CenturyLink, Inc. – A Qwest for Growth
Back in April, CenturyLink, Inc. (NYSE: CTL) announced that the company and Qwest Communications International, Inc. (NYSE: Q) had agreed to merge, subject to regulatory and shareholder approval.
At the time, we didn’t think much about the announcement, nor have we paid much attention to how things are progressing, in the last 7 months.
Truth be told, had one of our clients not sent us a Worksheet Request for Qwest, we probably would not have thought about the proposed merger again.
But as we began to build the requested worksheet, we came across a Raw Value Report we had written in September 2009 for what was, at the time, CenturyTel, Inc., known today as CenturyLink.
Since our CenturyTel report, we have completed our proprietary valuation model, and curious, we applied our model to both CenturyLink and to Qwest.
What we found was, to us, good news for Qwest stockholders but not such for CenturyLink stockholders.
Financial information presented in this report for CenturyLink, Inc. is based on the company’s most recent SEC Form 10-K filing for year ending December 31, 2009, as filed with the Securities and Exchange Commission on March 01, 2010.
Financial information presented in this report for Qwest Communications International, Inc. is based on the company’s most recent SEC Form 10-K filing for year ending December 31, 2009, as filed with the Securities and Exchange Commission on February 16, 2010.
The merger of these two companies is being called “compelling”, with many “synergies”, providing the merged companies with greater “scale”, “scope”, and “expertise”.
Quite frankly the first thing we do when we hear words like these is grab our wallets and head for the exits, having learned over the years that these words generally mean soemthing is going to cost us.
Once the merger is complete, CenturyLink, Inc. which we think should be renamed CQ, Inc., may indeed have lots of synergies, executive washrooms, and gold inlaid water closets, we have no idea.
Nor do we have any idea if the new company will be able to provide more, better, or more far reaching services that current customers, will want to buy.
But one thing we do know, is that after the merger, Century will have a mountain of debt so vast we believe once interest rates start to increase, the company will simply not be able to service its debt and will have to seek protection through the courts.
We admit that $22 billion worth of debt may not seem like a big deal to many investors, especially considering that only $0.085 out of every Sales dollar goes to pay the interest on that debt.
But look around.
The current prime interest rate is 3.25%. Yet based on the combined companies FY09 financial statements, we estimate the interest rate for Century will be close to 6.5%, not the 4.75% that Century paid in FY09.
Why do we think this will be the case? First off, there will be a good deal more debt. Secondly, we think the merger at the very least will temporarily weaken the financial position of Century.
Accordingly, we think the company’s lenders will increase the company’s interest rate to compensate for the initial increase in risk.
Of course there is no guarantee that the company’s lenders will reduce the company’s interest rate once the company has completed integrating its new purchase.
As the matter of fact, we think that by the time Century has finished assimilating Qwest into its business model, the days of cheap interest rates will have ended.
So we seen no we see no potential decrease in interest rates for the company, maybe ever.
Based on our review of both company’s current annual financial information, we think that after the merger, Century will have a Current Ratio of 0.84, a Quick Ratio of 0.69, and a Cash Ratio of 0.38, none of which are to us, investment quality.
We also believe that after the merger, at least 30% of the company’s Total Assets will be made up of Goodwill and Intangibles, and that Total Debt will exceed EBITDA by an almost 3.5:1 ratio.
Certainly there are potential bright spots such as Free Cash Flow, which we think will level out in the $3 per share range, and Return on Invested Capital which we believe will consistently be in the 20%-25% range.
Based on our review of both company’s latest annual financial information, our Reasonable Value Estimate for the stock based on a 5-Year hold once the merger has been completed is $25, with a Buy Target of $15, a First Sell Target of $29, and a Close Target of $31.
We also believe that after the merger, Century will have an Enterprise Value of about $52 per share, an Equity Value of about $33 per share, and an Earnings Value of about $35 per share.
In addition, we estimate that EBITDA will run about 38% of sales, meaning that when our Enterprise Value estimate is considered, and assuming EBITDA stays at or near current levels, it should take Century approximately 16 years to pay for its investment in Qwest.
We said at the outset that we believed the merger with Qwest would be good for Qwest stockholders but not so good for Century stockholders.
Certainly we have no idea what the basis is for the current stockholders of Qwest, but coupling an entry point in the stock sometime in the past 5 years with an acquisition price of $6.02, the company’s current stockholders should recoup the vast majority of their investment.
In addition current stockholders of Qwest would be left with shares in CenturyLink, which we estimate will have a value of about $25 after the merger.
The same cannot be said for the current shareholders of CenturyLink. Considering our valuation estimate, many of them that took a position in the stock within the last 5-years are simply going to end up underwater.
In the end, Century must grow, and to do that they need access to additional markets, so merging with Qwest makes good business sense.
Our issue comes down to the assumption of more than $11 billion of debt, making us wonder if this merger is a Qwest for growth or grope for Qwest.