No Rest for Dealmakers on Labor Day

 | Sep 04, 2013 | 9:00 AM EDT  | Comments
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Over the long holiday weekend, Wall Street dealmakers were busy. They didn't get a chance to relax in the Hamptons and were forced to work on Labor Day. First, Verizon (VZ) announced it would acquire the 45% of Verizon Wireless it didn't already own and Microsoft (MSFT) decided to drop $7 billion to buy the mobile phone portion of Nokia (NOK).

Verizon/Vodafone

On Sunday Verizon made a big splash by announcing one of the biggest deals of the century. The company will pay $130 billion for the portion of Verizon Wireless it doesn't already own. The deal is composed of $58.9 billion in cash, $60.2 billion in Verizon stock, which will be directly issued to shareholders of Vodafone.

Verizon will also offload its minority stake in Omnitel to Vodafone for $3.5 billion. Plus, Verizon will cover an additional $2.5 billion of odds and ends, like legal fees and luncheons. The deal sent Wall Street bankers scrambling to find $50 billion to loan to the company. With so much of the deal financed, Verizon will likely suffer a credit downgrade, but the company expects to stay well within the bounds of investment grade. The merged company will have at least $31 billion of cash flow available to pay down the debt.

If approved by the various government authorities, management estimates the deal will close within the first quarter of next year. Dealmakers were able to use some last minute offshore magic to reduce Vodafone's tax bill from $10 billion to $5 billion.

The deal had to happen for a variety of reasons. First, for the first time in a decade, Verizon can move all of its wireless profits onto its own balance sheet. The company will no longer have to share bounty with Vodafone. In the just reported second quarter, the wireless business had revenue of $17.1 billion, up 8.3% year-over-year and earnings before interest, taxes and depreciation grew 10.2%. The wireless business is very profitable generating 49.8% margins. The company added 1.03 million new accounts, up 6.3%. Verizon Wireless ended the quarter with 100.1 million subscribers.

Of those, 31.1 million subs are smartphone users and 81% of new activations were smartphones. The company just completed its 4GLTE build and now covers 500 markets with 4G services. (For comparison AT&T (T) ended the quarter with 107.9 million wireless subscribers.)

While Verizon had operational control over Verizon Wireless, owning the whole enchilada allows Verizon to attack the global wireless marketplace. With Softbank from Japan controlling Sprint (S) and Deutsche Telecom from Germany controlling T-Mobile, the wireless business is a truly global marketplace and this deal allows Verizon more flexibility going forward. Don't be surprised to see Verizon announcing more deals overseas in order to capture more international growth.

In the short run, the issuance of $60 billion of new shares to holders of Vodafone will be dilutive to Verizon shareholders and will likely weigh on the shares. But, for those with a longer investment horizon, I think the deal will allow Verizon to grow faster as it clarifies the company financial structure. Europe and Latin America have more than 100 wireless operators that are begging for consolidation. By going on an overseas deal making binge, I can envision Verizon scooping up market share and making those marginally profitable carriers much more profitable.

Microsoft/Nokia

Microsoft's acquisition of Nokia's mobile phone operations is more problematic. Microsoft announced it is acquiring Nokia's mobile phone operations for about $7.2 billion. Nokia will be left with its carrier business and various left overs from years of failed deal making.

Microsoft is not only getting Nokia's massive feature phone business, but Microsoft is taking on 24,000 of Nokia's 35,000 employees. (Most of which will probably be let go within a year or two.) The merged company expects $600 million of "cost synergies" within 18 months of the deal close. Microsoft has approximately 100,000 employees. Microsoft expects the deal to add 4 cents a share to earnings in fiscal 2016.

Nokia is the second largest low-end maker of inexpensive feature phones, but according to Gartner Research has only a 3.3% market share in the smartphone business. Gartner forecasts global smartphone shipments of 1 billion units in 2013. 

Nokia/Microsoft and some smaller third-party developers sold about 25 million Windows-based smartphones last year, but needs to sell more than 50 million units just to break even. Apple (AAPL) sold 140 million phones, while phones on the Android operating system sold some 430 million units.

The opportunity for the combined companies is huge. By 2018, Microsoft estimates worldwide shipments of smartphones at 1.7 billion units generating annual revenue of $45 billion. (Assuming the company can achieve a 15% market share.)

But it's a long way to 15% market share. Analysts estimate Microsoft will have revenue of $87 billion in fiscal 2015. But at the current royalty rate of less than $10 per unit, it seems Microsoft makes less than $350 million gross profit from the Windows phone. The company claims it will make more than $40 per unit when the deal is done. But still, it's not enough for the company to make any money building phones.

To me, this is more of the same from Microsoft. The company doesn't make much money in a variety of endeavors. Skype, Bing and even Xbox are either losing money or just barely making any money. While Microsoft can handle losing money since its enterprise business is so profitable, this deal is a big drain on management time and talent. Why not stick to what you are good at? Judging from the decline in the stock price, the market agrees with me. It's just not enough to move the dial on revenue and earnings and the deal is just a huge distraction for a packaged software company.

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