CenturyTel and Qwest Merger Off to a Rocky Start

Last Thursday, CenturyTel (CTL) and Qwest (Q) announced plans for a merger that would make one of the largest operators of landlines in the country. The deal would be a tax-free, stock swap in which each share of Qwest would be exchanged for 0.1664 CenturyTel shares. At the time of the announcement, the deal was equivalent to a 15% premium to the previous close for Qwest. However, due to the market’s movements in just three trading days CTL has fallen down, the premium is now just 8% compared to the close of trading prior to the announcement. With each day that has passed the market has sent shares lower.

CenturyTel management touted the deal as a combination of two great companies, both of which have strong cash flow. In addition, the deal is estimated to create cost savings of $625 million annually a few years after the deal closes. However, Wall Street has begun to raise concerns that CenturyTel is growing too aggressively, as it just recently completed another large acquisition of Embarq less than a year ago. CenturyTel is well known for growth through acquisition, but after the completion of the deal, CenturyTel will claim 17 million local landline customers which is 8 times as many as they had at the end of 2008. Clearly, there are concerns about management’s ability to seamlessly integrate yet another acquisition so soon following the Embarq deal. The deal also may raise the attention of regulators, which may explain why Qwest is not trading up to the offered price.

CenturyTel was downgraded to Market Perform from Outperform by analysts at Oppenheimer following the announcement, yet overall the analyst community remains bullish on the stock. At Ockham, we have placed an Overvalued rating on CTL as it trades at a level that we see as out of line with historically normal valuations. For example, the market has historically been willing to pay 4.5x to 6.7x multiples of cash earnings, but at the current price the stock trades at a price-to-cash earnings of 7.3x. Perhaps more importantly, the company will absorb more than $11 billion worth of debt from Qwest’s balance sheet, which will accelerate the expansion of debt held on CenturyTel’s books. Debt more than doubled from fiscal 2008 to fiscal 2009 to $7.75 billion thanks to the Embarq deal, and would more than double again following this deal. The growth of debt on their balance sheet is concerning, and Standard & Poors has already stated that they would likely rate the combined company’s debt below investment grade. Furthermore, as of their last reporting the company has a current ratio of less than 1, meaning it owes more in debt and other payments in the coming year than it has in assets ready to use in the next year.

The question investors have to ask themselves is, will CenturyTel be able to generate enough cash flow to service its ballooning debt load? Obviously, their management believes that the combined company will be able to or it would not have undertaken the deal. We are a little more skeptical about the company’s ability to circle the wagons against such telecom heavyweights as AT&T (T), Verizon (VZ) and Sprint (S). All of which have massive wireless divisions and can more easily absorb shrinking revenue from landlines. Maintaining and upgrading existing lines is costly especially as they are spread out through many rural areas, and without the wireless business generating cash flow it is far more difficult.

CenturyTel is clearly looking at it from a different angle and would like to dominate the rural landline business and also run other, more expensive services (broadband Internet, television, bundles) through that infrastructure. Consolidation among providers would seem a logical step in dealing with strong competition as it generally lowers costs, but it remains to be seen if CTL has bitten off more than it can chew in such a short amount of time. At this time, we recommend investors avoid this stock because it is too debt laden and facing too many challenges to be trading this high.

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