Windstream to overpay for PAETEC

August 23, 2011

I have been indisposed recently, but I will be ready to resume m usual schedule of posting in the near future. But before then I have some old news that needs addressing, and that is Windstream’s planned merger with PAETEC.

Whenever there is a merger announced, at least one and usually more than one plaintiff’s firm will announce an investigation into a possible breach of fiduciary duty of the board of the target company. In the case of this merger, there were about ten such announcements. Most of these suits are pointless and never go anywhere, and boards of directors have come to regard them as a cost of doing business. But one rarely if ever sees any investigation of the acquiring firm. No one seems to bother to investigate them, despite the historical evidence that shows that a majority of mergers fails to add value.

So, after a long wait, I have decided that I will investigate them–not in preparation of a lawsuit, just to assess the wisdom of a merger. And what I have found is that this merger has all the signs of one of those mergers that fail to add value. Specifically, it places a great deal of pressure on synergy to produce value. Synergy is notorious for often being a thing that the M & A industry makes up to justify a merger that cannot stand on its own merits.

The specifics of the deal are that Windstream will take on $1.4 billion of PAETEC’s debt and issue roughly $900 million in stock, plus $100 million in merger and integration expenses. In exchange, Windstream anticipates synergies of $100 million from operations and capital expenditure savings of $10 million, and  tax benefit of $250 million based on PAETEC’s reported operating losses. PAETEC itself has produced $130 million in operating cash flows last year. Although this year PAETEC is on course to generate a figure closer to $160 million, this figure cannot be isolated as the result of organic growth or savings; PAETEC is also a serial acquirer, having acquired a large business itself in 2010.

So, subtracting out the $150 million from the tax benefit and the merger and integration costs, we have a $2.15 billion price tag. Starting with the generous $160 million figure as an estimate for PAETEC’s operating cash flow, we first consider the cost of debt. $1.4 billion in debt assumed by Windstream at, say, 8% consumes $112 million right away and resolves part of the price tag. The remaining $48 million becomes about $32 million after taxes. This amount, capitalized at 10x, produces a value of $320 million. Set against the $750 million in the remaining purchase price we have a gap of $430 million. Now, $110 million in operating synergies also reduces to a bit over $70 million after taxes. So, it would seem that PAETEC has to produce 61% of its projected synergies (although the merger announcement adds that it estimates that it will take a full three years to ramp up the synergizing, which lowers its present value, obviously).

According to Damodaran in his Investment Fables, a study performed by KPMG concluded that synergies associated with cost reductions, as this merger is, tends to be more effective than synergies based on new product development or sharing R & D. This is a plus, but the study seemed to confine itself to reducing headcounts. At any rate, such mergers have a 66% success rate, as opposed to 25-33% on the R & D category. So, converting this figure into an expectancy, we find that there is a 5% margin of safety on this merger based on the above 61% synergy performance requirement; 5% of $730 million, or $36.5 million dollars on an acquisition of $2.3 billion. Not the clear creator of value that I would like to see.

Windstream may have been caught in the panic on Wall Street this August, and its share price suffered accordingly, but I am concerned that another source of its price drops was the possibility that the market shares my view of the dubious wisdom of the merger. It has not motivated me to sell, but I will be  observing the company’s performance in future.

Disclosure: I am long Windstream at the time of this writing (yes, I am including this disclosure now).

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