CenturyLink’s Acquisition of Level 3 Weakens Leverage
Last Monday, CenturyLink, Inc. (Ba2 review for downgrade) announced that it would acquire Level 3 Communications, Inc. (Ba3 stable) for $24 billion with a mix of 40% debt and 60% equity. The transaction will be credit negative for both companies, with CenturyLink’s Moody’s-adjusted debt/EBITDA increasing to a pro forma 4.4x from an actual 3.4x as of 30 June 2016, and diverting Level 3’s cash flow to help service the acquisition debt. We placed CenturyLink’s ratings on review for downgrade because of the leverage increase we expect and the time it will take the combined company to de-lever. We think that EBITDA growth and debt repayment will allow debt/EBITDA to decline only 0.2x to 4.2x by 2019. We changed Level 3’s ratings outlook to stable from positive because the company’s positive cash-generating momentum will be allocated toward acquisition debt service. From a business perspective, the transaction, which we expect shareholders and regulators to approve before the fourth quarter of 2017, will improve the supply-demand balance for the hyper-competitive fixedline enterprise telecommunications sector. Constantly evolving technology continually reduces the cost of providing applicable fixed-line services, and ever-declining sales returns make it more difficult to justify the investment in incremental sales. Since this unattractive dynamic has led the major telecommunications companies to de-emphasize their fixed-line coverage, combining the No. 3 (CenturyLink) and No. 4 (Level 3) companies into a strong No. 2 benefits both the merger participants and their prospective customers. Additionally, smaller, more specialized operators such as Windstream Services, LLC (B1 stable), Zayo Group, LLC (B2 positive), Cogent Communications Group, Inc. (B3 stable) and LTS Group Holdings LLC (B2 stable) will also benefit from increased opportunities for growth in the enterprise segment and from some customer cannibalization as part of the CenturyLink/Level 3 combination. The smaller companies can also provide back-up capacity for CenturyLink and Level 3 customers whose primary service providers are telecoms giants AT&T Inc. (Baa1 review for downgrade) or Verizon Communications Inc. (Baa1 stable). Over the next three to five years, these developments may allow the combined company to de-lever more rapidly than we anticipate. Additionally, Level 3 and CenturyLink have complementary local fiber assets and Level 3’s backbone and advanced services portfolio will be an asset for CenturyLink. The company estimates that it can realize $975 million in run-rate cash synergies, with 80% within 36 months of closing, which we believe is achievable given both companies’ history of integrating large-scale acquisitions. The transaction will also allow CenturyLink to use $9.6 billion of net operating losses from Level 3, which will offset a portion of the pro forma consolidated company’s taxable income for several years. However, although the tax assets are a key component of the transaction, benefits accrue to shareholders while bondholders suffer higher leverage and, in some layers of the capital structure, significant additional subordination. We will downgrade some debt instruments by two notches even though the corporate rating falls by only one. Additionally, with CenturyLink issuing approximately 521,000 new shares, the company’s annual cash dividend nearly doubles to $2.3 billion, further eroding creditor access to the free cash flow benefits of the deal, adding another credit-negative dimension to the deal.
Last Monday, CenturyLink, Inc. (Ba2 review for downgrade) announced that it would acquire Level 3 Communications, Inc. (Ba3 stable) for $24 billion with a mix of 40% debt and 60% equity. The transaction will be credit negative for both companies, with CenturyLink’s Moody’s-adjusted debt/EBITDA increasing to a pro forma 4.4x from an actual 3.4x as of 30 June 2016, and diverting Level 3’s cash flow to help service the acquisition debt. We placed CenturyLink’s ratings on review for downgrade because of the leverage increase we expect and the time it will take the combined company to de-lever. We think that EBITDA growth and debt repayment will allow debt/EBITDA to decline only 0.2x to 4.2x by 2019. We changed Level 3’s ratings outlook to stable from positive because the company’s positive cash-generating momentum will be allocated toward acquisition debt service. From a business perspective, the transaction, which we expect shareholders and regulators to approve before the fourth quarter of 2017, will improve the supply-demand balance for the hyper-competitive fixedline enterprise telecommunications sector. Constantly evolving technology continually reduces the cost of providing applicable fixed-line services, and ever-declining sales returns make it more difficult to justify the investment in incremental sales. Since this unattractive dynamic has led the major telecommunications companies to de-emphasize their fixed-line coverage, combining the No. 3 (CenturyLink) and No. 4 (Level 3) companies into a strong No. 2 benefits both the merger participants and their prospective customers. Additionally, smaller, more specialized operators such as Windstream Services, LLC (B1 stable), Zayo Group, LLC (B2 positive), Cogent Communications Group, Inc. (B3 stable) and LTS Group Holdings LLC (B2 stable) will also benefit from increased opportunities for growth in the enterprise segment and from some customer cannibalization as part of the CenturyLink/Level 3 combination. The smaller companies can also provide back-up capacity for CenturyLink and Level 3 customers whose primary service providers are telecoms giants AT&T Inc. (Baa1 review for downgrade) or Verizon Communications Inc. (Baa1 stable). Over the next three to five years, these developments may allow the combined company to de-lever more rapidly than we anticipate. Additionally, Level 3 and CenturyLink have complementary local fiber assets and Level 3’s backbone and advanced services portfolio will be an asset for CenturyLink. The company estimates that it can realize $975 million in run-rate cash synergies, with 80% within 36 months of closing, which we believe is achievable given both companies’ history of integrating large-scale acquisitions. The transaction will also allow CenturyLink to use $9.6 billion of net operating losses from Level 3, which will offset a portion of the pro forma consolidated company’s taxable income for several years. However, although the tax assets are a key component of the transaction, benefits accrue to shareholders while bondholders suffer higher leverage and, in some layers of the capital structure, significant additional subordination. We will downgrade some debt instruments by two notches even though the corporate rating falls by only one. Additionally, with CenturyLink issuing approximately 521,000 new shares, the company’s annual cash dividend nearly doubles to $2.3 billion, further eroding creditor access to the free cash flow benefits of the deal, adding another credit-negative dimension to the deal.
