SSB: WCOM, Sprint
Jack B. Grubman 1-212-816-2877 (ID 132)
WCOM: FON/PCS Adds Superb Strategic Assets
SUMMARY:
MCI WorldCom, Inc.--Telecommunications Services *WCOM is buying FON & PCS for a total of $115 billion. *FON holders will receive $76 per share in WCOM stock in between a collar of $62.15 & $80.85 or 1.2228 below $62.15 or 0.94 above $80.85. *PCS holders will receive a WCOM PCS tracking stock on a 1:1 basis plus a premium in the form of 0.1547 shares of WCOM ($11 per share today). *This deal gives WCOM ownership and control of the best wireless asset in U.S. while maintaining its cash eps & a pathway to fold in PCS to WCOM when it becomes financially prudent to do so from a dilution perspective. *WCOM has solved its wireless overhang while also expanding its wireline scale and scope & has clearly reinforced its stature as having the best set of strategic assets in the industry. *WCOM is cheap at 16x 2001 cash eps & 8.4x 2001 EBITDA with EBITDA & cash eps growth rates at or above 20%. *Reiterate Strong Buy Rating.
EARNINGS PER SHARE--------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 12/98 EPS $0.18A $0.21A $0.21A $0.22A $0.82A
Previous 12/99 EPS $0.36A $0.45A $0.55E $0.65E $2.00E
Current 12/99 EPS $0.36A $0.45A $0.55E $0.65E $2.00E
Previous 12/00 EPS $N/A $N/A $N/A $N/A $2.90E
Current 12/00 EPS $N/A $N/A $N/A $N/A $2.90E
Previous 12/01 EPS $N/A $N/A $N/A $N/A $N/AE
Current 12/01 EPS $N/A $N/A $N/A $N/A $4.15E
Footnotes: 1998 through 2000 Standalone WCOM GAAP EPS .
2001 is CASH EPS PRO FORMA WCOM & FON.
--FUNDAMENTALS--------------------------------------------------------------
Current Rank........:1M Prior:No Change Price (10/5/99).....:$67.94
P/E Ratio 12/99.....:34.0x Target Price..:$130.00 Prior:No Change
P/E Ratio 12/00.....:23.4x Proj.5yr EPS Grth...:28.0%
Return on Eqty 98...:N/A% Book Value/Shr(99)..:26.00
LT Debt-to-Capital(a)26.7% Dividend............:$N/A
Revenue (99)........:34094.00mil Yield...............:N/A%
Shares Outstanding..:1938.0mil Convertible.........:No
Mkt. Capitalization.:131667.7mil Hedge Clause(s).....:#
Comments............:(a) Data as of the most recently reported quarter.
Comments............:
--OPINION:------------------------------------------------------------------
*Salomon Smith Barney is advising MCI Worldcom Inc. in its pending merger with Sprint Corp.
WorldCom has announced that it is buying Sprint Corp. which includes the FON Group and the PCS Group in an all stock transaction valued at over $100 billion. The WorldCom/Sprint combination will have an industry leading position and tremendous assets in the 4 fastest growing areas in this industry; data, IP, international, and wireless. As a result, we do not think any other telco will be as fully integrated and growth oriented as the WorldCom/FON/PCS combination.
Specifically, WCOM will offer FON shareholders a collared fixed price deal identical to the structure of the MCI/WCOM transaction. In this instance, FON shareholders will receive $76 per share in WCOM stock as long as WCOM stock trades between $62.15 and $80.85. At the tails of the collar, the deal reverts to a fixed exchange ratio with FON shareholders getting 1.2228 shares of WCOM below the low end of the collar and 0.94 shares of WCOM above the high end of the collar.
All of our estimates for 2001 and beyond assume that WCOM's stock will be at or above the high end of the collar at deal closing. We would remind investors that WCOM's stock immediately traded below the low-end of the collar in the MCI deal only to have doubled within 8 months. Thus, MCI shareholders received an exchange offering based on the high-end of the collar which WCOM surpassed by roughly 40%. In fact, WCOM's stock price as recently as 2 weeks ago was above the high-end of this current collar and we believe, once the regulatory uncertainty dissipates, the logic of this deal becomes crystal clear and WCOM's Q3'99 earnings convince investors that the business is, in fact, very much on track, and thus WCOM's stock price will very quickly get to the high-end of this collar.
