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COVER STORY - Fair exchange

British Telecom thought that MCI was worth $21bn. WorldCom thought it was worth $37bn. The reasons why their bids differed by $16bn reveals interesting lessons in valuing takeover targets.

It was billed as the largest transatlantic M&A deal in history. British Telecom’s initial offer of $25.6bn to acquire MCI Communications was a ground-breaking bid in itself, though the price tag was later cut to $21bn. But when the relatively unknown WorldCom came on the scene and ultimately offered $37bn for the US-based long distance phone company, the sums became mind-boggling.

The two companies’ valuations differ by more than $16bn. This begs the question: why is MCI worth so much more to WorldCom than to BT? A clue lies in the only comment BT was willing to make on the MCI negotiations.

BT’s innocuous and oversimplified written statement reads: “We had a deal we were happy with; others simply valued the company (MCI) more highly than we did. MCI concluded that WorldCom’s offer was superior to what else was available, and so did we.” The clue is in the inference to the perception of value and what it means to different players.

The disparity is certainly due to more than differences of opinion over financial metrics or the value of MCI’s assets. It has to do with the size and culture of the two bidders, their strategies and their overall objectives as contenders in the global telecoms market. As Nick Griffin, a partner at KPMG, observes: “A lot of it is not to do with value as assessed, but on value as perceived or value that perhaps could be generated later on. I’m sure there is some science behind it,” he says. “But there’s a lot of logic applied and at the end of the day it’s a judgement that’s made about who the competition is and how desperate they are to actually run it.”

And there certainly was competition. The bidding war began in November 1996 when BT offered a combined stock and cash deal worth $37.50/share (a 36% premium on MCI’s share price of $27.25). The bid valued MCI at $25.6bn, including the value of the 20% stake BT already had in MCI. (The formal BT/MCI relationship dates back to 1993, when BT paid $4.3bn for a 20% stake in MCI. The following year BT created Concert Communications, a $1bn joint venture with MCI to provide global corporate communication services.)

In July 1997, MCI issued an unexpected profits warning and BT reduced its original bid to $21bn. Three months later the little-known Mississippi company WorldCom gazumped BT with a staggering $30bn (#18.5bn) bid for MCI.

Gary Brandt, vice president of investor relations at WorldCom, explains the negotiations: “We felt that BT was stealing MCI at that price. We couldn’t get into a bidding contest because you just didn’t know how high BT would go, and that wasn’t something that we wanted to get into.” However, when BT reduced its offer, WorldCom was ready to throw in their own bid.

“We knew comfortably at that time that, assuming no other competitors stepped in, BT was at its limit. That’s when we came up with our original price,” says Brandt.

That still leaves the question, why was WorldCom willing to pay such a premium for MCI and BT wasn’t? Brandt offers his explanation: “It comes down to location of assets. The fact that the majority, if not all, of BT’s assets are on the other side of the ocean and MCI is here in the US means it’s very difficult for BT to gain network synergies.

“On the network side the synergies between BT and MCI are minimal,” says Brandt. “For WorldCom and MCI the synergies are much more significant because, through our acquisition of MFS (in December 1996), we had actually acquired a significant presence in the US local service marketplace, which was exactly what MCI (a long-distance carrier) was lacking. When you start mapping out those savings you come to some numbers which are very significant, both in the short-term and over time.” Indeed, the acquisition of MCI also gives WorldCom a national fibre optic network in the US.

In fact, BT announced at the time of its initial bid that it expected the BT/MCI duo to yield savings of $2.5bn over five years. In November, WorldCom announced plans to achieve operating cost synergies of $2.5bn in 1999, rising to $5.6bn annually by 2002. In addition, it expects to save $2bn on capital expenditure in 1999 and beyond. But the huge difference in potential cost savings is only one factor explaining the difference in bids.

Dr Roger Pye, KPMG’s sector leader for the telecommunications industry, raises another theory. “Some people have said WorldCom has grown by making acquisitions and creating the perception that value is growing, but at some point it actually had to acquire some real cashflow in order to go on funding the business. And MCI can provide that,” he says. “That’s not quite a strategic premium, but it’s more than the value of the free cashflow which comes from the merged entities. There is a strategic need to do a deal of this nature and MCI fits the characteristic of the deal that WorldCom needs to do.”

This is a theory shared by others. Andrew Till, a former telecoms analyst and now technology strategist at Psion Dacom, is one. “MCI have had a rough time recently in terms of financial results, but WorldCom owes a very large amount of money to their investors. We’re into several billions of dollars here,” he says. “Now MCI is actually a profit-making entity in itself and would give WorldCom some positive revenues which would alleviate some of the debt ratios that they have.

