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November 11, 2016

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

Posted by Anurag Vardhan Sinha (View Profile | View All Posts) at 10:30 AM

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

Last Friday, I was having coffee with my team and discussing the wave of consolidations that are happening in the US communication industry when a colleague commented, "Anurag, with this pace of deal announcements, it looks like you will have to write an article every week." His words were prophetic, for two days later, on the eve of the historic US elections, EarthLink announced its merger with Windstream Communications in an all-stock transaction. The deal values EarthLink at about $645.2 million, and with debt at approximately $1.1 billion. Windstream shareholders will own about 51%, while EarthLink shareholders will own 49% of the combined company.

EarthLink was founded in 1994. It was envisaged as an alternative to dial-up internet service providers (ISP) like AOL who had a closed ecosystem. Dial-up internet services from EarthLink became popular by the turn of the millennium. They extended their success to broadband services but soon started facing pushback from Telcos. At the time of the merger, EarthLink had 29,000+ fiber route miles, 90 metro fiber rings and secure data centers that provide data and voice IP coverage. Dial-up as a mode for accessing the internet went out of vogue and by the end of the first decade of the new millennium, most of the dial-up giants like AOL got acquired. Those like EarthLink have been finding their new 'avatars' through partnerships/mergers and are focusing on niche markets not served or underserved by the telco giants of today. And it was only a matter of time that a player like EarthLink would want to grow beyond their niche market.

On the other hand, Windstream started as a boutique telecom company providing voice, and data connectivity using broadband, VoIP and MPL. They have expanded their consumer footprint into digital TV services and are today the 9th largest communication service provider in the US. They serve over 8.1 million people in 21 states. Windstream also services small and medium businesses through their managed service offerings like virtual servers, managed firewall, data storage. In a way this merger was on the cards, and here are some of the reasons why,

1. Enhancing Balance Sheet

Earthlink has been operating in a shrinking dial-up space and in order to fend off competition, have been diverging to new areas like home VoIP and IT services. Both Windstream and EarthLink had been facing stiff competition from telecom heavyweights and through this merger will achieve economies of scale and become more competitive. EarthLink's annual revenue is ~18% of Windstream's run rate and the merger will almost double Windstream's market capital and increase its cash flows by ~40%.

2. Complementary Networks & Operational Synergies

Apart from enhancing the balance sheets, synergies from this merger will make the offering from the combined entity more attractive to its clients. EarthLink had about 671,000 consumer subscribers, while Windstream has about a million residential internet subscribers. EarthLink had 29,000 route miles of fiber, of which 16,000 route miles are in areas where Windstream does not have coverage. This will result in an enlarged footprint of 145,000 route miles for Windstream's in its primary markets.

According to the merger note from EarthLink and Windstream, the combined entity is expecting more than $125 million in annual operating and capital expense synergies, within 36 months of closing. The expected Net Present Value (NPV) of this $125 million+ of synergies will come to ~ $900 million!

3. Customer Synergies & Complementary Services

Unlike large telco's, the focus of Windstream and EarthLink has been on medium and small enterprises. These customers account for 38% of Windstream's revenue and about 41% of EarthLink's revenue. The merger will give the combined entity complementary market reach and service capabilities. For example in Q2 '16, EarthLink launched their new 'software-defined wide area network' (SD-WAN) service that allowed enterprises to determine the most effective way to give internet connectivity to remote locations, such as a company branch offices. Post-merger, the expanded fiber network and access to Windstream's enterprise customers will strengthen SD-WAN offering.

4. EarthLink's debt as asset

In the merger note, it was announced that Windstream plans to refinance EarthLink's debt of ~ $436 million. However EarthLink's recent operating losses can also be carried forward to reduce tax, which are expected to have an estimated net present value of $95 million.

Competition has been heating up in the communication industry since 1982, when AT&T was broken into competing 'Baby Bells'. Post the AT&T breakup, hundreds of long-distance companies sprung up, heating competition in this space. By 1996, both Democrats and Republicans were convinced about the need to extend competition in telecom and allow local service providers, long-distance providers and cable companies into each other's markets. In 1996, President Clinton signed on the 'Telecommunications Act of 1996', which eased restrictions on media cross-ownership so that a single company or person could own multiple media businesses like broadcast stations, cable stations, newspapers, and websites. This resulted in huge influx of capital to the industry and companies set of on a rat race to build networks over land, undersea and in the air. This resulted in overcapacity and eventual implosion of the communication industry by the turn of the millennium. Since then, the US communication industry has been plagued by commoditization, regulatory controls, decreasing margins and new 'Over-the-Top' (OTT) entrants like Google, Facebook, Amazon and Netflix.

Romantic poet P.B. Shelley in his famous poem, "Ode to the West Wind" wrote "O, wind, if winter comes, can spring be far behind?" For the communication industry, the spring of consolidation had to finally arrive, to combat their existential threat. We saw waves of consolidation in the last 15 years which have resulted in the formation of large Tier -1 communication providers like AT&T, Verizon and T-Mobile. We have now reached a stage where the wave have turned into a 'Tsunami' of mega - consolidations. I had covered the premises for mega-consolidation in my previous posts, 'CenturyLink - Level 3 Merger: Expensive Network Buy or Strategic Consolidation?' and 'AT&T's Business Transformation: From Connectivity, to Services, to Experiences'. The Windstream-EarthLink merger is the third such deal we are witnessing with a fortnight.

The US communication market is still heavily fractured and there is scope for further consolidation. The image below shows the US communication market.

The market has been abuzz with rumors that Tokyo based SoftBank Group Corp.'s who owns more than 80% of Sprint is in a merger conversation with T-Mobile US. This, despite being stopped by regulator two years ago. The other potential acquirers of T-Mobile could include Charter Communications, Liberty Media, Dish Network, foreign carriers (for whom T-Mobile is the only way to enter the US market) and/or a private equity. Post the second wave of consolidation, the US communication market has six major providers - AT&T, Verizon, T-Mobile, CenturyLink, Sprint and now Windstream, besides four Cable MSO / Satellite TV provider -Dish Network, DirecTV(AT&T), Charter and COX. It would be interesting to see the next move from Tier 2 providers like C Spire, Frontier and US Cellular who now have become prime targets for acquisition. There is still plenty of potential in the rural areas for growth in high speed internet. These are areas not covered by the Tier-1 or Tier-2 providers and regional/ boutique players can pursue M&A as a quick way to consolidate their capabilities and grow their footprint.

You may also be interested in reading

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

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

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