As for PCS shareholders, they essentially own the same security they own today but they will receive a premium of 0.1547 shares of WCOM for every share of PCS they own. This exchange ratio is fixed and is not a function of a collar, thus if WCOM's stock increases to our $130 price target (which remains unchanged), over the course of the next 12 months, the PCS premium will be worth $20 per share to PCS shareholders.
VALUATION A STEAL
At current prices, WCOM is selling at 16x 2001 cash eps and 8x 2001 firm value to EBITDA multiples. According to our economic group, S&P 2001 cash eps is $58.71, thus the S&P is selling at 22x 2001 cash eps. WCOM is growing cash eps 20% off of a 2001 base, and closer to 22%-23% off a 2000 base and is selling at a 27% discount to the market on cash eps with a growth rate which is 2x-3x the rate of the S&P. Thus, our $130 price target remains intact since this only implies a 31x p/e on 2001 cash eps which would be roughly 1.5x the growth rate, still well below the p/e to growth rate ratio of the S&P and of other large cap growth companies. Furthermore, we believe WCOM without question has the best set of assets in the industry and has the proven ability to leverage these assets which should drive growth and multiple expansion.
KEEPING PCS AS A TRACKER MAKES SENSE
There have been many questions raised as to why WCOM did not put the whole package together in one security. The reason is quite straightforward. Under the terms of the current Sprint arrangement if Sprint were to buy-in PCS before Nov. of 2001, it would be subject to a separate class vote and with 43% of PCS in the hands of cable companies, there is no question that a premium would be extracted which would be well beyond the premium being paid by WCOM in the form of 0.1547 shares of WCOM. From Nov. 2001 to Nov. 2002, Sprint has the right to call-in PCS at a 10% premium over where PCS would be trading in the market. Beyond 2002, Sprint had the right to call-in PCS stock based on a fair market appraisal of PCS. This last parameter has changed such that now, WCOM as the owner of Sprint will have the right after Nov. 2002, to call-in PCS stock based on a relative fair market appraisal between the WCOM and the PCS stock. Unlike the original Sprint deal where an outside appraiser would appraise value, in this case it would be a function of WCOM's board.
The bottom line is that since Sprint PCS won't be net income positive until 2003 on a full-year basis, and since WCOM's stock price is clearly severely depressed relative to its fair value, it is in the best interest of WCOM to wait until 2003 to fold-in PCS stock, especially since WCOM will not have to pay a control premium. In the meantime, WCOM owns and controls the PCS asset. To be blunt, WCOM can dictate to PCS its business plan, including bundling services with WCOM's long distance offerings, local offerings or other packaged products. Thus, WCOM gets the full virtue of owning a great wireless asset, while maintaining maximum financial flexibility in terms of near-term earnings and longer-term optimizing the right time to fold in the asset from an i ntrinsic value perspective.
WCOM FILLS WIRELESS HOLE WITH BEST ASSET IN INDUSTRY
The logic of this transaction is self-evident. There has been a "wireless" overhang on WCOM's stock for some time. We continue to believe that near-term (i.e. 12-18 months) the lack of wireless would not have impaired WCOM's growth rate. The fact is that WCOM is outgrowing both Sprint and AT&T which have wireless assets. Furthermore, both Sprint and AT&T have the same long distance rate plans in the market that WCOM does, thus we believe that having wireless does not keep one from having to be aggressive on the competitive front. However, as wireless data becomes more of a reality (why wouldn't wireless become more data-centric - albeit thin data applications - like wireline), the ability to solidify customer accounts and open more customer doors (espec ially in business but increasingly in consumer) will become more of a function of having wireless as part of one's suite of services.
