April 26, 2005 - 3:40pm EST by
2005 2006
Price: 26.65 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 8,660 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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The purchase of MCIP is a free call option on capturing the synergies from a Q/MCIP combination. If Q does not win, VZ will have to pay at least the current price to win MCI. As I hope to show below, VZ should be paying a premium to Q a bid, not a discount. In other words, preferring VZ’s bid for MCIP, even if VZ matched Q's $30 bid, is a financial contradiction because of the greater upside, on a risk-adjusted basis, to a Q/MCIP combination.

All along, consensus has assumed that Q needs a higher bid than VZ to win MCIP. Q’s own bidding has supported this view because it has had to fight the prejudice that VZ was a better partner. Ironically, the opposite view is implied by Q’s deal terms.

Despite being the higher bidder in absolute dollars, Q, via a March 2, 2005 presentation made to investors, has implied that its current $30 bid is really worth $47 per MCI share. The $47 value is derived as follows:
1. The current $30 bid, which involves the issuance of 1.1bn new Q shares.
2. If 1.1bn Q shares are issued, total outstanding Q shares will be 2.9bn, implying MCIP shareholders would own 38% of the Quest-MCIP combination.
3. In its March 2, 2005, presentation, Q stated that the NPV of syngergies with MCIP would be $14.8bn. 38% of $14.8bn is $5.62bn, or $17.30 per MCIP share, which is the incremental value that MCIP shareholders would gain via the Q and MCIP merger.

Per VZ’s comments, MCIP’s synergy value with VZ is $7bn. Therefore, even if VZ matched Q at $30 per MCIP share, Q’s estimated NPV of synergies would have to fall by more than 50% to make the bids equal in value. In other words, even if VZ matched Q, joining Q would still offer MCIP shareholders a free call option on capturing 38% of Q’s incremental synergies of $7.8bn, a value of $9.10 per MCIP share.

Hence the largest MCIP shareholders have vehemently preferred the Q bid. Leon Cooperman, chairman of Omega Advisors, has stated that “Verizon better stop trying to buy MCI at a discount…[and that] the (MCI) board would be seriously mistake if they accepted a discounted offer.” Bruce Berkowitz, managing partner at Fairholme Capital Management LLC, believes Q offers more potential, stating “the upside is staggering,” while noting that the upside with Verizon is much less clear given MCIP would be a small part of a larger company.

One might argue that Q’s synergies are overstated. Such argument assumes that despite Q’s 10 months of studying the MCIP and Q combination, involving over 55 conference calls with MCIP management, Q is either inept and/or lying regarding its synergy estimate of $14.8bn. But even if one ignores the free call option on perhaps getting synergies greater than $7bn, ie one is not paying anything for synergies over and above $7bn, preferring the VZ bid still has another major problem.

The problem is that Q’s synergy value, even at only $7bn, is a bigger percentage of Q’s market cap versus $7bn as a percentage of VZ’s market cap of $95bn. In other words, a $7bn NPV, means that if Q won MCIP, Q’s debt that day would be reduced by $7bn, thus causing its equity value to increase by $7bn. I assume that Q’s EV would stay constant, though it would probably increase as it reduces its debt, reducing bankruptcy risk.

Per the current Q deal terms, if Q won MCIP, there would be 2.9bn Q shares out. Assuming that synergies with Q are only $7bn, dividing $7bn by 2.9bn shares means that the Q shares should increase by $2.40 in value, or a 67% increase in equity value. The synergies to Verizon/MCIP would increase equity value of Verizon/MCIP by $7bn divided by the VZ market cap of $95bn, or 7%. The financial insight is simple: VZ’s leverage re increasing equity value by buying MCIP is about 1/10 that of MICP/Q because VZ’s equity value is 13.5x Q’s equity value. Please note we are assuming Q can only realize $7bn of the $14.8bn synergies they have projected.

In other words, VZ’s bigness and perceived stability is precisely the reason that MCIP shareholders would profit much less by joining Verizon.

One might argue that if Q’s synergy value has merit, VZ’s synergies should be substantially greater than $7bn. Well then why was this probability not disclosed? Perhaps VZ was trying to downplay the value of MCIP? After all, VZ tried to buy MCIP by paying $4.7 billion for MCI in stock, getting $7 billion in net present value of synergies, and the rest of the purchase price, roughly $6.00, funded from the excess cash that MCIP was legally obligated by bankruptcy court to return to shareholders anyway. Moreover, Verizon's estimate of synergies is well below that of SBC-ATT, which SBC estimated at $15.8 billion even though Verizon and SBC are of roughly equal size, their long-distance businesses are of roughly equal size and the headcount at MCI is only about 10% lower than AT&T. This suggests that either SBC is grossly overstating the synergies (which involve a reduction of headcount of 26,000) or Verizon's are grossly understated.

MCIP’s largest shareholders have stated that Verizon would be getting MCI at a “bargain” price, even at $30 per share. Given MCIP trades just below $27, the market disagrees, but the projections Q enumerates in its March 2005 presentation support these shareholders’ contention.

Q’s (March 2, 2005) presentation suggests the value is much greater than $30 because pro-forma a Q and MCIP combination, the free cash flow (FCF) per share in year 3 after a merger would be $3.9bn, or $1.34 per share (assuming 2.9bn shares for the combined Q and MCIP). Applying a conservative 10x multiple to this FCF, one gets a $13.40 stock. The 10x multiple is conservative because the leverage ratio, per the Q presentation, would be 1.4x. Such reduction in leverage would allow for upgrade to investment grade status, and EBITDA would grow in excess of 9% CAGR over the foreseeable future.

The $13.40 stock price implies a market cap of $39bn, about a $32.5bn increase in equity value over the current market cap of $6.3bn. Therefore, Q is paying $10bn to get $32.5bn in incremental equity value, or creating $22.5bn in incremental value.

Another way to arrive at the incremental value that Q would create by buying MCI is to assume that MCI’s EBITDA would receive the Q EBITDA multiple. At its current price, Q is trading at roughly 5x 2004, 2005, and 2006 estimated EBITDA. MCIP’s 2004 EBITDA was $2.7bn. I don't see why Q would get a 5x EBITDA multiple and the MCIP EBITDA receive a lesser multiple, especially given stability of MCIP Enterprise business, after a combination.

A 5x EBITDA multiple would put $13.5bn of value on MCIP’s business. The $14.8bn in NPV of synergies would be incremental to that $13.5bn; MCIP would therefore add value of $28.3bn to Q. The Q bid of about $10bn would still create more than $18bn in value for Q (comparable to the $22.5bn cited in previous paragraph). Assuming even 2.9bn Q shares will be outstanding if Q buys MCIP, that $18bn is more than $6 per Q share, or nearly 200% in incremental equity value from the current $3.50 price. One could even dream a bit that Q’s EBITDA multiple expands to 6x or 7x as it delevers and wins an investment grade rating.

The last two paragraphs outline that Q’s buying MCIP would create $18-22.5bn in incremental value. So how does this translate into value per MCIP share? The Q deal offers 3.373 shares per MCIP share and $16 in cash. Well, in 3 years, if Q trades at $13.40, the value of every MCIP share at that time would be $45.20 plus $16 in cash, or about $61 per MCIP share.

One telecom analyst (from a firm known for the depth of its fundamental research) has stated that Q alone is worth $5 and that with MCIP, Q is worth at least $6. Even if this excessively conservative analysis is correct, the current Q bid is worth 3.373 times $6 plus $16, or $36 per MCIP share.


higher bids and/or value of Q bid rising as Q stock rises from synergies
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