Will Qwest Turn to Direct Dial?

Now rejected by MCI's board three times, the Baby Bell is likely to take its bidding war with Verizon to MCI shareholders

By Brian Grow and Steve Rosenbush

MCI dashed Qwest's hopes of winning a straight bidding war against rival Verizon on Apr. 6, rejecting the local Bell's third merger offer. Now, say analysts, a bruising proxy fight -- and debate over MCI's corporate-governance rules -- is about to begin.

In the wee hours of Wednesday morning, the MCI (MCIP ) board said no once more to Qwest's (Q ) cash and stock offer, now worth $8.9 billion. Instead, the board, citing Qwest's rickety finances and unwillingness to offer a higher price, elected to stick with a bid from telecom behemoth Verizon Communications (VZ ), valued at $7.6 billion.

For now, the decision caps a nearly two-month slugfest between Qwest and Verizon for control of the nation's second largest long-distance company -- and sets the stage for a heavy-duty lobbying campaign to win over MCI investors (see BW Online, 4/5/05, "Takeover Hostility for MCI"). "Qwest will allow shareholders to dictate next steps," the Denver company said in a statement on Apr. 6.


  MCI has now rejected three offers from Qwest, each worth at least 10% more than ones from Verizon. And both Qwest management and some MCI shareholders are fuming at the board's apparent determination to stick with a cheaper offer.

However, sources familiar with the board's late-night deliberations say Qwest had a chance to win. MCI board members presented Qwest Chief Executive Richard Notebaert with requests, among others, to raise his bid to $30 per share and toughen commitment language in Qwest's loan agreements. He refused, say sources. The upshot: MCI's board decided it was "not willing to jeopardize the certainty of its Verizon agreement for the uncertainties surrounding the Qwest proposal."

Qwest now faces a particularly tough slog. Verizon has strong support from a large number of MCI board members, according to a source familiar with the group's deliberations. What's more, MCI's corporate-governance rules could undercut Qwest in a proxy fight. Written by ex-SEC Chairman Richard C. Breeden, who now serves as MCI's court monitor, the guidelines encourage the board to consider the long-term interests of shareholders, not just an offer price.


  Designed to help MCI bounce back after predecessor WorldCom descended into bankruptcy following an $11 billion accounting scandal, the rules -- and Breeden -- could sway a merger decision that must be approved by the bankruptcy court. "He's like a probation officer," says Scott C. Cleland, president of telecom consulting firm Precursor Group.

As it stands, Verizon is offering $23.50 per share for MCI, or $7.6 billion. The offer includes $8.75 per share in cash and the remainder in Verizon stock. Qwest has proposed to buy MCI for $27.50 per share, or $8.9 billion, an offer split almost 50-50 in cash and stock. The Qwest offer is worth $2 billion more than MCI's current market capitalization of $6.9 billion. Investors anticipating the bidding war to continue send MCI shares up. On Apr. 6, the stock closed up 1.5%, to $25.39.

Still, some MCI shareholders are miffed that the board appeared to send mixed messages to Qwest about its chances of winning. Throughout the debate over dueling deals, MCI's board has stated its concern that Qwest's financing was less than stable. After Qwest's first offer was rejected, one person close to the board said Qwest was unable to provide satisfactory "material adverse change" language -- the wording in loan agreements that allows a lender to walk away.


  Qwest denies the problem. But in the latest round, MCI asked it to raise its offer to $30 per share, a much riskier price for the highly leveraged company. "They said no to $27, but they wanted $30 -- that's a bit inconsistent," says Leon G. Cooperman, founder of Omega Advisors, a New York-based hedge fund that owns 3.5% of MCI shares.

As a result, analysts expect Qwest to fight hard in a proxy battle. Some MCI shareholders are lining up on Qwest's side, though they don't yet represent a majority. Bill Miller, chief executive at Legg Mason Capital Management, which owns 1.7% of MCI's shares, said in an Apr. 5 letter to the MCI board that he'll vote against Verizon. Elliott Associates, a hedge fund with about 1% of MCI shares, said on Apr. 6 that it, too, will vote for Qwest. Miller's position may not be typical, though. He's also a major shareholder in Qwest. Legg Mason owned 13% of Qwest shares at the end of last year.

That means owners of at least 26% of MCI's shares have expressed support for the Qwest deal in recent weeks. MCI executives acknowledge that Qwest is likely to leverage that support by taking its current offer -- or a new, higher one -- straight to all MCI investors. "Qwest is not going away," says Cooperman. "And the MCI shareholder will not vote for this [Verizon] deal."


  For Qwest to prevail, however, it will have to overcome MCI's unique governance rules. Known as "Restoring Trust" and part of WorldCom's court-mandated overhaul, the guidelines say the board should consider the "long-term interests of shareholders," while "addressing the concerns of...employees, customers, suppliers, government and regulatory officials, communities, and the public at large."

Those rules are unusually broad, say corporate-governance experts, and will be factored in when a merger agreement is reviewed by Federal District Judge Jed S. Rakoff. The upshot: They may give Breeden, who has participated in all of the MCI board's merger-related meetings, a de facto veto over a higher Qwest offer. "We doubt the corporate monitor supports making price alone the overriding determinant of long-term shareholder value," says Precursor Group's Cleland.

Sources close to MCI say the Breeden-written rules were instrumental in creating the current bidding war because they erased the stain of WorldCom's stock-fueled largesse. Since Verizon and Qwest presented their first offers for MCI in early February, the target's market capitalization has risen by more than $2.5 billion.


  What's more, any legal case that argues MCI's board should consider price alone is likely to be shot down by a chancery court in Delaware that hears shareholder lawsuits, these people say. "The governance rules were instrumental in restoring the company's credibility, which made it viable for both Verizon or Qwest to try to acquire it," Breeden told BusinessWeek Online. "People know they're acquiring a responsible company, not the Black Hole of Calcutta."

In addition to the board's current support, Verizon has other advantages. Under its revised merger agreement with MCI, Verizon has the contractual right to call an MCI shareholder vote at any time after filing its proxy and waiting at least 60 days. Analysts believe a vote could occur in June, possibly enough time for Qwest's jittery stock price to tumble and some shareholders to have second thoughts.

One telecom banker says Qwest is already paying too much. Excluding promised cost cuts, it's offering to pay 6.1 times the 2005 enterprise value of MCI. By contrast, SBC Communications (SBC ) is paying 4 times the value for AT&T, which is much stronger than MCI financially and strategically. "I don't think Qwest has a chance in hell of winning," says one investment banker.


  Still, some investors are handicapping Verizon. With the spread between the competing offers at 19%, such investors are also betting that arbitrageurs who now own as much as 30% of MCI's shares could jump on board with Qwest -- and force Verizon to raise its bid once more. "Verizon needs to bring [its] offer up to at least $25 per share to get the shareholder vote," says Timothy Gilbert, a fixed-income analyst at Principal Financial Group, who owns bonds in all three companies.

That means the MCI takeover saga appears far from over. "We're only in the fourth inning here," says one person close to MCI. Next up: a bidding war for shareholder votes.

With Christopher Palmeri in Los Angeles

Grow is a correspondent in BusinessWeek's Atlanta bureau, and Rosenbush is a senior writer for BusinessWeek Online in New York

Edited by Phil Mintz

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