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Will Anyone Dance with Qwest?

By Christopher Palmeri and Brian Grow No matter that it happened in the corporate arena. It was the ultimate brush-off, and it occurred on Valentine's Day. MCI (MCIP) announced on Feb. 14 that it was accepting a $6.7 billion merger proposal from Verizon (VZ). That's despite receiving a higher offer from rival Qwest Communications (Q).

In a earnings conference call with analysts on Feb. 15, Qwest Chairman and CEO Richard C. Notebaert said "just over $1 billion of cash was left on the table" by MCI. "We will look at lots of opportunities and keep all of our options open as we go forward, and we will just have to see how this unfolds."

BETTER COST TRENDS. Once a hot date in the telecom world, Qwest has been a wallflower since this market began to slide four years ago. It narrowly avoided bankruptcy by selling its yellow pages business for some $7 billion in 2002. Still stuck with $17.3 billion in debt and lacking a significant wireless business, Qwest's prospects appear bleak.

In its Feb. 15 release, Qwest reported slightly improved revenue and cost trends. Thanks to efforts to retain local-phone customers by selling additional services such as long-distance and high-speed Internet access, Qwest's revenues dropped only 1.7% in the fourth quarter, the smallest decline in two years. The company has also cut costs, laying off 5,500 people, or 12% of its workforce, in 2004. But Qwest ended the year with a $1.7 billion loss on revenues of $13.8 billion.

Qwest's next steps are uncertain. The Denver-based telecom could try to offer even more money for MCI. It could also try to challenge the MCI-Verizon merger on legal grounds. Such cases are tough to win because courts in the past have given boards of directors discretion to choose a lower offer if it looks better for shareholders in the long run.

JOINT BID? Qwest may also try to challenge the Verizon merger at the Justice Dept. and the Federal Communications Commission, arguing that it impedes competition. A Qwest spokesperson declined to comment.

The biggest drag historically on Qwest has been its fiber-optic network. This business, which provides voice and data services to enterprise customers, has suffered from continued price erosion. The yearly rent for a line capable of providing 2,400 simultaneous phone calls from New York to Los Angeles cost $856,000 in 2000, according to research firm TeleGeography. Today that same line costs $93,000.

By combining Qwest's network, ranked fourth in the industry, with MCI's second-place business, Notebaert had hoped to be able to cut expenses even further. Still, he believes in the business. Through staff reductions and more efficient use of equipment, he has cut $1 billion a year out of Qwest's cost structure, much of it on the network side. And he has vowed that the fiber business will be profitable in this year's first quarter.

QWEST-BELLSOUTH? Also, the telecom industry veteran may not have run out of partnership options entirely. In the newly unfolding telecom oligopoly, analysts suggest that a Qwest-BellSouth combination could create a viable competitor to the brawny Verizon-MCI.

Qwest would bring a state-of-the-art long-distance network, while BellSouth (BLS) could contribute its share of the Cingular Wireless joint-venture. Or if BellSouth extracted a large fee from SBC Communications (SBC) for its 40% stake in Cingular, a combined Qwest-BellSouth could pursue Sprint-Nextel. Together, Qwest and BellSouth would have a footprint covering 23 states from Florida to Washington.

Merger mania, even if it doesn't directly involve Qwest, could also benefit the company. An MCI-Verizon combo coupled with the previously announced pairing of SBC and AT&T (T) means large corporations will have at least two fewer providers pitching services to them. AT&T, in particular, has been very aggressive on pricing for corporate customers.

UPHILL BATTLE. SBC Chairman and CEO Edward E. Whitacre Jr., however, hasn't been as keen to compete on price. "You may have a period of 6 to 18 months where you might actually see data-circuit prices increase," says Gerald Murphy, an analyst with Meta Group, a technology consulting firm.

Still, MCI's willingness to accept a lower offer from Verizon shows that Notebaert has a lot more work to do to get Qwest sitting pretty again. It isn't going to be easy. Palmeri is a correspondent in BusinessWeek's Los Angeles bureau, and Grow is a correspondent in the Atlanta bureau

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