The board of directors of MCI accepts and considers bids from Verizon and Qwest. The two companies have their own advantages. Qwest, although a smaller company, is offering almost a billion dollars more than the offer of Verizon, one of the largest telecommunications companies in the world. However, the latter company has a better experience in mergers and acquisitions.
Malcolm P. Baker and James Quinn
Harvard Business Review (206045-PDF-ENG)
November 11, 2005
Case questions answered:
- What are the strengths and weaknesses of Verizon, MCI, and Qwest? Where are the synergies in the proposed combinations?
- Evaluate the two offers in Exhibit 7. What explains the two structures? In each case, what is the value to MCI shareholders?
- Merger arbitrage (or risk arbitrage) funds speculate on the completion of stock and cash mergers, typically buying the target and hedging the risk of the acquirer’s shares according to the exchange ratio in stock mergers. What positions would risk abs take in this deal? How would their positions change if the board appeared to favor the Qwest offer?
- Consider the WorldCom-MCI merger and the Qwest-US West merger? Trying to avoid hindsight bias, should the boards of MCI and US West have accepted those offers? What is the obligation to shareholders? Was the obligation fulfilled? What about WorldCom and Qwest? Did their shareholders benefit?
- Which offer should MCI accept?
- What approach should Verizon take to win the takeover contest? Qwest?
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MCI Takeover Battle: Verizon Versus Qwest Case Answers
This case solution includes an Excel file with calculations.
1. What are the strengths and weaknesses of Verizon, MCI, and Qwest? Where are the synergies in the proposed combinations?
Strengths: Verizon is strong financially compared to many other telecommunication companies, highlighted by positive net income ($7.8 b), strong interest coverage ratio (3.84), ROE (7%), ROTC (8%) and an A+ bond rating.
Strategically, Verizon has focused operations, after completing multiple divestitures in 2002 & 2003, and now has a strong domestic presence in telecom ($39 b rev.) and wireless ($28 b rev. & 45 m customers) forming 90%+ of the total rev.
Weaknesses: Verizon has a significant lack of international presence, as suggested by under $2 billion in international revenue (2.8% of the total rev.). Additionally, 9/11 caused significant damage to their main offices in New York and 11 cell sites in that area.
Strengths: MCI has a strong international presence with products and services in over 200 countries. Specifically, it has a strong presence in business ($14.1 b of $27.3 b total rev.), mass markets ($6.4 b rev.), and international markets ($3.9 b). Additionally, MCI has a well-established infrastructure, including 100,000 route miles of network connections linking regions globally, and a well-established customer base that includes 65% of Fortune 1000 companies and 75 government agencies.
Post-bankruptcy, MCI also has low debt levels. Lastly, MCI has a strong internet protocol backbone and is one of the largest international voice carriers.
Weakness: Even with all of its strengths, MCI has been experiencing falling revenues ($24.3 billion to $21 billion in 2004) and negative net income ($4 billion in losses) due to price compression caused by technology displacement (aging technology) and competition. Additionally, as MCI is emerging post-bankruptcy, there are likely reputational concerns that may hurt the company in the capital markets (equity/debt raising, M&A, etc.).
Strengths: Owns a nationwide fiber-optic network and has a strong wireless segment, with $13.2 b of its $13.8 b in revenue coming from that segment in 2004.
Weaknesses: Bad timing with investments in new assets, for an anticipated industry growth that didn’t materialize, led to high debt levels and need to sell assets for liquidity. Simultaneously, industry decline led to weak sales, which together, led to reductions in operations.
The synergy between Verizon and MCI:
Verizon brings a strong domestic market presence to MCI’s global presence. Thus, the two companies together will be competitive on a global scale – backed by their large combined customer base. Verizon also has strong financials, with the cash to invest in technologies such as wireless technology, an area highlighted by both companies as a growth opportunity.
The synergy between Qwest and MCI: Qwest brings a domestic market to MCI’s global presence in 200 countries. Qwest will also benefit from MCI’s post-bankruptcy balance sheet, which has significantly lowered debt-levels. The combined entity would also have significant tax shields due to loss carryforwards.
2. Evaluate the two offers in Exhibit 7. What explains the two structures? In each case, what is the value to MCI shareholders?
Both Verizon and Qwest offer a combination of cash and stock. The cash portion of the two offers are similar, but they structure the stock portion differently. For the equity value calculations, we assumed MCI’s 319.6 million shares outstanding (case exhibit 8) is fully diluted since no further information in regards to other stock options has been provided in the case.
Verizon’s equity offer structure is a combination of fixed ratio and fixed value, with a one-sided collar. If Verizon’s stock price on the trading day immediately preceding the acquisition is between $0 to $36.31, the Verizon offer would be $8.75 cash and $14.75 in stock. However, if Verizon’s share price is above $36.31, the exchange ratio will be fixed at .0402, and the stock value to MCI will exceed $14.75. Appendix 1 presents a visual representation of the deal payoff.
From this information, we valued Verizon’s stock upside (fixed ratio component) treating it as a call option using Black-Scholes. Using Black-Scholes (using case provided volatility, risk-free rate, and dividend yield and an assumed .5 year estimated deal timeline) the value of Verizon’s call is $1.28 (Appendix 2). Therefore, MCI shareholders’ value will be…
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