Deals

Tara Lachapelle is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

CenturyLink Inc. is showing what it means to make an acquisition from a position of weakness:

CenturyShrink
As CenturyLink's sales decline and margins come under pressure, the company is pursuing its biggest merger ever: Level 3 Communications for $34 billion
Source: Bloomberg
Note: Growth is year over yera

The $15 billion company provides internet and landline phone services primarily to businesses, and it's being hit from both sides: Not only is the legacy phone division obviously shrinking, but CenturyLink is also increasingly having to compete against the larger cable giants for business customers. All it can really do is make acquisitions to add new customers and services and drive down costs, helping it to maintain its profitability and, in theory, support its dividend -- the key reason investors own CenturyLink.

And so, Monroe, Louisiana-based CenturyLink is acquiring Level 3 Communications Inc. for about $34 billion. Level 3's content delivery network services help facilitate traffic across the internet. But CenturyLink shareholders aren't at all excited about this purchase, and short interest surged as the merger negotiations were unveiled last week.

Bulking Up
CenturyLink's biggest acquisitions:
Source: Company filings

CenturyLink's stock price took a nosedive on Monday amid concern that the partially debt-financed transaction will put shareholders' beloved dividend at risk -- even though management says it won't and assured investors just the opposite, that this deal will improve free cash flow. You can understand the trepidation, though, because it's happened before: In 2013, CenturyLink unexpectedly slashed its dividend so that it could repurchase stock and repay debt.

Skeptics Emerge
Short interest hasn't been this high at CenturyLink since the end of 2010
Source: Markit, Bloomberg

The elephant in the room at CenturyLink has long been its goodwill, which now eclipses its market value by some $6 billion. Only two other companies in the S&P 500 have less in market cap than they do in goodwill: CenturyLink's peer Frontier Comunications Corp. and Endo International Plc, a beleaguered, formerly acquisitive drugmaker. (CenturyLink did take a $1.1 billion writedown on its data-hosting business in 2013.)

Hmm
Investors value CenturyLink at less than the company values its goodwill
Source: Bloomberg

As bullish as analysts have been on Level 3, it's hard not to see how this deal accentuates CenturyLink's relative weaknesses. Hopefully, investors won't find out down the road that CenturyLink actually overestimated the value this transaction will create. It's paying almost 12 times Level 3's estimated Ebitda this year, which is (perhaps unsurprisingly) more than double the multiple CenturyLink's own shares command. And revenue at Level 3 just declined last quarter by the most since 2010, so it's not without its own challenges.

Despite the 40 percent premium being offered, there's also risk for Level 3 shareholders. While the takeover is currently worth about $65 a share, they're getting only 40 percent of that in cash. Including synergies -- which the companies project to be $975 million a year -- CenturyLink's net debt to Ebitda ratio will be "less than 3.7" when the deal closes, the highest it's been since 2011.

So, investors get to own part of a declining business with mountains of debt and goodwill that's reliant on cost-cutting to drive margins. What could go wrong? 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Tara Lachapelle in New York at tlachapelle@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net