After one of the best quarters in corporate history, the announced buyout of TW Telecom (NASDAQ: TWTC ) by Level 3 Communications (NYSE: LVLT ) is mildly surprising. Considering the deal is mostly in stock, it might also signal that Level 3 stock has appreciated too much, with the company choosing to use it as the major currency in this deal.
In general, the deal is portrayed as an ability to gain scale and reduce costs via synergies. Remember, the companies compete against the likes of AT&T (NYSE: T ) for access to the global data communications needs of enterprise customers.
Level 3 Communications agreed to pay $10 cash and 0.7 shares of stock for each share of TW telecom. The transaction is valued at $40.86 per share, based on June 13's market close. With $1.6 billion in assumed debt, the total deal is valued at $7.3 billion.
The deal is based on the expectations of $240 million of annualized synergies and free cash flow accretion after the first year. The combined company should have revenue of nearly $8 billion and adjusted EBITDA of $2.4 billion after synergies. But, the combined entity will have $11.5 billion of debt following the assumption of TW Telecom's debt and $1.2 billion of additional borrowings to pay the cash portion of the transaction.
Considering TW Telecom's limited debt, the deal will actually help reduce the debt to adjusted EBITDA ratio for Level 3 from 4.9 to 4.7.
What TW Telecom offers
For the communications sector, TW Telecom offers decent 7.4% overall revenue growth. However, the company has only forecasted revenue of $1.7 billion for 2014 and $1.8 billion for 2015. At a market cap around $5.5 billion, the company sold for a high revenue multiple for the industry. With limited debt of only $1.6 billion, the enterprise value of roughly four times revenue is slightly more attractive. As an example, Level 3 trades at slightly less than three times revenue. The significantly larger AT&T trades at an enterprise value of two times revenue and has the much more attractive wireless network.
TW Telecom provides a more local-centric focus, with the company moving forward on a strategic expansion to extend metro fiber into five new high-demand markets, including Boston and Philadelphia. It also plans to accelerate the density of its metro fiber footprint in most of the important existing markets, which include New York City, Chicago, and San Francisco. Unfortunately, though, the company still obtains 40% of revenue from non-data sources like legacy voice applications and network services.
With network overlap of only 10%, the two networks might provide a more compelling offering to global enterprise customers. Typically, though, network integration in the telecom space isn't as nearly flawless as forecasted.
The buyout of TW Telecom could have some intriguing cost synergies and accretive free cash flow down the road, but the deal probably signals that the strong gains by Level 3 Communications stock over the last year will probably come to a halt, at least for a while. The company was more than ready to use the increased value of the stock to purchase TW Telecom at slightly rich valuation multiples. Assuming a smooth integration, the combination probably makes sense, especially with both management teams located around Denver, but that doesn't mean investors will prosper any time soon with the stock trading at multi-year highs.
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