Level 3 Communications Investors Might Not Prosper After Synergistic Deal

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.

Deal details
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.

Bottom line
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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  • Report this Comment On July 07, 2014, at 12:10 PM, carlkiefer wrote:

    On the negative side:

    1) A Premium multiple to the aquiree

    2) Integration risk

    3) Debt; the four letter word

    Excluding item #1 above, LVLT has suffered profusely for many years as a result of poor integration of their seven prior acquisitions while hitting The Great Recession head on during the process. This was in concert with their mammoth debt tied to DEBT/EBITDA multiples previously.

    What is being overlooked besides the size, scope and scale this merger accomplishes by penetrating the 94% market share incumbent oligopolists like AT&T control today inside the enterprise space that is ripe while begging for change?

    The significant increase on an EPS basis notwithstanding the nearly 400M shares that will be outstanding as a result of this powerful domestic competitor against The Status Quo.

    This story is morphing quickly into one of high growth versus the past, and no longer requires faith based investing while Fools on this board know that one will "Pay a Dear Price for A Cheery Consensus," so let FOOLS carry on ignoring this stock!

  • Report this Comment On July 07, 2014, at 5:50 PM, carlkiefer wrote:

    Mr. Holder:

    It seems I have overlooked your affinity for AT&T shares during my earlier comment.

    Would you be so kind to share how the T merger with Direct TV is going along?

    Also, what expected "synergies" do you anticipate from them going into unchartered waters representative of the satellite space, especially while considering "integration risk"?

    Earlier in T's history, C. Michael Armstrong was on the right path whilst attempting to address the broadband space head on both locally and long haul(LH), only to watch his plan disintegrate inclusive of selling some of the accumulated assets to Comcast, I recall.

    It wasn't very long after that, and during the peak of the Y2K bubble that T had been rumored to have made an offer for LVLT's LH network at or near an all time stock price high of about $132.00 pps pre-reverse stock split.

    Moving away from T's core competencies may well become the death knell for them since I recall a wonderful presentation at UCLA by one of the internet's founding fathers, Dr. Leonard Kleinrock, where he eloquently quoted the conundrum T faces today.

    He said: "In the short term(circa 1969), Telephone was right to have shunned by not embracing the advent of the internet, but in the long term they were very wrong indeed."

    From my perspective(LVLT shareholder), we seem to have finally reached that period of time when "the long term" has arrived.

    As importantly, if not more important, I am happy to see that LVLT is accumulating more valuable metro assets through the acquisition of twtc while moving the battle lines for "building access" inside the faces of crucial enterprise customers who are coveting mandatory, non-discretionary communication services fit for the 21st Century, i.e. eyes around the globe over ears.

  • Report this Comment On July 30, 2014, at 1:27 PM, MayTepper wrote:

    Canaccord Maintains Buy On Level 3 Communications Following Solid 2Q14 Results http://bit.ly/1AzdapW

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