Level 3 - Good Deal To Acquire TW Telecom, Yet Overall Leverage And Lack Of Earnings Limits Appeal

| About: Level 3 (LVLT)


Level 3 participates on Merger Monday, acquiring TW Telecom in a $7.3 billion deal.

Sizable synergies are expected to be realized.

Yet the high valuation, lack of current earnings and high leverage makes me hesitant to jump on the bandwagon.

Level 3 (NASDAQ:LVLT) participated on Merger Monday, announcing the acquisition of TW Telecom in order to consolidate its business, creating a more formidable player in the internet backbone industry.

Investors in both firms appear enthusiastic about the synergies to be achieved which are sizable in dollar terms and in relation to the very low GAAP earnings as reported by both businesses.

That being said, the lack of significant earnings and leveraged position makes me hesitant to invest in Level 3.

The Deal Highlights

Level 3 announced that it has entered into a definitive agreement to acquire TW Telecom (NASDAQ:TWTC). Under terms of the deal, Level 3 will pay $40.86 per share in a deal involving both cash and equity.

Investors in TW Telecom stand to receive $10 per share in cash and 0.7 shares of Level 3 for each share they currently hold in TW Telecom. The offer represents a mere 12% premium compared to Friday's closing price.

This values TW Telecom at $7.3 billion, including the assumption of $1.6 billion in net debt. Given the stock component in the deal, TW Telecom's shareholders will end up holding roughly 27% of Level 3's shares upon closing of the deal.

The deal is expected to close as soon as the fourth quarter of this year.

Strategic Rationale

The company stresses the rationale behind the deal citing complementary strength in order to create a stronger, more nimble and customer service-oriented player which can aid large and more complex communication customers. Especially the "more nimble" comment is surprising, as the company is actually growing its operations.

Following the deal closure, Level 3 should bolster its position in the global communications market to both governments and carriers. With the acquisition of TW Telecom, the combination can build managed solutions for customers through advanced IP/optical networks.

More specifically, Level 3 will benefit from a better metropolitan footprint, creating a more reliable and higher quality experience for consumers. At the same time, TW Telecom's current customers benefit from networks and data centers available in over 60 countries.

The company will derive 70% of its revenues from enterprise customers following closure of the deal with the remainder of sales coming from the wholesale segment. Nearly 80% of sales are achieved in North America. The remainder of sales are generated in Latin America as well as Europe, the Middle East and Africa.

Financial Implications Of The Deal

Besides the strategic rationale, the deal is also driven by expected annual synergies estimated to be $240 million down the road. Some $40 million of synergies are seen through lower capital expenditure requirements while the other benefits are derived from network expense savings and operating cost savings.

Some $140 million of these savings should be realized as soon as 18 months following closure of the deal, resulting in a total estimated net present value of $2 billion for these cost savings. To realize these savings, Level 3 expects to incur roughly $170 million in one-time charges.

Level 3 posted trailing revenues of $6.34 billion over the past year. The company posted reported EBITDA of $1.53 billion and net earnings of $81 million. The company operates with $600 million in cash and $8.4 billion in debt, resulting in a net debt position of $7.8 billion.

Debt will increase towards $9.2 billion after factoring in the cash component of the deal with Level 3 already having arranged $3 billion in committed debt financing to close the deal.

TW Telecom posted trailing annual revenues of $1.59 billion, EBITDA of $475 million and net earnings of $33 million. Unlike Level 3 it has shown decent growth in recent years.

Combined, both firms report revenues of $7.9 billion, on which they generated EBITDA of $2.0 billion and GAAP earnings of a paltry $114 million. This excludes $240 million in anticipated synergies which could push earnings up by $170 million next year on an after tax basis.

Level 3 will see its shareholder base increase by roughly 97 million shares as a result of the deal, pushing the total share count towards 335 million shares. This results in a market value towards $14 billion.

Investors Vote In Favor

Investors in Level 3 are not happy with the deal despite initial enthusiasm in pre-market trading. Shares are losing 5% of their value after the opening at $42 per share. This has lowered the valuation by roughly $700 million assuming dilution resulting from the acquisition. On the other hand shares in TW Telecom jump just 8% as the stock component in the deal reduces the offer value. This represents a roughly $400 million acquisition premium.

Overall, investors in the combination have lost money today despite the company's estimates for annual synergies of $240 million, representing a present value of roughly $2 billion.

The leverage is a real concern, or at least the absolute amount. However, as TW Telecom employs relatively less debt than Level 3, relative leverage is declining, although it remains elevated. Furthermore, note that only $475 million in debt is due in 2015, with the next significant maturity only seen in 2019, when $3.4 billion has to be repaid.

With consolidation occurring in all segment of the media and telecommunications scene, the deal might not be a complete surprise, seeing consolidation in the backbone of the communication networks.

Despite the strategic and financial rationale for the deal, investors react very cautiously. Both companies report very dismal earnings on a GAAP basis, driven by the relative high usage of debt. While the deal seems solid, driven by the larger scale and synergies, the valuation remains problematic given the lack of significant GAAP earnings, the high leverage and high debt in relation to earnings.

While the prospects might be rosy with demand for internet and data traffic increasing on the back of the popularity of data-rich content like Netflix (NASDAQ:NFLX), I remain cautious given the reasons outlined above.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.