Writing the right ending to the MCI saga

MCI's management has done a great job so far in bringing the long-distance carrier out of bankruptcy and in creating a bidding war for it.

But there is one last big step to completing the process--they need to pick the merger partner that is best for their shareholders.

This choice could make a huge difference in whether they complete the task or fall way short of the goal line. Local phone companies Qwest Communications and Verizon Communications have each made bids to buy MCI and at the same time tried to taint the other's bid by claiming it involves substantial uncertainty and regulatory risk.

Ultimately, however, the board's choice should come down to money.

Both companies have offered a combination of cash and stock. The cash part is relatively easy to evaluate. The stock part is a bit more complicated, but only because of the delay in closing the deal.

The easiest way to think about this is to imagine that a deal could close tomorrow. At that point, the cash and shares would flow to the current MCI owners. They could then keep or sell the new shares. If they thought that the other company had better long-term prospects, then they could sell the shares they got and buy stock in the other company.

The difference in deals that might close tomorrow would be small. In that case, the decision would be easy--accept the more highly valued deal.

The real difference in these two deals arises from two factors: the stock price risk over the next year and the regulatory review process. Both companies have argued that the regulatory-risk factors favor their particular deal. Qwest has pointed to antitrust concerns for the Verizon deal, and Verizon has pointed to state regulators' concerns

about investment and national security issues. It appears that the antitrust authorities would approve the Verizon deal in some form, so that should not be a big factor in the board's decision. On the other side, the national security and investment risks that Verizon points to do not appear to be a big factor either--MCI went through bankruptcy, and these concerns were not significant then.

Some people point to a difference between "long-term" and "short-term" shareholders, and say that the board has to evaluate the different interests of each group. However, the distinction is a chimera--transaction costs are low enough that long-term holders could adjust their portfolios to take account of the deal. So that leaves the stock price risk over the next year.

The Qwest deal, as of March 31, has about 50 percent cash and 50 percent in Qwest equity. The Verizon deal is structured similarly, with an additional cash dividend.

Many people have made the argument that Qwest's prospects are not as promising as Verizon's and therefore the Verizon offer should be valued more highly. Unless Michael Capellas and the rest of the MCI board know something that the rest of the world does not know (and can't tell from MCI's words and actions), the Verizon bid already reflects this premium. Qwest's current stock price reflects the nature of its territory, its lack of a wireless business and all of the other factors that Verizon is claiming should discount the Qwest bid.

In fact, if the riskiness (or volatility) of Qwest is expected to be higher than Verizon, an equal value bid by Qwest based on today's stock prices would have a higher expected value one year from today, because of the risk premiums that investors have already built into the stock price. Now, you don't have to believe in the "efficient market" theory to accept this logic--you simply have to believe that the MCI board is not any better at determining long-term prospects for Qwest and Verizon than the rest of the market.

Synergies
There is one additional point--synergies. Qwest claims substantial synergies in its bid. Verizon also claims synergies. But it is likely that the acquisition of MCI would have a much smaller impact of the long-term prospects of Verizon, a $100 billion company, than it would on those of Qwest, a much smaller company.

It is hard to understand why MCI is not valuing these offers in a more straightforward manner. In many cases, people believe that management wants to increase its personal stake through additional shares or roles in the newly merged company. This does not appear to be the case with Capellas, who left Compaq and presumably has no desire for a leading role in either Verizon or Qwest.

Another explanation is that accepting a sure thing may not have an upside potential, but it also does not have downside risk. MCI's management may want to be able to claim success with a nearly certain deal, even if it leaves some shareholder money on the table. However, the risk preferences for a successful deal completion should be based on shareholder preferences, not management's reputation.

The bottom line is the bottom line: MCI's board should ignore all of the rhetoric about antitrust, regulation and future prospects. Instead, they should look at the liquid assets--cash and stock--that its shareholders will receive when the deal closes and pick the deal that brings in the higher amount.

I should note that it could also be that Qwest's management is not acting in the best interests of its shareholders, if it is paying too a high price for MCI. The management could see an MCI acquisition as Qwest's best chance for long-term survival in the telecommunications industry, even if that chance might be small. If that is not in the best interests of Qwest shareholders, Qwest should reevaluate its bid. But that is not MCI's concern.

It should not matter to MCI whether Qwest or Verizon overpays for MCI--MCI shareholders will win on that, and the acquiring firm's shareholders will lose. MCI should just be concerned with how much they can get for their shareholders. The competition and bidding between Qwest and Verizon so far has been great for MCI's shareholders.

Ultimately, MCI's board will have to recommend a deal to its shareholders. The answer should be easy. Is $8.9 billion larger than $7.6 billion? Even top-notch CPAs should be able to figure that one out.