FOOL ON THE HILL
An Investment Opinion
The Qwest-US West Merger
So what have we got?
Bill Mann (TMF Otter)
October 8, 1999
In the ruckus that followed the MCI Worldcom (Nasdaq: WCOM)/Sprint Communications (NYSE: FON) $129 billion merger announcement last week, there was the inevitable speculative banter about the "next" big merger candidate in telecommunications. But the MCI/Sprint merger still has huge hurdles to cross before it comes much closer to reality. Lost in the noise was the news of two previously announced and ongoing mergers, the September 28 closing of the Global Crossing (Nasdaq: GBLX)/Frontier merger, and the progress to shareholder vote in the even more substantial merger between Qwest Communications (Nasdaq: QWST) and US West (NYSE: USW).
The Qwest merger is a watershed of sorts: a symbolic recognition of the market power of the new communications carriers some 15 years after the breakup of Ma Bell.
Should this merger be approved by the shareholders of both companies and consummated, it will represent the first time a Baby Bell (a former local component of AT&T) will be subsumed into a non-RBOC (Regional Bell Operating Carrier) company.
But what of the Qwest/US West merger? What will the combined companies (to be called Qwest Communications) look like, what are its prospects, and what advantages and weaknesses can be found?
In a recent letter to Qwest shareholders, CEO Joseph Nacchio describes it as a "$65 billion global broadband Internet communications company." In the opening paragraph of this letter he points to the synergy between Qwest's international network and US West's local communications resources. This is right in line with the strategy being enacted by other telecom, broadband, cable, and even power companies to leverage their integrated network capabilities to provide Internet, communications, content, and other value-added services all over their own internal network.
As an aside, this past week I read one of the most prescient examples of what Phillip Fisher calls "scuttlebutt" right here on the Fool boards. It was written by firenza in regard to the ongoing jockeying for position between AT&T, @Home, and America Online. It is a must for anyone interested in learning more about the convergence of communications services.
The combined Qwest has a formidable asset base. This includes a worldwide network of some 3 million miles of cable with the local loops for all of its customers in the current US West service area (parts of 14 Western states), an 18,000 mile fiber optic domestic backbone, a 1,400 mile backbone link to Mexico, and joint ventures on trans-Atlantic and trans-Pacific and significant gateway facilities. Qwest will have to divest itself of its long distance service customers in US West's local coverage area.
On the financial side, the company will have a combined market cap in excess of $65 billion and projected 2000 revenues of $18.5 billion. For comparison, BellSouth (NYSE: BLS), another Baby Bell, has a market cap of $83 billion and average estimated 2000 revenues of $26.4 billion. On a Price-to-Sales basis, the premium for Qwest by comparison is just under 13%, though given the relative estimated growth rates of the two companies (35% vs. 10% for BellSouth) this doesn't seem to be out of line. Add to this the fact that the conjoined company will not be issuing much debt in order to complete the merger, and the transaction, from a high level analysis, makes good financial sense.
But what is motivating each of these companies to merge? Obviously, the economies of scale and the convergence of technologies described above are helping push this and other collaborations in the industry, but there are other factors at work. Of utmost importance are two growing trends: globalization and commoditization.
By globalization we are talking about both a geographic and a service-offering notion. The advent of the Internet has accelerated the movement of data in a borderless environment. Whereas even a decade ago only the largest, most capital- and labor-intensive industries could effectively use relative economies as a central economic benefit through outsourcing and offshore operations, now even the most specialized information based company can cheaply exploit the inequalities of the global marketplace through technology. The global economy has become intertwined in a way that would have seemed inconceivable not that long ago. At the center of this revolution is communications technology and the companies that provide it.
But globalization means something else as well, something discussed to varying degrees by some of the most respected technological pundits of our generation such as John Naisbitt and Nicholas Negroponte. Globalization is the trend by which the companies most likely to succeed become those that provide everything to everyone, or those that provide a very niche, specialized service for a specific application. The upshot of this is that the companies in the middle ground will be outflanked on both sides: by the economy of scale from the larger companies and the superior services coming from the specialists.
This has happened in banking, it is happening in airlines, electric utilities, and certain types of retail. It is also happening in communications. Qwest and US West were seeing the pricing models in their bread-and-butter businesses plunge. For Qwest, the centerpiece of its business was to be as the service provider of massive pipelines for usage by wholesale and retail customers. But over the last year the market for bandwidth has tanked, with a fiber end-to-end DS-3 (45MB) pipe between New York and London, for example, decreasing by more than 65%, from $175,000 per month to as low as $59,000. Similarly, the FCC continues to pressure the RBOC's to lower their access costs (the money paid to them by long distance carriers to terminate calls) and to open their territories up to competitors.
Further, communications carriers are finding that the high margins they used to be able to command for their basic services are eroding, as the barrier to competitive entry becomes smaller and the number of competitors increase. The increase of competition and the difficulty in differentiation has accelerated basic telecommunications and bandwidth service provision into a commodity industry where competition can really only be done on price. Witness the drop in the past three months of domestic long distance rates by more than 40% as a prime example of the erosion of market power carriers have.
So these companies are looking away from a differential cost model and to vertical integration to provide them a service advantage. MCI trumps its "OnNet" service as a way that companies can transport their data on its "end-to-end" network. Sprint has one as well called "Ion." AT&T's strategy seems to focus more upon providing content along with telephony services, while Cable & Wireless (NYSE: CWP) has concentrated upon its dispersed network (providing service in more than 70 countries) for its particular strategic advantage.
All of this refocusing belies the fact that the revenue model for providing basic services is very much in flux, but no one expects the pricing to increase. However, Qwest is joining the fray of companies able to provide a "complete end-to-end" solution for retail customers in the West and to wholesale customers throughout the U.S., Mexico, Canada, and Europe. For this extended reach and the integrated nature of its services, Qwest, the aggregator, will be able to charge a premium.
The end result is that Qwest & US West have decided that standing still was a way to guarantee failure over the long term. And I think that this is right. This combination will give each a complimentary roster of service offerings to combine with its own- Internet, local, long distance, broadband, regional, international, wireless, and advanced on net data services.
It also gives the company gravity, making it a viable dance partner with an international carrier, such as Cable & Wireless or Deutsche Telekom (NYSE: DT). Aggressive growth through mergers and acquisitions is not necessarily as good as organic growth, but it can provide a quick path to legitimacy. This is perhaps best evidenced by the rapid rise of Bernard Ebbers, who took a tiny Mississippi company and merged and acquired his way to the helm of the second largest U.S. telecom, MCI Worldcom.
In the same light, perhaps Qwest is looking to be someone else's dance partner on the international scene. I'd have to hope that Mr. Nacchio does not rack up too much additional debt in the process of future acquisitions. Servicing the $2.3 billion of long-term debt on the company's balance sheet in Qwest's 10-K will begin to loom large if the company has too much indigestion trying to integrate US West.
But in the end, this is a good and necessary move for Qwest and US West. Neither wants to be in a marginal position because they lack market power or service breadth. This move should be accretive to its combined balance sheet and intrinsic valuation.
So, what's next Mr. Nacchio?