WCOM's history has been to buy pristine assets, including its purchase of WilTel in 1994, which was clearly the newest and best network in the U.S. at that time. In 1996, WCOM acquired MFS Communications which had the largest array of new local fiber networks and UUNET which was and continues to be the best and largest IP backbone in the world. With MCI, in 1998, WCOM achieved scale in terms of customers and state-of-the-art systems to leverage its assets. The Sprint transaction is consistent with these prior deals. Sprint PCS is flat-out the best wireless footprint in North America. Basic engineering tenets tell us that one technology on one spectrum will drive a far greater degree of inter-operability and cost effective seamless deployment of services than wireless footprints which mix and match spectrums and even technologies.
SPRINT PCS MOST LEVERAGEABLE FOR DATA - WHICH IS WHY WCOM WANTS IT
We believe the differentiation of large wireless networks will grow as we evolve towards 2.5 G (2G refers to digital voice networks) leading to the provisioning of high speed packet data services in addition to voice services. We are still in the earliest stages of mobile data services but the benefits of mobile/wireless based services are clear -- the ability to provide real time (more relevant) and geographic context to any internet-based/information service, ranging from stock trading, mobile advertising (beaming ads to our handset as we pass in front of a GAP store), commerce (being in a Barnes and Noble and getting a simultaneous wireless price quote from Amazon) or even email and chat (buddy lists on handsets). In our view, the best positioned (and successful) carriers are those who have adopted a digital technology that will easily evolve towards high-speed data and 3G (CDMA and GSM are the best positioned), own licenses with substantial bandwidth (spectrum remains a scarce asset) and are not saddled with legacy subscribers (think analog).
Sprint PCS is well positioned to provision higher-speed packet-based data services given the company's use of highly efficient CDMA digital technology, substantial network capacity as well as nationwide scale. Within 18 months, Sprint PCS will offer its customers 1.5 Mbps data access on its wireless network, easily surpassing speeds achieved by iDEN, TDMA and even GSM's GRPS and EDGE technologies. From a capacity standpoint, Sprint PCS has only used about 5 MHz of its 25-30 MHz nationwide (in other words, only 20% of its bandwidth) to service its 4mm customers and therefore has substantial capacity (80% left) to accommodate the expected ramp in mobile data traffic. It is also increasingly clear that internet content, applications, commerce and information providers are focusing their efforts on scale operators such as Sprint PCS with the Yahoo! alliance being the most recent example.
As for other carriers, we believe AT&T will need to sacrifice voice capacity to provision higher speed packet data services (which is problematic given AT&T's current capacity problems in major markets). AT&T plans to roll-out 115 Kbps GPRS (GSM packet radio services) on its TDMA network in the next 12-24 months to provide higher-speed packet data services. As GRPS will not mix voice and data traffic over the core TDMA backbone, AT&T will reserve specific spectrum for GPRS. Given frequency reuse patterns, this translates into only 5.5 MHz of dedicated bandwidth per market solely for data services-- or about 20% of its existing voice capacity.
As for Nextel, we believe the company will struggle to evolve towards higher data speeds on its iDEN network. The key issue remains the lack of a clear upgrade path towards 2.5G and 3G services given iDEN current closed architecture as well as more limited spectrum bandwidth. Currently, Nextel's packet data network achieves a maximum speed of 16 Kbps, and with bandwidth lashing (combining channels) can reach 64 Kbps. While the company remains confident regarding its current voice capacity, the expected explosion of packet data services could strain the company's current capacity.
The bottom line on wireless is that WCOM's view of owning a wireless asset was to enhance its already data/IP-centric approach to telecom. WCOM views wireless data as a way to solidify more revenue per customer, especially in customer accounts where WCOM's data, IP, and On-Net services are being sold. Sprint PCS provides WCOM with the most robust wireless footprint for data with the greatest degree of interoperability. This dovetails perfectly with WCOM's fiber networks and UUNET IP backbone to offer customers end-to-end, on-net data and IP solutions--wired or wireless.
