CenturyLink's Acquisition of Level 3 Communications Could Be Brilliant

By Steve Symington Markets Fool.com

When CenturyLink (NYSE: CTL) announced in late October that it will acquire Level 3 Communications (NYSE: LVLT), shares of the telecommunications giant plunged more than 13% over the next few days to flirt with a fresh 52-week low. And though the stock has partially recovered since then, CenturyLink is still well below the levels it stood at just before news of the acquisition broke.

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With shares now trading at just 11 times this year's expected earnings, have investors overreacted to CenturyLink's acquisition of Level 3? And more importantly, could the deal possibly be a smart, value-creating move for shareholders?

I think so.

Image source: CenturyLink.

All opposed?

Before we get there, however, I'll admit it's hard to blame the market for bidding shares of CenturyLink down.

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For one, recall that shares of both CenturyLink and Level 3 skyrocketed 18% and 13%, respectively, in a single day the previous week after reports surfaced stating the two companies were in "advanced talks" to merge. So CenturyLink's subsequent plunge wasn't quite as pronounced as it might have seemed at the time.

And to be fair, when the dust cleared and the deal was formally announced a few days later, CenturyLink had agreed to acquire Level 3 for $26.50 in cash and 1.4286 shares of CenturyLink stock for each Level 3 share. That equated to $66.50 per share at the time, valuing the deal at$34 billion, including the debt CenturyLink will assume.

That's a big pill to swallow considering CenturyLink's enterprise value stands at "just" $33.5 billion as of this writing. More than anything else, then, this acquisition should be considered a merger of equals. And if there are any hiccups as these two enormous companies begin to integrate following the planned third-quarter 2017 closing of the deal, you can be sure CenturyLink shares will invoke the market's ire again.

The 8.5% elephant in the room

But those risks may be worth taking in light of the expected benefits of this deal.

First, for those of you worried about CenturyLink's sky-high annual dividend of $2.16 per share (yielding 8.5% at today's prices) and disconcerting 127% payout ratio,note that CenturyLink anticipates maintaining its annual payout.

But how? As fellow Fool Brian Stoffel pointed outa few months ago, CenturyLink's use of both earnings and free cash flow to fund capital returns was already enough to ensure that its lofty dividend could survive at the time. And now, with the help of Level 3's nearly $10 billion in aggregate net operating losses, the acquisition should substantially improve free cash flow, and in turn, according to CenturyLink, help to "enhance the combined company's financial flexibility and significantly lower its payout ratio."

CenturyLink will also enjoy the massively increased scale of the two companies' combined fiber networks, increasing its network by 200,000 route miles of fiber and giving it a presence in more than 60 countries. On-net buildings should increase almost 75%, to 75,000 -- even after accounting for buildings already served by both Level 3 and CenturyLink -- including 10,000 buildings in Latin America and the EMEA regions.

Moreover, CenturyLink anticipates significant cost synergies, as it will be able to focus capital investments on increasing capacity and extending the reach of its fiber network. And the company should be able to identify significant incremental revenue growth opportunities through its impending ability to deploy the combined product portfolios across the combined customer base. In particular, CenturyLink is excited to be able to offer its larger enterprise customers the benefits of Level 3's global footprint.

If that wasn't enough, CenturyLink anticipates generating $975 million in annual run-rate cash synergies from operational efficiencies, systems consolidation, and removal of duplicate functions.

What now?

To be fair, CenturyLink also expects that realizing these synergies and integrating the two networks will result in one-time costs of roughly $685 million, the majority of which will be incurred by 2019. In addition, the deal is still subject to federal and state regulatory approvals, as well as the approvals of both CenturyLink and Level 3 shareholders. So there is plenty of room for hiccups along the way that could derail the process.

But if the acquisition closes as planned later this year, and if CenturyLink is successful in the integration process, I think shareholders who opt to hang on despite the broader market's pessimism will probably be more than happy with their decision over the long run.

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Steve Symington has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.