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Vodafone's Tricky Wireless Split

A report of a potential acquisition of Verizon, though quickly denied, leads to a flurry of speculation about the two companies

No one ever thought the wireless relationship between Verizon Communications (VZ) and Vodafone Group (VOD) would last forever. Indeed, the joint venture's demise has been the subject of speculation for nearly the whole of its eight-year history (see, 3/14/06, "Why Would Vodafone Sell Verizon Wireless?").

Still, a July 16 report that the British telecom giant was mulling a bid for its New York-based partner to gain Verizon Wireless—a tale quickly denied—raised eyebrows and investor intrigue. It also points out a case where the real story raises questions beyond the headlines.

Vodafone owns 45% of the second-largest U.S. wireless operator, which generates $38 billion in annual revenue. Citing "well-placed financiers," Alphaville, a blog run by Financial Times (PSO), said Vodafone had considered offering $160 billion for Verizon Communications, a 32% premium over its Friday closing price of $35.53. Vodafone had considered a two-part strategy of buying Verizon and then aiming to sell off the landline business in a record $90 billion private equity deal. Assuming such a deal would find a place in newly skittish debt markets, Vodafone would then retain the Basking Ridge (N.J.)-based wireless unit and its 60 million U.S. customers.

Shares of Verizon soared as much as 12%, to $44, on news of the proposal before Vodafone issued a statement saying it was not considering a bid. By the end of trading, Verizon shares were 2.4% higher at $42.76. Vodafone's U.S.-traded depositary receipts dipped 1.1% to close at $33.15, just below a 52-week high reached last week.

Tighter Lending Standards at Play?

Some media commentators called the story a Vodafone "trial balloon," while Alphaville readers peppered the blog with comments concerning the report's veracity. Why might such speculation surface now?

There are several possible reasons, one of which may have more to do with Vodafone's bankers than with Vodafone itself. Goldman Sachs Group (GS), which has had a banking relationship with Vodafone, has a private equity arm that recently co-led the $27.5 billion offer to buy U.S. wireless carrier Alltel (AT). The deal, which is still awaiting shareholder approval, would leave the Arkansas-based wireless outfit with a debt-to-equity ratio of almost 8 to 1. That was necessary to fund the $71 a share price, which was nearly $20 higher than where the stock traded before buyout rumors last fall.

It could be that Goldman and its partner in the buyout, private equity giant Texas Pacific Group, are getting nervous about whether the credit markets will readily support such a deal. Lending standards have tightened considerably since the Alltel deal was announced during the spring. Tighter lending standards are making it harder for some of the more aggressive private equity deals to sell their debt (see, 7/10/07, "End of the Private Equity Party?").

Breaking Up Is Expensive

The Alphaville posting suggested there could be a connection between Goldman, Alltel, Verizon, and Vodafone. If Goldman wants out of the Alltel deal, the easiest exit would be to coax a competing bid for Alltel out of Verizon. If Goldman and TPG simply decided to walk away, they'd owe Alltel a $625 million breakup fee (see the Alltel proxy filing).

"One option here has been to press Verizon into gate-crashing the $27.5 billion [Alltel] deal," as Alphaville put it. The chance of that happening is far-fetched, though. Verizon executives had plenty of time to weigh such a bid, and it's nearly inconceivable to think the company would assume such a deal just to avoid the unlikely prospect of a Vodafone bid. (Verizon would be larger and far more difficult to acquire if it were to buy Alltel.)

It's also worth noting that Vodafone is facing increasing shareholder pressure regarding its U.S. business and the prospects of boosting share value even further. Vodafone Chief Executive Arun Sarin has various avenues to force Verizon to buy pieces of its stake in Verizon Wireless. The latest opportunity, known as a "put," expires on Aug. 9 and covers up to $10 billion worth of Vodafone's interest in Verizon Wireless. However, it's unlikely that the put will be exercised. Vodafone wouldn't stand to gain much by slowly dissolving the venture by exercising one put after another for several years. It's much more likely to strike a negotiated comprehensive agreement with Verizon, the majority partner.

A Taxing Situation

An investor group, Efficient Capital Structures, is pressing Vodafone to sell the Verizon Wireless stake. Its plan is scheduled to come up for a vote July 24 at Vodafone's annual meeting in London.

If Vodafone management wanted to confront that pressure by doubling down on its bet in the U.S., now would be a good time. Vodafone's share price has soared from $20 to nearly $34 over the past year, swelling its market cap to $175 billion (see, 10/20/06, "Vodafone Regains Its Balance"). That gain would facilitate a takeover of Verizon, although such a deal would still face massive regulatory and financial obstacles, not to mention transatlantic management and integration issues that would be highly complex, to say the least.

Alternatively, if Vodafone were to sell its stake in Verizon Wireless, it could incur a huge tax bill. By acquiring all of Verizon, it may find a way out of that tax burden. "Such a structure would eliminate an estimated…$20 billion tax liability Vodafone could face with an outright sale of the asset," analyst John Hodulik of UBS (UBS) said in a July 16 report. On the financial downside, Vodafone would have to pay a premium to acquire all of Verizon, even though it would likely seek to spin off much of the company and recoup a lot of its purchase price.

In time, the joint venture behind Verizon Wireless is almost certain to be revamped. The companies have both expressed an interest in owning the business, which outstrips its larger rival AT&T (T) in some key areas, most notably profit margins. But, bankers or no bankers, there's no indication the telecoms will be able to resolve the matter in the immediate future.

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