MERGER SOLVES EACH COMPANY'S WEAKNESS AND COMPLIMENTS THEIR STRENGTHS
This transaction brings WCOM a great wireless asset, maintains its financial flexibility, brings an additional broadband footprint, and strengthens what were weaknesses in the Sprint model (i.e., lack of international facilities for global accounts and lack of local network facilities on which to drive its data products). Sprint's ION initiative and MMDS spectrum dovetail nicely with WCOM's local broadband access initiatives. (WCOM has 40,000 buildings connected around the U.S., is already collocated in 1500 central offices with DSL and has its own MMDS spectrum.) Between WCOM and Sprint, the proforma company will have MMDS in 85% of the top U.S. markets and 58% of the households covered. This clearly gives WCOM a huge footprint to attack high-end data-centric consumers. ION, which really is a very ambitious and focused broadband provisioning effort, now will have WCOM's vast array of local networks on which to deploy the ION service.
In addition, Sprint does add 800,000 business customers to WCOM's over 2 million business customers plus 8 million consumer accounts to WCOM's 16 million consumer accounts. All of which adds to the scale and scope of WCOM's capabilities to drive down costs and deliver services on an expanded scale. WCOM's ability to provide end-to-end on-net services on a global basis is unmatched. Adding the best wireless platform in North America, in addition to enhancing WCOM's already fabulous presence in local broadband capabilities, while bulking up WCOM further in terms of customers and scale and scope of facilities, just works to enhance WCOM's already formidable competitive position.
Thus, the combination of these two companies eliminates both company's weaknesses and bolsters each other's strengths. Both WCOM and Sprint are very data-centric, IP-oriented companies and the combined assets of these companies add to these strengths. In addition, WCOM's hole in wireless has been filled superbly and Sprint's inability to provide on-net end-to-end services has been solved. Thus, both companies' existing business models are enhanced just by virtue of this combination before one takes into account synergies which are derived from putting these two companies together.
NUMBERS SUGGEST NO DILUTION TO CASH EPS, SLIGHT DILUTION TO GROWTH AND MINOR CHANGE TO REVENUE MIX.
As far as the numbers are concerned, Table 1 below shows the earnings per share accretion/dilution analysis on both a GAAP and cash eps basis. Table 3 outlines the revenue mix of these companies and Table 2 shows the synergies. This transaction clearly puts the focus on cash eps. In general, with pooling going away and goodwill amortization being shortened 20 year lives from 40 year lives, no company of any consequence can do a deal of any size without materially impacting GAAP eps. In fact, WCOM has never done a sizable deal that was anything but purchase accounting. Pooling is accounting driven, shareholders should care about deals that are economically driven. Purchase accounting allows companies to make proper business decisions without having to adhere to ridiculous pooling rules. For example, every investor would agree that WCOM's sale of SHL was a prudent financial move. SHL was a declining revenue growth business with unacceptable margins which would be better served within EDS. If WCOM had bought MCI in a pooling transaction, WCOM would not have been able to sell the SHL business. Thus, we are going to focus on cash eps not only for WCOM but in general for the industry. However, outside of AT&T, most of the other major companies have done pooling transactions and thus cash and GAAP eps are relatively the same.
As Table 1 shows, WCOM's cash eps in the standalone basis, would have been in the $4.25-$4.30 range for 2001, the first full year of the combined company's operations. It should also be noted that in Table 1 the WCOM GAAP and cash eps are based on a share count higher than most analysts have in their models because we are using the treasury stock method to have fully-diluted shares including all options assuming no share buybacks for option grants even though buybacks have usually been the case. As shown, at the high-end of the collar, WCOM's proforma cash eps is $4.15 in 2001, roughly 3% dilutive, with cash eps roughly break-even by 2002 and slightly accretive thereafter. These cash eps numbers include synergies laid out in Table 2. As shown, we do not include any revenue synergies which should be significant especially when one considers the cross-selling of PCS with WCOM's business and consumer services. It should be noted that WCOM, which just started ramping up as a cellular reseller, is adding 80,000 subs per month. Clearly, WCOM can drive sub growth at PCS, especially when one considers that PCS with Sprint has roughly 9 million customers of Sprint long distance to sell into whereas now with WCOM PCS will have a total of 27 million customers to sell into.
