Level 3 Communications Stock Upgraded On Likely CenturyLink Merger

It's not official yet, but it's starting to look awfully like fiber network operator Level 3 Communications (NYSE: LVLT) and internet services provider CenturyLink (NYSE: CTL) are going to merge. And according to investors, this is good news -- good enough to drive Level 3's stock price up as much as 13% yesterday when rumors of the merger began floating, and to send CenturyLink's stock price soaring up to 18%.

Wall Street is starting to warm to the deal as well. This morning, no fewerthan three separate stock analysts chimed in with thoughts about the proposed merger, and one of them climbed out on a limb and upgraded Level 3 shares on the belief the merger will, in fact, come to pass.

Here are three things you need to know about it.

CenturyLink and Level 3 Communications seem to have the urge to merge. Image source: Getty Images.

1. The upgrade

Let's start with the actual upgrade. This morning, analysts at Oppenheimer (CAPS rating: 72.42) announced they are upgrading Level 3 Communications stock to outperform with a $60 price target. Level 3 shares cost less than $47 before the merger rumors began floating on Thursday. They cost $53 and change today -- but even so, a continued march toward $60 implies there is still another 12% worth of potential profit in the stock.

Oppenheimer says the combination of CenturyLink's business with Level 3 could result in a "powerful combination," but argues that even without a merger, Level 3 has made progress in growing its free cash flow output, and is worth buying in its own right.

2. The deal

According to TheFly.com, merging CenturyLink with Level 3 would result in a combined company worth well over $60 billion ($34 billion in enterprise value from CenturyLink, plus $28 billion from Level 3).

Quoting from a report by JPMorgan (CAPS rating: 88.83), TheFly notes that there are two main ways a deal could go down: Either as a "merger of equals" in which one company trades in all of its stock for shares in the other, valuing both companies roughly equally; or as a purchase of the smaller company (Level 3) by the larger (CenturyLink). In the latter case, which JPMorgan sees as more likely, CenturyLink would be expected to pay at least $61 per share for Level 3.

So far, therefore, the analysts are broadly in agreement about the potential for profit in Level 3 stock.

3. The reasons for the deal

Our third bit of Wall Street insight this morning comes from UBS (the most successful of the three analysts named so far, with a CAPS rating of 92.96), which provides further details on why CenturyLink would probably be the buyer in this transaction, and Level 3 the seller.

According to UBS, Level 3 possesses "sizable" net operating loss carryforwards that CenturyLink could use to decrease its income tax liabilities in future years. UBS also highlights the growing free cash flow at Level 3 ($950 million in cash profits generated over the past year, according to data from S&P Global Market Intelligence), wrapping up with a general comment that the two companies combined could expect to reap $1 billion in cost-saving "synergies" from a merger -- regardless of who buys whom.

The most important thing: Valuation

Do all these arguments in favor of a merger between Level 3 Communications and CenturyLink make sense? It's hard to be sure, but the numbers do look attractive at first glance. Here's why:

Combining Level 3's $3.6 billion in annual profit with CenturyLink's near $1 billion -- with another $1 billion in "synergies" tossed in -- implies a combined company could earn roughly $5.6 billion annually in net profit. At $62 billion in debt-adjusted market capitalization, that works out to a P/E ratio of just 11.1 on the hypothetical combined company, which sounds pretty cheap.

Valued on free cash flow, the deal seems only slightly less attractive. CenturyLink does $2.4 billion in annual free cash flow, and Level 3 just under $1 billion. Another $1 billion in savings implies free cash flow of $4.4 billion-ish for a combination of the two companies, and results in an enterprise-value-to-free-cash-flow ratio of 14.1.

Of course, these valuations both assume that the promised "synergies" will materialize. But if they do, then I have to admit: Wall Street's enthusiasm for this deal has merit. And the investors who are buying Level 3 Communications stock, and CenturyLink stock, too, just might be on to something.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 324 out of more than 75,000 rated members.

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