A Telecom Con-Qwest for Private Equity?

Richard Notebaert's plan to move onalong with two other chief officerscould leave an opening for a buyer

Richard Notebaert has done such a good job rescuing Qwest from near financial ruin that his plan to retire could leave a tasty cash-generating treat for private equity investors, who have shown an appetite for telecom plays of late. On June 11, Qwest (Q) announced that Notebaert, who turns 60 this summer, will be retiring as chairman and CEO once a replacement is found.

It's likely that a successor will come from outside Qwest's managerial ranks, as two of Notebaert's top deputies have also announced their departures in the past few months. Notebaert was recently elected chair of the board of trustees at Notre Dame University, a position he may want to turn his full energies to after five years of leading Qwest's revival from the telecom market's collapse and a financial scandal in which his predecessor, Joe Nacchio, has been found guilty of insider trading (see BusinessWeek.com, 4/19/07, "Nacchio's Defense-Lite Strategy Backfires"). The departures of the CEO, Chief Financial Officer Oren Shaffer, and Operations Chief Barry Allen suggest that Qwest's board may be hoping to move in a new direction now that the turnaround has returned the company to stability and profitability.

Still, investors appear to worry that Notebaert is leaving while the going's still good in a hugely difficult industry where Qwest, the dominant local phone company in the Rocky Mountain and Pacific Northwest regions, is hardly the strongest player despite the impressive turnaround he has led. Qwest's shares, which recently notched a five-year high of $10.45, slid 8% on the news.

A Good Buy

Despite those jitters, analysts have been upbeat about Qwest's prospects of late. Last week, Standard & Poor's raised its rating on Qwest's unsecured debt. And a month ago, Bank of America analyst David Barden raised his rating on Qwest to buy, arguing that the company has transformed itself into a reliable cash-flow machine despite abundant market threats. At the end of March, Qwest had nearly $900 million in cash on hand with long-term borrowings of $13.2 billion—only slightly more than half the $25.6 billion debt hangover from the telecom boom that Notebaert inherited when he joined the company in June, 2002.

Meanwhile, free cash flow is expected to reach about $2 billion next year, according to estimates from both Barden and UBS industry analyst John Hodulik. That cash stream could prove tempting for private equity, which has shown a sudden interest in telecom investments in the past month with deals to acquire Alltel (AT) and Avaya (AV). The difficulty in trying to buy Qwest, however, is that the wireline telephone industry remains highly regulated by the government. While the Federal Communications Commission has tried to scale back its regulatory intrusions, state agencies remain bent on ensuring and improving local phone and Internet service for consumers.

"We believe senior level departures represent a 'changing of the guard' rather than 'abandoning ship' as Qwest has regained both operational and financial footing in the aftermath of its post-bubble woes," Barden said in an update to investors. "We believe private equity or strategic buyers could be attracted to Qwest by the ability to place senior leadership and set the tone of the company."

A Repaired Reputation

If the company isn't destined to be acquired, then it's still well on the way to resurrecting its past as a reliable dividend-paying telecom utility stock, Barden says. For now, the company is using excess cash to repurchase shares on the open market (see BusinessWeek.com, 4/13/07, "Private Equity Targets Telecom").

During Notebaert's tenure, Qwest's share price has more than doubled, surprising skeptics on Wall Street who more or less left the company for dead in the wreckage of the telecom market's post-bubble collapse. Many analysts expected the company to skid into bankruptcy or be acquired by one of its stronger rivals. Instead, Notebaert slashed costs, paid down debt, and then launched an audacious hostile takeover bid for MCI that Qwest ultimately lost to Verizon (VZ) (see BusinessWeek.com, 5/16/05, "One Big Qwestion Mark").

Despite that defeat, Qwest built new credibility on Wall Street during the process and investors took notice—some even provided the financial backing to help Qwest mount a bidding war against Verizon.

Notebaert's Success and His Successor's Challenge

The stock's rebound has brought big personal gain to Notebaert as well, though he recently donated a chunk of that to charity. He currently holds $38 million worth in vested shares and stock options awarded to him by the company. That's after exercising 3,875,000 stock options in November, selling those shares for a profit of roughly $18.5 million, the after-tax proceeds of which are to be donated. He also announced in May he was donating 58,000 shares of stock, worth more than $550,000 at the time.

There's no doubt that Notebaert's successor will take the helm in a more uncertain environment than ever for traditional telecommunications companies. Cable TV companies have lured millions of residential customers away from AT&T, Verizon, and Qwest by introducing phone service using Voice-over-Internet Protocol, or VoIP, technology. Millions more have gone all-cellular or switched to standalone VoIP providers like Vonage (VG) and eBay's Skype (EBAY). While AT&T and Verizon are responding with multibillion-dollar investments in network upgrades that can deliver cable TV, Qwest has chosen to hold off on the major capital expenditures it would take to enter the television business. Denver-based Qwest also doesn't own a cell-phone business like its bigger rivals, though it does resell Sprint's (S) wireless service under its own brand name.

"Cable's presence is being felt among all wireline companies, but it has proven far from catastrophic to the cash streams of these companies," Bank of America's Barden wrote last month in upgrading Qwest.

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