TABLE 1 -- ACCRETION/(DILUTION) ANALYSIS
(Dollars in Millions Except per Share Data)
STANDALONE PROJECTIONS 2001 2002 2003 2004 CAGR
---- ---- ---- ---- ----
WCOM Standalone GAAP EPS (a) $3.66 $4.50 $5.48 $6.51 21.2%
WCOM Standalone Cash EPS (b) 4.27 5.08 6.06 7.08 18.4
ACCRETION/(DILUTION) ANALYSIS 2001 2002 2003 2004 CAGR
---- ---- ---- ---- ----
PROFORMA WCOM GAAP EPS $2.77 $3.70 $4.74 $5.79 27.8%
EPS Accretion/(Dilution) to WCOM Shareholders ($) (0.89) (0.80) (0.74) (0.72) NM
EPS Accretion/(Dilution) to WCOM Shareholders (%) (24.3)% (17.7)% (13.6)% (11.1)% NM
Add'l Pre-tax Synergies Required for No Dilution to WCOM $4,279 $3,867 $3,638 $3,544
(6.1)%
WCOM Cash EPS $4.15 $5.05 $6.05 $7.10 19.8%
Cash EPS Accretion/(Dilution) to WCOM Shareholders ($) (0.12) (0.03) 0.01 0.03 NM
Cash EPS Accretion/(Dilution) to WCOM Shareholders (%) (3.0)% (0.7)% 0% 0.4% NM
Add'l Pre-tax Synergies Required for No Dilution to WCOM $624 $181 NM NM NM
(a)WCOM Standalone EPS and cash EPS projections use fully diluted share counts via treasury stock method and assuming no stock repurchases for option grants.
(b)Cash EPS is defined as EPS plus amortization of good will.
The synergies in Table 2 also are quite conservative on the cost side, with total expense synergies representing roughly 4% of total expenses. In comparison, in the first year after the MCI merger, WCOM realized synergies of 8%-10% of total expenses and 15% of cash expenses. As usual, WCOM did its typical drill down on the synergies (which is why MCI is well ahead of plan). The network synergies focus on DEOT termination of traffic, special access savings from converting Sprint from Bell to WCOM entrance facilities, movement of Sprint enhanced international services off of PTT facilities to WCOM's, and having ION use WCOM co-locations and local access facilities. The SG&A savings are in the usual areas of sales, marketing, back-office and other areas where natural duplication exists in a horizontal merger.
Thus, we believe our cash eps estimates in 2001 and beyond, are quite conservative given the level of synergies baked-in and the fact that we are not including revenue synergies. The net present value of the synergies (as we are estimating today which are conservative) is worth $32 per Sprint share, thus, giving WCOM a lot of cushion regarding the value proposition of paying the stated price for Sprint. Thus, from a financial perspective, we would argue that WCOM's cash eps is essentially unchanged and in reality this will be an accretive deal if one puts in what will likely be the true cost synergies and a legitimate level of revenue opportunities which will seep into this combined company.
TABLE 2 -- SYNERGIES
($ in millions) 2001 2002 2003 2004
---- ---- ---- -----
Cost of Goods (Network) $620 $755 $930 $1,151
SG&A 1,300 1,360 1,405 1,475
---- ---- ---- -----
Cash Expense Synergies 1,920 2,115 2,335 2,626
Depreciation Synergies
(Via Capex Savings) 95 280 465 650
---- ---- ---- -----
Total Expense Synergies $2,015 $2,395 $2,800 $3,276
% of Expenses 4.1% 4.2% 4.3% 4.5%
Interest Synergies 90 280 465 705
Total PreTax Synergies $2,105 $2,675 $3,265 $3,981
Revenue Synergies 0 0 0 0
Table 3 shows the revenue mix for WCOM standalone and proforma for FON (excluding PCS). One of the big worries of course is that Sprint will materially slow WCOM's top-line growth. The fact of the matter is WCOM's revenue growth rate from 2000 through 2004 would likely have been in the 16% range, with FON it is now in the 14% range, not bad for a $70 billion enterprise. Once PCS gets folded back into the mix, the growth should increase 100 to 200 basis points. Keep in mind that these growth rates do not include any revenue synergies or benefits of having the combined enterprise all leveraging both companies combined assets. In addition, this revenue mix does not include PCS. If PCS were included clearly the percentages of voice long distance, in particular, would be diluted further. Thus, we do not believe that the incorporation of FON into WCOM materially changes WCOM's growth rate or WCOM's composition of revenues away from the very data/IP-centric orientation WCOM currently possesses.
