Why I sold Qwest
As you may have noticed, the stock market has been doing very well over the last few months, and even my staid old telecoms have been caught in the updraft despite (or perhaps because of) the high dividend payouts. As the entire market now seems to be looking for yields now that cash and most fixed income (not my junk bond recommendations) have anemic yields, and the general trend seems to be for companies to do something with their excess cash other than making capital investments (Qwest has been eagerly buying back its debt), the recent advance in Qwest is unsurprising. Now, many of the talking heads have begun to question whether the rally is stalled and we should all get out (a sure sign that the rally is likely to continue). However, in my view the value of Qwest and CenturyLink have crossed a key valuation threshold.
As I said in my last article about how CenturyLink (then CenturyTel) was buying Qwest for less than its fair value, I calculate Qwest (Q) to be worth about $13 billion based on applying a multiplier of 10x to its average five-year free cash flows to equity of $1.33 million. CenturyLink’s five-year average flows are complicated due to a recent spate of mergers, but I would think that $800 million, or an $8 billion value for the pre-merger company, is not out of the question. The companies estimate that they will gain about $500 million in synergy from the deal, which, capitalized at a multiplier of 10x again, comes to $5 billion. So, $13 billion + $8 billion + $5 billion comes to $26 billion. The combined market caps of Qwest and CenturyLink are now $24.9 billion, within spitting distance of this price.
Now, it is not unusual for a company to swing from below fair value to above it, and so I may see a higher price for Qwest in future. But as a value investor, I am satisfied with buying below fair value and selling at fair value, because at that point there is no advantage in continuing to hold an investment. Furthermore, the case for $5 billion of that value is from synergy, which represents a dangerous assumption.
As was shown in Damodaran’s Investment Fables, an important book that examines the true historical performances and other concerns about various investment strategies, mergers have a mixed record when it comes to enhancing value. The book cites a study that assessed mergers along two lines: 1, Did the return on the amount invested in the merger exceed the acquirer’s cost of capital?, and 2, Did the combined company outperform the competition? Of the 58 mergers studied, 34 failed at least one test and 28 failed both of them. Furthermore, Damodaran concluded that firms that acquire companies of a similar size has a worse record than firms that acquire smaller firms. In the case of the CenturyLink/Qwest merger, the target, Qwest, is actually bigger than the acquirer by most fundamental measurements. However, the book also claimed that firms that merge to gain economies of scale have statistically greater success than firms that merge to keep their growth streak going in order to impress analysts, which is to be expected. At any rate, it appears that actually realizing synergy from a merger is more difficult than managements and investment banks would have us believe. Therefore, conservatism demands not counting the full value of the synergy (or perhaps even not any value at all) to the combined company.
I cannot say for certain that this current price ($6.93 as of today’s close) is the best price I can get for Qwest (there is, after all, a $1 billion discrepancy between the market cap of Qwest and CenturyLink that will theoretically have to be resolved as the companies are merging roughly as equals), but I can say that it is about the highest price I feel comfortable in getting. As is suggested in Marty Whitman’s Value Investing: A Balanced Approach, sometimes the merger and acquisition market overtakes the ordinary investor market, and we have to take what we can get. In this case, then, the current price of Qwest is about as good as we can get without running the risk of overvaluation and the possible risk of loss that comes with it.
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