“In terms of securing future investment capital at WorldCom, MCI is a very nice part of the portfolio to have. This is not an issue for BT, which obviously does not have a problem securing or raising capital, but I think somebody like WorldCom, when you look at their financial situation, could have started encountering those kinds of problems as they moved forward.”

Even WorldCom’s Brandt admits: “We acquired some very significant scale and scope to our business for a very fair price. MCI adds substantially to our US-based revenues. It triples our revenues right off the bat.”

In addition to the fact that MCI brings in the money and will help WorldCom achieve efficiencies of scale, there is another factor which adds to MCI’s value. That is the changing nature of the global telecoms industry itself.

Psion Dacom’s Till explains: “We’re seeing a shift in the way that the telecoms market is structured at the moment. We’re actually going through some paradigm changes. And I think that WorldCom, quite rightly, has identified that, to be a major telecoms player today, you have to be a global player.

“That’s why we’re seeing not only the WorldCom/MCI negotiations, but all of the telecoms merger and partnering activities going on across Europe, Asia and the US. The provision of telecoms services is now a global business. You can’t confine that to an individual continent or country. Just to be a large company is not good enough anymore.”

Another trend in global communications which has a bearing on the WorldCom/MCI deal is the shift from voice services to data communications – that’s where the money is going to be made: “Voice services, for the fixed carriers, are becoming more of a commodity and the key element that they’re all after is data,” says John Harley, a partner specialising in telecoms at Price Waterhouse. “This is because as the Internet comes more on stream, businesses want to transfer data messages. Similarly, things like digital telephony come into play. The market is moving much more in the data transmission arena.”

WorldCom’s business is heavily oriented towards datacommunications in the US market (although it’s also involved in reselling voice services internationally). This may mean that, together, WorldCom and MCI can grow the datacommunications market in the US faster than BT and MCI could have grown the international corporate telecommunication market.

KPMG’s Pye explains: “One of the key differences between the two bids is that the BT one was heavily concentrated on the corporate market, dealing with both voice and datacommunications on a global basis, whereas the WorldCom bid is principally about the US market and principally about datacommunications. What everybody expects is that voice will be integrated into datacoms. So we will have a datacommunication carrier service carrying voice as an application.”

Given the trend towards datacommunications, the acquisition of MCI appears to fit WorldCom’s strategy better than BT’s. “WorldCom is conducting the two-pronged attack on the datacommunication market,” says Pye. “Acquiring MFS gives them lots of transmission capacity in central business districts in the US and Europe, which allows it to address the corporate market especially for datacommunications. Then through its acquisition of Internet service providers, it is obviously attacking what is the main consumer-oriented datacommunications market, the Internet. These two things are occurring because more and more corporations are using Internet technology as the basis of their own datacommunication capability. In a sense what WorldCom is doing is addressing the main threads of the datacommunication market both the residential side and corporate side.”

Perhaps the most important effect of the WorldCom/MCI deal is that it keeps BT out of the US, if only temporarily. BT provides services in and out of the US through partnerships, but needs to own an infrastructure there if it wants to make a significant profit out of US-based business.

Preventing BT’s acquisition of infrastructure has a twofold effect. Firstly, it removes a potential competitor and, secondly, it scuppers BT’s global strategy.

“To a certain extent the value to WorldCom comes from keeping BT out of the US,” explains Psion Dacom’s Till. “BT has, certainly for ten years now, been trying to get a global strategy in place. If you look at the alliances BT has been forming around the world, such as the alliance with Telefonica to get them into Latin America for example, BT is really trying to push for global service provision. If BT can provide large global organisations with global services, global billing and global management then that is very attractive and companies will pay a premium for that.

“Without some presence in the US there is no global strategy in place for BT. When you start looking at where it has its alliances, where it trades and where the volume of trade goes, it is all in and out of the US. So if you don’t have a concrete service offering in the US, then your strategy is not complete. What BT actually needs is a physical network in the ground that it has100% ownership of. Going into partnership in that market is not going to make it any richer. In fact it could actually cost the company a significant amount of money.”

Fourteen months ago, City and Wall Street analysts were scratching their heads wondering what BT had to gain from a $25bn acquisition of MCI. Now, ironically, they are amazed and impressed by WorldCom’s audacious $16bn trumping of BT’s card. WorldCom had simply spotted value that BT couldn’t exploit.

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