TABLE 3 -- REVENUE MIX (EXCLUSIVE OF PCS)
1999 2000 2001 2002
-------------- -------------- --------------
--------------
WCOM Proforma WCOM Proforma WCOM Proforma WCOM Proforma
---- -------- ---- -------- ---- -------- ---- --------
Voice LD 60% 57% 52% 52% 45% 47% 40% 42%
Data/IP 32% 25% 37% 29% 40% 34% 44% 38%
Int'l 5% 3% 7% 4% 9% 5% 11% 6%
Local 2% 13% 3% 12% 4% 12% 5% 11%
Other 1% 2% 1% 3% 2% 2% 0% 3%
More interesting though is the reality of the revenue mix. In 1999, WCOM is roughly 60% voice long distance. In actuality, the proforma company in 1999 would have a lower percentage of voice long distance thanks to Sprint's local phone business which is a very protected business. If one looks out over time, in 2002, we estimate that WCOM's voice long distance business would have been 40% of revenues, data/IP would be 44%, international 11%, local 5%. On a proforma basis, the percentages do not shift all that much except with local and international flipping. Voice long distance would only be 42%, data/IP would be 38% (we predict that there will be no other large telecom company on the planet with data/IP remotely close to this percentage), international would be 6%, and local would be 11% (thanks to the Sprint local exchange business which while not growing at a very rapid rate, nonetheless, is not facing the kind of competition that the more urban-oriented LECs are given its markets).
WCOM AND SPRINT HAVE COMPLIMENTARY REVENUE STREAMS
In fact, we would argue that WCOM & FON's composition of businesses are quite complementary from a growth perspective. WCOM with Sprint, is by far the most data/IP-centric major telecom carrier, thus the company will continue to drive growth disproportionate to the industry. On the local side, proforma WCOM is an attacker in the large urban markets, but is an incumbent in the more suburban and rural markets where frankly competition will not emerge as quickly. Thus, proforma WCOM has what we would consider a very positive arbitrage in the local exchange business. Attacking where it makes economic sense and defending where it makes little economic sense for attackers to enter.
We would argue that the upside to the revenue forecast and thus the change in revenue mix would come in international. We have not put any revenue opportunities into our models for Sprint's array of global multi-national customers leveraging the WCOM global network assets. We suspect that if there is a change in composition of this revenue mix it would be that international, in fact, grows much faster than we are forecasting due to the fact that Sprint's global accounts drive more business over the combined company's global assets.
BUILDING AN ALL-STAR ARRAY OF ASSETS
The bottom line is that if one thought of the global telecom game as getting ready to play the SuperBowl, we view proforma WorldCom/Sprint's collection of assets as akin to having the following players on the field: Joe Montana throwing to Jerry Rice, Jim Brown running the ball, the early 1990's Dallas Cowboy offensive line and, of course, the Steel Curtain defense of the Pittsburgh Steelers of the 4 SuperBowl winning teams of the 1970s. WorldCom with Sprint, possesses the largest IP backbone on the planet, the most owned and operated networks on earth, a very data/IP-centric suite of services and now the best wireless network in North America.
Clearly, WCOM can put all-star players on the field and there is no question about the coach's (i.e., management's) ability to drive value. We would take advantage of the sloppiness in the stock to buy every share we could buy. We defy anyone to find a company of this size growing its top and bottom-line as fast, selling on 2001 eps which are 6 multiple points below the S&P. We fundamentally believe that 12-15 months from now, this stock will have doubled which is very similar to what occurred at this point 2 years ago after WCOM had announced the MCI merger.
NET/NET:
WCOM has solved its wireless overhang by getting the best asset in the industry, maintaining its earnings base, and having a pathway towards folding in the wireless properties at the prudent time. WCOM remains the fastest growing enterprise in one of the fastest growing industries in the world and yet, it is selling at a deep discount to the market. We would aggressively take advantage of this dislocation and we strongly reiterate our buy recommendation.
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