How The Cingular Deal Helps Verizon

By paying a premium, SBC and BellSouth could hobble themselves in a fast race

After winning an 11th-hour bidding war with Vodafone Group (VOD ) for AT&T Wireless Services (AWE ) on Feb. 17, the folks at Cingular Wireless professed themselves well pleased. For a cool $41 billion in cash plus $6 billion in debt, they had agreed to acquire the nation's No. 3 wireless operator. But as happy as Cingular's staff appeared to be, execs at rival Verizon Wireless may been even more pleased. Why? Because by entering the bidding at the last minute, Vodafone -- a major investor in Verizon Wireless -- forced Cingular's parents, SBC Communications (SBC ) and BellSouth (BLS ), to pay a 37% premium over their initial bid. "Verizon probably sent a case of Dom Perignon to Vodafone," says Kenneth M. Leon, a telecom analyst for Standard & Poor's. "This is quite a bid."

Maybe too big a bid. The question is whether, by paying so much for AT&T Wireless, SBC and BellSouth have put themselves at something of a disadvantage in making the merger work in a brutally competitive market. Making matters worse, it will take at least nine months to complete the deal, so Verizon Wireless will have time to lure customers away from the lame-duck AT&T Wireless management. That's not to say SBC CEO Edward Whitacre and BellSouth chief Duane Ackerman lack the wherewithal to pull this off. But by paying $11 billion more than they had initially intended, they need to execute the integration of AT&T Wireless into Cingular flawlessly -- and that won't be easy given AT&T's myriad challenges. "This is an extraordinarily complex merger," says Scott A. Ellison, head of wireless services at researcher IDC. "It's not clear Cingular can move as fast as the market wants it to."

Cingular and its parents insist the deal makes financial sense despite the hefty price tag. In a joint presentation to investors, SBC and BellSouth execs concede that the acquisition will cause a short-term hit to earnings. SBC says the costs will bite up to $1.3 billion out of its net income in 2005 and $630 million in 2006, while BellSouth estimates the dilution will last a year longer, whittling away $165 million in 2007. Still, the companies insist that after that, AT&T Wireless will help turbocharge earnings. Why? By combining the operations of Cingular and AT&T Wireless, they will be able to trim capital investments, slash marketing costs, and reduce staff. Total savings should hit $1 billion in 2006 and $2 billion annually after that. "This is about taking two good companies and putting them together to make one big, great company," Cingular CEO Stanley T. Sigman told BusinessWeek.

BETTING ON SAVINGS. It's certainly a bet on the future. Together, Cingular and AT&T Wireless will have about 46 million wireless subscribers combined, far more than the 37.5 million customers at No. 2 Verizon Wireless. The deal is important strategically because it will give parents SBC and BellSouth the opportunity to have a greater stake in the fast-growing wireless industry, which is quickly becoming a legitimate alternative to their traditional phone businesses. BellSouth already gets about 20% of revenues from wireless, which should rise to about 35% after the merger. Some analysts agree that faster revenue growth, combined with cost savings from the merger, should boost earnings at SBC and BellSouth. Analyst Michael Rollins of Smith Barney (C ), which advised BellSouth on the deal, estimates that, despite taking a hit, SBC's earnings will surge 18.7% annually through 2008, while BellSouth's earnings will rise 13.6%.

But Cingular's sunny view of the merger rests on several assumptions. For starters, there's a question of when the deal will close. Cingular and its parents expect the acquisition to be finalized by yearend. While there's little chance regulators will stop the deal, since it combines two of six national wireless players, they may take a year or longer to sign off, analysts say. That's critical -- not only because it delays the expected synergies but also because it could hurt AT&T Wireless' operations. Employees at the target company may start looking for new jobs, and customers may defect, figuring the company they had a relationship with is disappearing anyway. Already, AT&T Wireless' churn rate -- the share of customers who leave the company each month -- is 3.3%, the highest among the major U.S. carriers. "Verizon could have a two-year advantage," says analyst Susan Kalla of Friedman, Billings, Ramsey Group Inc.

MANY A SLIP...? More important is whether Cingular will be able to extract the cost savings it's anticipating. The company is banking on synergies in two major areas -- capital investment and operations. By melding AT&T Wireless' network into its own, Cingular expects to trim combined capital costs by $600 million to $900 million in 2005 and $800 million to $1.2 billion each year after that.

Certainly, Cingular has control over whether to write a check for equipment or not. But it may feel pressure from rivals such as Verizon Wireless, which is spending heavily to roll out new mobile Web services. If Cingular is forced to offer such services quickly, it may not be able to wring the savings out of capital investment it's counting on.

Operational savings will be even trickier. Cingular is telling investors that by combining marketing, customer care, and other administrative tasks, it expects to save $100 million to $400 million in 2005, $500 million to $800 million in 2006, and more than $1.2 billion after that. But it may have little control over some of those expenses. AT&T Wireless' customer service has come under pressure, especially last year, when customers won the right to keep their mobile phone number when they switch carriers. Cingular may have to invest more, not less, to straighten out some of those issues.

Already, shareholders are curbing their enthusiasm. Shares in SBC and BellSouth slipped as negotiations for AT&T Wireless proceeded and dropped 2% each in the two days after the deal was announced. Analysts are particularly sensitive to the fact that the dilution will cut the companies' once-stable earnings for an uncertain payoff in the future. The acquisition is expected to cut SBC's expected 2005 earnings from $4.6 billion to $3 billion, or 91 a share. "We know there are better places for investors to put their money than a company that's not going to earn one dollar next year,"says S&P telecom analyst Todd Rosenbluth.

Cingular's parents also will have to take on a major chunk of debt. Of its $21 billion share of the purchase price, SBC can pull together $11 billion in cash but will have to borrow the remaining $10 billion. BellSouth also will have to finance about $10 billion. The added debt already has caused S&P to put SBC, BellSouth, and Cingular on credit watch.

The problem is, while SBC and BellSouth wrestle with a bigger burden, Verizon Wireless will no doubt roll out services and steal customers. Verizon's 39.7% cash-flow margins are already 74% higher than those of Cingular and AT&T Wireless. Verizon can produce such fat margins because it has an efficient network that enables it to add network capacity without incurring huge costs. A first-rate network has helped Verizon lure customers at an impressive rate -- the 1.5 million net new subscribers added in the fourth quarter last year were twice the 770,000 won by Cingular and AT&T Wireless.

SBC and BellSouth say that once Cingular digests AT&T Wireless, it will be in shape to take on Verizon. It gains much-needed wireless licenses, boosting the number of top markets it serves to 97 out of the top 100. It also gets more capacity to offer high-speed data services. Asked if Cingular will use its newly acquired scale to usurp Verizon's top spot in quality and other categories, Sigman pledges: "Yep, we'll do that. And you can hold me accountable." He can only hope that by the time Cingular gets up to speed, Verizon won't already be far, far ahead.

By Roger O. Crockett in Chicago

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