FOOL ON THE HILL
An Investment Opinion
The proposed merger between WorldCom (Nasdaq: WCOM) and Sprint (NYSE: FON) may be in big trouble due to heavy scrutiny by U.S. and European regulators. The Washington Post reported today that European Union (EU) regulators are set to block the merger because it would put too much of the Internet under the control of one company.
According to the Post, European Competition Commissioner Mario Monti has come out urging the commission to do just this when it makes its finding on the merger early next month. This follows a few weeks after the review board for the U.S. Justice Department recommended to antitrust chief Joel Klein that he reject the deal on competition grounds as well.
The issues for each market are a bit different, but both have the power to scuttle a merger valued at $129 billion. In the case of the U.S., the Department of Justice is worried about the re-concentration of long distance telecommunications service provision between two companies, the combined Sprint/WorldCom and AT&T (NYSE:T). In spite of deregulation and some significant growth by second and third tier companies, particularly Qwest (NYSE: Q), more than 90% of the domestic and international LD market is currently controlled by the three companies. And with the limited exception of Bell Atlantic (NYSE: BEL) in New York, no Regional Bell Operating Company has received FCC approval to provide long distance.
But in Europe the sticking point is the Internet. WorldCom and Sprint are two of the four largest providers of Internet backbone services, the others being British-based Cable & Wireless (NYSE: CWP), and GTE (NYSE: GTE), which recently jumped over some merger-related hurdles of its own. The combined Sprint/WorldCom would control as much as 45% of the total backbone traffic, giving it critical mass as other companies would feel compelled to link to it for the sake of speed and connectivity.
Interesting also is the thought that the EU is offering some "payback" to WorldCom for its handling of its merger with MCI in 1998. At that time, the EU ruled that it would not approve the merger unless MCI divested itself of its Internet business for the same perceived threats to competition the merger posed. MCI did so, selling its backbone to Cable & Wireless.
But Cable & Wireless sued less than a month after the agreement, claiming that MCI sabotaged the asset by not delivering key personnel, withholding customer information, and poaching customers. In February, WorldCom settled with C&W for $200 million in exchange for C&W dropping all litigation and regulatory complaints. Last month Mr. Monti said before the European Parliament that the EU had been na�ve in its treatment of that transaction, and that "important lessons [were] to be drawn from this dispute in the resolution of the MCI/Sprint deal."
It's pretty clear that the EU did not like being made a fool of in 1998, and as such when the same company comes back to the well for an even larger deal, we should expect that the price extracted by the commission would be dear. But prior to this week the pundits seem to have believed that the merger deal would be cleared. At least they were hoping so. But all along two items that would scupper the deal have jumped out at me: the first was the EU response to the Cable & Wireless deal, and second would be WorldCom's unwillingness to give up its prized asset, UUNET, as a condition to the merger.
One part of the EU commission's determination is that the proposed sale of Sprint's Internet business would be insufficient to alleviate regulatory concerns. Interestingly, one European commissioner told the Post that shedding UUNET would not have been enough to gain approval.
But investors seem to have discounted the possibility of the deal going through for some time. Sprint's shareholders are to receive $76 in WorldCom stock for each share of Sprint. But since the announcement in November, Sprint shares have slid slowly downward, currently trading at a 25% discount to the merger value. Given the fact that the merger "guarantees" (in quotes because really there's no such thing) 76 bucks, that difference is a good proxy for how confident investors are about the deal going through.
A merger between the two would create a world telecommunications powerhouse with the aforementioned Internet backbone presence, along with extensive domestic and international cable assets. Most importantly for WorldCom in the merger would be the augmentation of its wireless strategy, with Sprint's PCS (NYSE: PCS) division and its fixed wireless assets being part of the deal. But it is just these strengths that also make the company ripe for regulatory scrutiny.
Given the rash of mergers as of late, this may be looked upon by regulators on both sides of the Atlantic as the warning shot against too much consolidation. More chilling to the telecom industry is that as these multi-national carriers gain power, they will be forced to submit to ever more government oversight from additional jurisdictions.
In this case, both companies are American, and yet a European finding could kill the merger. WorldCom and Sprint have substantial assets in Europe that cannot be extracted from their networks. For example, Sprint's fiber-optic network carries both voice and data, and as such, should the data portion of the traffic be sold off, the combined company would still have control of the facilities and would have to be negotiated with should the purchasing company wish to expand.
There's real danger here for both WorldCom and Sprint, as well as the other mega-carriers. WorldCom could see its strategy of rounding out service items to include wireless be rebuffed, and have to quickly look elsewhere. The company has proven to be the master of the deal, concluding more than 60 mergers to constitute the majority of its growth. The company seems to have hit a wall on these large mergers and would have to take on smaller ones to limit regulatory scrutiny. Some candidates for wireless partners include Voicestream (Nasdaq: VSTR), Nextel (Nasdaq: NXTL), or even Vodaphone Airtouch (NYSE: VOD). WorldCom may also find itself as a target rather than an acquirer, perhaps by a Deutsche Telekom (NYSE: DT) or a BellSouth (NYSE: BLS).
For Sprint the problem lies in that, in spite of its wireless and Internet divisions, it is still quite beholden to residential and commercial long distance and its ever-shrinking margins and cutthroat competition. Sprint's long-term performance requires that it round out its revenues to become less dependent on these basic services, which it has tried to do in a number of ways, including its disastrous involvement in Global One.
The merger is not yet dead, but it seems somewhat doubtful, particularly given WorldCom's unwillingness to give up UUNet, that the companies are willing to submit to the demands of the regulators to make it happen. Both companies have some significant challenges should they have to change their strategies and go to the dance without each other.
Bill Mann, TMFOtter on the Fool Discussion Boards