Jeff Halpern
212-407-5958 May 4, 1999
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O - Outperform, M - Marketperform, U - Underperform
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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