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November 4, 2016

CenturyLink -- Level 3 Merger: Expensive Network Buy or Strategic Consolidation?

Posted by Anurag Vardhan Sinha (View Profile | View All Posts) at 10:06 AM


On 31st October, within 10 days of the mega- merger announcement by AT&T and Time Warner Inc, CenturyLink announced its decision to buy Level 3 Communications in a massive $34 billion cash-and-stock deal. The equity value of the deal, excluding debt, is about $24 billion. CenturyLink, offered $26.50 in cash and 1.4286 of its shares for each Level 3 share, there by valuing Level 3 at $66.50 a share. Post the acquisition, CenturyLink shareholders will own about 51% of the combined company.

CenturyLink, services 6 million residential Internet customers, mainly in rural areas and Level 3 operates mainly in cities on the East and West Coasts. Both companies have been facing immense competition from larger rivals and through this merger, believe that they can consolidate and stand up to the might of AT&T and Verizon. CenturyLink and Level 3 is expecting the combined company to save over $900 million in cost-cutting synergies, according to the press release announcing the deal.

CenturyLink shareholders have not reacted positively to the deal and it is evident from the fact that their stock dropped by over 10% on the day of the announcement. They haven't recovered since. Many fear that it will be difficult to realize the expected synergies and CenturyLink will be taking a huge risk by carrying a debt laden Level 3 which is operating in a hyper competitive market. The skepticism expressed by shareholders could be temporary and these types of trends are not uncommon when large M&A's happen. Over time we expect the trend to change as the dust settles down, and shareholders and market analysts start to see synergies at work.

Further, skepticism is also because such consolidations haven't really produced spectacular results in the past. The graphs below show the stock movement in the past 5 days, since 31st Oct. 2016.

CenturyLink shareholders.jpg

It is my firm belief that it is the contrary, that in the long run this deal can realize synergies and benefit all stakeholders. Here are seven reasons why I think so.

1. Focus on the core-business

This M&A focuses on the core business of CenturyLink & Level 3 and it is here that this union derives its strength -- unlike AT&T (to point out an example), which seems to be putting its $ bets on adjacent, and maybe not so adjacent markets. This union is all about strengthening their core offering -- fiber/broadband, and enterprise is their clear focus segment. Further, it is adequately apparent (from AT&T, Verizon and others) that consumer ARPU is dropping year-on-year, and other revenue sources are needed. This union is smartly betting on the 'niche' it wants to keep.

2. Creating the scale and size to compete

The communication industry requires high capital investments and the return cycle is long. Traditional communication services are getting commoditized at a fast pace and the sector is characterized by a classic 'winner takes all' situation. CenturyLink and Level 3 have been facing revenue and profitability pressures from larger competitors like AT&T, Verizon and Comcast.

CenturyLink and Level 3 has been competing hard for the same turf, but were curtailed in their inability to compete individually with juggernauts like AT&T and Verizon. This union helps them put up a joint front even while AT&T and Verizon's are shifting focus away from their core as their recent acquisitions indicate.

Post this deal the combined company will be the second-largest provider of communications to business in the US after AT&T with ~ $25 billion of revenue and 55,000 employees. CenturyLink has a 250,000-route-mile US fiber network and a 300,000-route-mile international transport network. Level 3 will add 200,000 route miles of fiber to CenturyLink's network, which includes 64,000 route miles in 350 metropolitan areas and 33,000 subsea route miles connecting multiple continents, springing it to a leader's position both in the US and globally. The image below shows the assessment by Vertical Systems Group before the deal.


3. The Enterprise push

The deal comes at a time when business clients are seeking more bandwidth and faster networks to move data. CenturyLink makes about 60% of its revenue selling network services to businesses, while Level 3 sells only to businesses. As per the press release, 76% of the combined company's revenue will come from business customers.

