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Danger for MCI ?
by Dale Wettlaufer (TMF Ralegh)
October 01, 1997

MCI COMMUNICATIONS (Nasdaq: MCIC) jumped $5 7/8 to $35 1/4 today after long-distance, competitive local exchange carrier, and wide area network access provider WORLDCOM (Nasdaq: WCOM) trumped BRITISH TELECOMMUNICATIONS (NYSE: BTY) with a bid to acquire MCI for $41.50 per share in WorldCom stock. As of last night's close, the value of BT's stock and cash offer for MCI stood at $32.73 per share. This deal is beautiful for WorldCom, especially because of the non-dilutive character of the stock swap. At $41.50 per share, MCI is valued at less than 10 times gross cash flow (net income plus depreciation and amortization plus non-cash charges). WorldCom, on the other hand, is valued at more than three times that multiple, making dilution a non-issue for WorldCom shareholders.

Assuming that WorldCom grows its own cash flow 40% in the coming year and MCI can grow cash flow 10%, cash flow per share for WorldCom shareholders doesn't start to become dilutive until WorldCom issues over two billion shares for MCI, which is highly unlikely. At the current offer of 856 million WorldCom shares, WorldCom shareholders are looking at cash flow per share for 1998 of $2.69 (pro-forma, or as if the merger were completed for the full year) under the combined company, instead of $1.61 per share as a stand-alone company (using the same growth assumptions as above).

WorldCom would increase its global fiber capacity, gain managers who run a tight ship, gather in MCI's brand name and capital expenditure-light wireless operations, and finally, acquire MCI's software assets, which are very much a hidden asset in the bundle of assets that MCI represents. One of the reasons why this deal works is because MCI won't have to spend the cash it would have under British Telecom to get into the local loop. Costs associated with local loop access have brought down MCI earnings estimates and reduced the merger valuation that British Telecomwas willing to offer. MCI shareholders avoid spending $1 billion in the second half of this fiscal year and immediately gain a share in what can quickly become a global powerhouse, rather than waiting around for it to be built. Also protecting MCI shareholders, WorldCom will be able to meet any competing offers without risking a dilution to its future cash flow per share. In other words, it can raise its bid to meet competing offers.

The danger to MCI shareholders can be found in WorldCom's current multiple to cash flow. At 29 times trailing 12-months' cash flow, WorldCom is valued at about 3 times the 9.8 times cash flow at which MCI closed the day. That makes WorldCom's currency inflated to some eyes. The fact remains that each share of MCI currently represents $4.22 in cash flow while each share of WorldCom represents approximately $1.15 in cash flow. Under the above growth estimates, each WorldCom share would represent $2.69 in cash flow, a nice 67% increase for WorldCom shareholders but a 36% diminution year-over-year for each MCI shareholder.

Nevertheless, MCI shareholders appear to have little chance of winning a higher multiple to those cash flows unless MCI launches an all-out effort to cherry pick competitive local exchange carriers and other telecom services companies. Barring that, they might just take the per-share cash flow dilution and opt out for a higher multiple to those cash flows. Cash flow per share of $2.69 next year would produce a share price of $53.86 if the market decides that WorldCom/MCI is only worth 20 times cash flow. So, even if the combined companies' cash flow multiple declines next year, both groups of shareholders are looking at a good scenario for substantial shareholder return and for building strategic global and U.S. advantages over less integrated competitors.

Continental investors and arbitrageurs like WorldCom's bid for MCI since the move also lets BRITISH TELECOM (NYSE: BTY) off the hook. Shares of British Telecom gained $8 to $54 11/16. British-based global telecom company CABLE & WIRELESS (NYSE: CWP) rose $1 3/8 to $27 1/4 in tandem with BT, even though the company would be facing a new global competitor. Cable & Wireless investors apparently see a combination of MCI and WorldCom as a lesser evil than a significantly more robust British Telecom. DEUTSCHE TELEKOM (NYSE: DT), Europe's largest telecom company, gained $15/16 to $20 on the reduced chance of a realignment of competitive forces in European telecommunications.

In the wake of this news, investors have launched a wholesale re-valuation of facilities-based interexchange carriers and competitive local exchange carriers. PRIMUS TELECOMMUNICATIONS GROUP (Nasdaq: PRTL) rose $2 5/8 to $12 5/8; IXC COMMUNICATIONS (Nasdaq: IIXC) gained $2 3/8 to $34 1/8; ICG COMMUNICATIONS (Nasdaq: ICGX) popped up $1 1/4 to $25 3/4; and INTERMEDIA COMMUNICATIONS (Nasdaq: ICIX), which recently acquired fiber-rich Digex, rose $4 7/8 to $51 13/16. Other companies gaining ground included GST TELECOMMUNICATIONS (AMEX: GST), with a $1 1/16 rise to $14 3/4; WINSTAR COMMUNICATIONS (Nasdaq: WCII), up $2 1/16 to $21 1/4; and TELEPORT COMMUNICATIONS GROUP (Nasdaq: TCGI), with a $3 3/4 boost to $48 5/8.

WorldCom began the day by announcing a stock-for-stock offer to acquire BROOKS FIBER PROPERTIES (Nasdaq: BFPT), a competitive local exchange carrier, for nearly $3 billion. For more on this story, see the October 01, 1997 Evening News.

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