February 14, 2005

Verizon + MCI; Jilted Qwest Left at the Altar

Will Verizon succeed in its bid for MCI, or will Qwest sweeten its offer?
MCI made the smart move by agreeing - or presuming it'll agree - to be bought by Verizon, leaving its last Baby Bell suitor, Qwest, standing at the altar of heartbreak. So far, the reaction has been mostly relief:
    Verizon's purchase of MCI earlier this week will strengthen its business, provide access to lucrative business and government contracts, and, most importantly, prevent rivals from snapping up the Ashburn, Va. company.

    In a coup likely to make rivals Qwest Communications International Ltd. and BellSouth Corp. sweat, Verizon Communications Inc. agreed to buy MCI Inc. for $6.7 billion in cash, stock and dividends. The merger follows two telecommunications mega-mergers last year: SBC Communications' acquisition of AT&T Corp. and Sprint Corp.'s purchase of Nextel Communications Inc.

    Although MCI had its share of suitors—both Qwest and BellSouth were pursuing the company as well—company executives chose to sell the company to Verizon, despite the fact that Qwest offered a larger incentive package.

    Verizon's financial stability as well as synergies in network infrastructure and customer base made the choice of Verizon a sound one, said Taher Bouzayen, vice president and long-distance sector analyst at Atlantic-ACM, a Boston-based research firm.

    "Financially, although Verizon has some large debt, it has the financial strength to pay off that debt and a framework that's large enough to absorb a company like MCI, which came out of bankruptcy with very little debt," he said.

    Verizon may have pushed so hard to buy MCI simply because others wanted it, noted Sean Hackett, senior analyst at Yankee Group of Boston, Mass. "It was a defensive move," he said. "It was about taking MCI out of play so somebody else couldn't buy it."

    The move also allows Verizon to exploit its deep presence in the Northeast and strong branding by cross-selling many of MCI's services. "It helps to be able to take a brand that has been beaten up as much as MCI's has and leverage that brand equity," Hackett said.

    But the reason Verizon was so intent on buying MCI may have been for its lucrative business and government contracts—an area where former RBOC Verizon simply didn't have much of a foothold.

    Access to business contracts, in fact, also was one of the main reasons why SBC acquired AT&T, Bouzayen noted. "They are all hungry for business customers, because that's where most of the profit is. Those are the accounts where you build your margin."

    Now that Verizon has a stronger foothold in the business arena, it would do well to exploit the combined technological strength of the two companies to provide better prices and service for its business customers, Bouzayen said.

    "MCI's strength is on the long haul portion of the network, while Verizon has the last mile. Now they can offer end-to-end services at relatively good prices, once they work out some interoperability issues caused by merging two types of networks," he said. Bouzayen predicts that the integration will happen quickly.

    In the end, it may be the business customers who really win. Not only will businesses experience less competition in the telecommunications marketplace, but they should expect to see price stabilization, Hackett predicted.

    Although experts believe the move was a good one, the road may be less than smooth as consolidation gets underway. In addition to consolidating a host of business processes, Verizon will face the mammoth challenge of integrating MCI's confusing billing system with Verizon's more stable one.

    MCI's billing system is a cobbled-together patchwork system that combines bits and pieces of the nearly 50 companies it has acquired over time. Four or five years after an acquisition, it's not unusual for a customer to receive multiple bills from companies owned by MCI instead of one integrated bill, Bouzayen noted.

    "Verizon has a great billing platform that is extremely well managed, and if it succeeds in incorporating and integrating MCI's billing system into its platform, it will be a very successful company, but it will take some time," he said.

    Despite challenges, analysts expect the combined company to succeed and prosper. Atlantic-ACM predicts that the combined company will generate $18.6 billion in 2005 for long-distance services alone, a number that will grow to $21.6 billion in 2009.

    The unanswered question, of course, is what happens to erstwhile suitors Qwest and BellSouth, as well as to Sprint's wireline business.

    "It really leaves them hanging. In those businesses that require scale to succeed, such as traditional voice/data-type transport businesses, BellSouth and Qwest will have to decide whether they want to compete," Hackett said.

    Given enough time, the market may experience further consolidation, ending up with three or four mega-companies competing with each other, Bouzayen said.

    "I could see the wireline business of Sprint combined with Qwest, or perhaps companies like Level 3 or Global Crossing could come into the mix in some fashion," he said. "Maybe we're really reversing the wheel and going back to a pre-1984 RBOC system. Only time will tell."

But watch out Verizon... MCI's a heartbreaker. Just ask Bernie Ebbers. And I still expect Qwest to sweeten their bid enough to either, get MCI and improve their balance sheet, or the worst case scenario is they force Verizon to pay more and take a hit competitively. In short, not a lot of risk in Notebaert moving forward with his offer.

Analysts found the whole deal a no-brainer for both MCI and Verizon and REALLY bad news for Qwest:

    The deal to buy MCI at what amounts to $20.75 a share is a bargain for Verizon, but MCI accepted the terms because it sees Verizon as a stronger company than Qwest, said Jay Arnold, portfolio manager at Abacus Asset Management.

    "I think [Verizon] stole the company," said Arnold of the MCI purchase. "It's a great deal for Verizon. The shareholders of MCI didn't get a great deal, but maybe the combined companies will be more powerful and the returns will offset that."

    Arnold said that even though Qwest outbid Verizon by about a billion dollars, MCI made the right move. The reasoning behind MCI's decision is that Qwest carries considerable debt and is somewhat of "a junk-rated Baby Bell," said Arnold.

    "MCI felt a Qwest deal would be largely a stock deal and if Qwest shareholders didn't like the deal, they would sell shares, weakening the overall value," he said.

    Allan Tumolillo, COO of Probe Financial Associates, said a decision to sell to Qwest would have been a mistake.

    "MCI merging with Qwest would have been the end of the whole thing," said Tumolillo. "[MCI President and CEO Michael] Capellas is a smart guy. He may not know telecom all that well, but you look at Qwest and its $17 billion in debt, and you see they are struggling. MCI doesn't need to go into a mess like that. The only purpose for MCI to talk to Qwest was to provoke Verizon and Bell South to take a look at them more seriously."

    Without MCI, the future of Qwest is a major question mark, said Tumolillo. "I think Qwest is headed into oblivion," he said.

Fish or Cut Bait?

Although many believe Verizon would have preferred to wait before cutting a deal, or even offer a bid for Sprint instead, the company decided it needed to act once Qwest made its play for MCI. "This is the right deal at the right time," said Verizon Chairman and CEO Ivan Seidenberg. "It is a natural and logical extension of Verizon's strategy to transform our company to serve growth markets and offer broadband technologies."

Seidenberg said he and Capellas had been talking about a possible deal since late summer. He said the two companies match up well, and that he doesn't expect any other bidders. Maybe now that Carly's out at HP, Capellas thought he should strike while the iron was hot and force Verizon into making a move?

Whatever happens, if I were an MCI shareholder, I'd be trying to get that extra billion dollars somehow... can you say "class action lawsuit"?

- Arik

Posted by Arik Johnson at February 14, 2005 02:44 PM