4. On-Net capability

CenturyLink is rolling out its GPON-based fiber-to-the-premises (FTTP) to multi-tenant units (MTUs) so as to rapidly scale business service installation. On-Net buildings or Near-net buildings, which are within close proximity to the fiber the company already has in the ground, allows it to rapidly scale service to business customers. With the Level 3 acquisition, CenturyLink increases its on-net buildings by nearly 75% to about 75,000, including 10,000 buildings in EMEA and Latin America.

5. Transformation for new telco services

Telcos have been focusing on software defined networks (SDNs) and network function virtualization (NFV) as strategies to combat the rapid commoditization of their traditional business. Combined synergy between CenturyLink-Level 3 can come from its virtualized capabilities.

CenturyLink has more than 50 % of its IP core network and data centers virtualized today. They have built their NFV platform in 36 network and data center locations with plans to expand into another 8 locations by the end of the year. Level 3 Communications has been building its own SDN infrastructure for the past three years and currently has about 75,000 network elements under the control of its SDN orchestration system. Both companies has been engaged in active in acquisition in the SDN space. In 2014, Level 3 acquired TW Telecom for about $6 billion and Level 3 has been using SDN for its Ethernet services that it acquired with the purchase of TW Telecom.

Both companies were already involved in network transformation efforts through SDN/NFV initiatives, including cloud, and this is bound to streamline, and introduce the required economics and agility necessary to rollout new services. This network transformation initiative will also bring OPEX and CAPEX savings in the long run for them to be able to invest in areas with highest revenue potential.

6. Combined Cloud & CDN play

CenturyLink has been positioning themselves as a cloud provider over the years and they had made several acquisitions in the past five years like Savvis, Tier 3 and AppFog to bolster their case. CenturyLink haven't been competing directly with giants in public cloud like Amazon, Rackspace and Azure but have been focused on offering a hybrid-cloud model for enterprises who due to strategic or compliance reasons wanted to retain a part of their data on premise. Last year, CenturyLink acquired ElasticBox, a multi-cloud application management startup who does orchestration across a dozen cloud providers, including AWS, IBM SoftLayer, Microsoft Azure, VMware, CenturyLink Cloud, Google Compute Engine and OpenStack.

Level 3 has created one of the largest content delivery networks (CDNs) with a capacity of 26.8 Terrabit per second using their tier-1 international transit network. The network features 93 locations around the world where more than 15,000 servers are used to deliver international content.

This deal will help in extending their footprint in CDNs and hybrid cloud as CDN actually drives cloud adoption through enhanced performance, scalability, security and cost savings.

7. Level 3's debt as a near term asset

Heavy investments in fiber by Level 3 outstripped its service revenues and this has led to debt on their books. The combined company can use this net operating loss to carry forwards and reduce their effective tax rates. The deal gives the combined entity ~$10 billion in tax credits that Level 3 has been carrying on its books and it can use up to $2 billion a year of the accumulated net operating losses as credit against taxes.

As discussed in my previous post -- "AT&T's Business Transformation: From Connectivity, to Services, to Experiences", communication service providers are taking either of the three consolidation strategies to defend their competitive positions -- market consolidation, horizontal consolidation or vertical consolidation.

The CenturyLink -- Level 3 deal did not receive as much attention as AT&T-Time Warner or Verizon-Yahoo/AOL (despite the size), probably because it was a routine vertical integration/consolidation of similar players, that industry has seen over the last several years. Companies like Level 3 and CenturyLink grew to their current size by acquiring capabilities across the value chain through vertical consolidation.

Both the companies are not new to M&A activities -- CenturyLink transformed itself from a traditional POTs company -- CenturyTel through the acquisition of capabilities from Embarq, Quest and Savvis. Similarly Level 3 grew by acquiring WilTel, Broadwing, Global Crossing and TW Telecom. We expect this big union to happen quickly, the dust to settle quietly and the new CenturyLink, to start business as usual.

You may also be interested in reading

AT&T's Business Transformation: From Connectivity, to Services, to Experiences

Thoughts on Windstream-EarthLink Merger - O Wind, if winter comes, can spring be far behind?

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