Shares of Verizon Communications (VZ) are higher by 61 cents, or 1.3%, at $48.63 after Citigroup’s Michael Rollins today raised his rating on the shares to Buy from Neutral, and raised his price target to $54 from $46, postulating that there’s a greater likelihood than he thought that the company could buy out the 45% of Verizon Wireless owned by partner Vodafone (VOD).
In collaboration with his European colleague, Simon Weeden, who follows Vodafone and has a Buy rating on that stock and a $32.50 price target, Rollins opines that there’s now a heightened prospect of a leveraged buyout of the Vodafone stake:
We believe the window of opportunity for VZ to pursue an accretive buyout of VOD’s VZW stake, even at elevated EV/OIBDA multiples, is more open today from a combination of low-interest rates, favorable VZW performance, lower debt leverage at the VZ parent level, strong dollar vs. Sterling & the Euro, VZW already paying a dividend to its parents, & improvement in domestic Telco valuations.
Mind you, Vodafone may be the bigger beneficiary, both analysts agree:
While both companies under our scenario analysis can benefit their respective shareholders through a range of transaction scenarios that we analyzed, we believe Vodafone stands to be the greater beneficiary and should outperform Verizon over the next 12-months.
Vodafone shares today are up 40 cents, or 1.4%, at $28.05.
Rollins’s and Weeden’s conviction seems to come mostly from a survey of chatter in the media, with Rollins writing, including an interview with Verizon CEO Lowell McAdam at a Citigorup conference on January 7th, and a Wall Street Journal interview with Vodafone CEO Vittorio Colao on February 21st.
Rollins writes that there are multiple paths to a deal, including a “partial or outright sale of the Verizon Wireless stake to Verizon” by Vodafone, an “outright merger between Verizon and Vodafone, and a scenario in which “Verizon exchanges Verizon Wireless with Verizon Stock.”
Rollins sees the first option as having a 55% probability, the second a mere 15% probability of happening, and thinks the third option “would likely not suit Vodafone relative to the status quo of owning the wireless assets.”
Here’s Rollins examination of the prospects for an outright sale by Vodafone to Verizon:
Citi’s European Telecom Team has reassessed Vodafone�s tax situation regarding a US exit and believes that a deal is achievable with an acceptable level of tax leakage. They estimate up to $5bn in CGT (capital gains tax) to extract non-US assets from the US holding company and none on a subsequent sale of the stake in VZW via an offshore transaction. They expect Vodafone to be dispassionate about remaining invested in the US as see a deal depending upon price, mix of cash, stock or preferred stock, and tax structure. As shown in Figure 10, we graphically describe our understanding of Vodafone’s ownership structure for its Verizon Wireless stake at a very high-level. We believe an Off-Shore Sale Scenario is now possible given the drop in value of the Non-U.S. assets relative to the rising value of Verizon Wireless. In the first step, we believe Vodafone would need to transfer the non-US assets from Vodafone Americas/AirTouch to another subsidiary under the Vodafone Group. Such an event could trigger capital gains tax on the Non-US assets to the U.S. Government. By way of reference, assets AirTouch owned, at acquisition by Vodafone, included 34.8% of Vodafone Germany and 17.8% of Vodafone Italy among a number of others. Verizon Wireless now represents most of the value within Vodafone Americas Inc. Citi’s European Telecom Team estimates the value of the non-US Assets at around $15bn implying a potential capital gains tax bill of up to $5bn to Vodafone, depending upon tax base and other mitigation options. As a second step, Vodafone then sells part or all of Vodafone Americas Inc. (US) from Luxembourg or Holland on a tax free basis to Verizon [�] we estimate a valuation range of 7-9x OIBDA, representing an equity value for Verizon Wireless of $236 billion – $303 billion. Vodafone only owns 45% of Verizon Wireless, implying a value for its stake of $106 billion – $136 billion. Normalizing 2013 free cash flow for full corporate taxes, excluding the impacts of bonus depreciation, should result in a free cash flow yield of roughly 5.0-6.4% Normalizing 2013 earnings for full corporate taxes given the partners are largely responsible for the taxes should result in an earnings yield of roughly 5.2-6.6% Hence, we believe a leveraged buyout of Vodafone�s Verizon Wireless stake by Verizon can be meaningfully accretive given Verizon�s current 8-year duration debt is yielding roughly 3.4% and its 28-year duration debt is yielding roughly 4.75%, according to FactSet and Bloomberg.
Funding for a deal could include as much as $70 billion to $80 billion of debt issuance, writes Rollins, or could issue preferred shares:
Based on our research, we believe the company could consider the use of some form of perpetual preferred that can provide some advantages from a credit ratings perspective and possibly a tax perspective that could attract roughly 50% credit as debt and 50% credit as equity. We are essentially envisioning a preferred stock structure similar to AT&T�s pending wireless preferred issuance to partly fund its pensions. Verizon could embed call provisions as well as an eventual step-up in the coupon rate to encourage Verizon to redeem the instrument within a 5-10 year period.
Issuance of common equity would be the least preferable option available to Verizon, he thinks.
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