Level 3 Acquires TW Telecom: Do the Numbers Add Up?

It was "merger Monday" today, but U.S. stocks still finished flat, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) up less than 0.1%. The technology-heavy Nasdaq Composite Index (NASDAQINDEX: ^IXIC  ) gained 0.2%.

Apparently, investors were either little moved by the flurry of acquisition announcements today, or they identified countervailing risks. Not even the largest agreed deal in the health-care sector this year, Medtronic's $43 billion offer for Covidien, seemed to rattle investors. This evening, however, I'm looking at another one of the announced deals: Level 3 Communications' (NYSE: LVLT  ) stock-and-cash offer for TW Telecom (NASDAQ: TWTC  ) in a deal that values the Internet service provider's equity at $39.61 per share based on today's closing prices, or $7.1 billion on an enterprise, once you add TW Telecom's $1.6 billion in net debt.

Source: Level 3 Communications.

Why do corporate chieftains carry out acquisitions, and how do they assess their attractiveness? Unfortunately, it's all too often for reasons, and at prices, that are poorly aligned with shareholders' interests, such as increasing the absolute size of their fiefdoms.

In a statement on the proposed acquisition of TW Telecom that Level 3 announced today, CEO Jeff Storey said that "the benefits created by this transaction deliver substantial value to both companies' stockholders, as it accelerates our objective of driving profitable growth and strengthening free cash flow per share growth over the long term."

Storey is looking at the right metric and the right goals -- management can do nothing more beneficial for shareholders than maximizing long-term growth in free cash flow per share -- so he's already off to a good start. In fact, Level 3 expects the deal to be "deleveraging" (translation: it will reduce debt levels) and "accretive to free cash flow per share after the first year following translation close" (in other words, Level 3's free cash flow per share will increase).

One of the means by which the combined entity will achieve free cash flow growth is through projected annualized cost savings of $240 million. Level 3 estimates the net present value of those synergies at $2.2 billion, which equates to $15.83 per share. If the estimate is realistic, the cost savings alone are worth three and a half times the $4.52 premium Level 3 offered over TW Telecom's Friday closing price. In that context, and assuming TW Telecom was fairly valued on Friday, the deal looks easy to justify on a financial basis. (Mind you, one ought to remain a bit skeptical, as present value estimates are very sensitive to discount rate assumptions.)

And speaking of value, Level 3's offer put TW Telecom's enterprise value (equity plus net debt) at 12.8 times estimated EBITDA for 2014. That multiple looks a bit rich, but once you add back $200 million in annualized cost savings at the EBITDA level, it falls to a more pedestrian 9.5. For reference, Level 3's enterprise value-to-trailing-12-month EBITDA is 11.10.

Once an acquisition is announced, it's not uncommon for the acquirer's shares to fall if the market reckons the target company's shareholders are making off with the bulk of the value in the transaction. Level 3's stock fell 4.1% today, but according to the deal terms, I have Level 3 shareholders coming out of this deal quite nicely. This doesn't look like a failed connection.

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