On September 2, 2013, US-based telecom company Verizon Communications signed an agreement with UK-based Vodafone Plc to acquire the latter’s 45 per cent stake in their joint venture (JV), Verizon Wireless, for about $130 billion. This is the third largest corporate acquisition ever after Vodafone AirTouch’s purchase of Mannesmann AG for $203 billion in 1999 and AOL’s acquisition of Time Warner for $164 billion in 2000.

Under the terms of the deal, Verizon Communications will pay $58.9 billion in cash and issue stocks worth $60.2 billion to Vodafone. Verizon Communications will acquire the 45 per cent stake in Verizon Wireless from Vodafone’s US-based subsidiary Vodafone Americas, which also owns assets in Europe, including 23 per cent stake worth $3.5 billion in Vodafone Italia. Verizon Communications would sell these assets back to Vodafone and issue notes worth $5 billion. The remaining $2.5 billion will be a combination of other considerations.

To finance its acquisition of Vodafone’s stake, Verizon Communications has secured debt funding of $61 billion, which is a combination of bonds and loans, through JPMorgan Chase & Co., Morgan Stanley, Barclays Plc and the Bank of America Merrill Lynch, which were also the consultants for the transaction. Goldman Sachs and UBS were the advisers to Vodafone on the deal.

The deal was approved by the US Federal Communications Commission (FCC) on December 4, 2013. This was the first time that the FCC used its newly implemented streamlined foreign-ownership procedures for deals in the telecom sector, which are aimed at reducing regulatory hurdles in attracting investments. The deal awaits shareholders’ approval and is expected to be concluded by the first quarter of 2014, following which Verizon Communications will own 100 per cent of Verizon Wireless.

Verizon Communications and the Vodafone Group had formed Verizon Wireless with equity ownership of 55 per cent and 45 per cent respectively in 1999. The JV began commercial operations in 2000. In the following years, the relationship between the JV partners deteriorated as Vodafone did not have management control over the operations of Verizon Wireless. Also, Verizon Communications had a bigger say in decisions related to the dividends offered by Verizon Wireless. Both partners were interested in acquiring the other’s stake in the JV to gain full control over the highly profitable business.

Consequently, the operators entered into discussions about a potential deal several times during their partnership. In 2004, Vodafone was planning to sell its stake in Verizon Wireless to raise funds for acquiring US-based telecom company AT&T Wireless. However, with Vodafone losing out in the bidding process for AT&T Wireless, the plan to sell stake in Verizon Wireless was shelved. In 2007, Verizon made an offer of $35 billion to acquire Vodafone’s stake, but the latter rejected the proposal. Despite several efforts, Verizon Communications was unable to persuade Vodafone to sell stake in Verizon Wireless during the past decade.

Talks between the partners restarted in April 2013, when Verizon Communications proposed to acquire Vodafone’s stake for $100 billion in cash and stock. This offer too was rejected by Vodafone, as the company was looking for a higher price for its stake. In August 2013, Verizon Communications made a higher offer of $130 billion for Vodafone’s stake, realising that any further delay would increase the acquisition cost due to rising domestic interest rates and its falling stock price. Industry analysts note that since Verizon was expected to raise funds through debt, any rise in interest rates would have had a major impact on future cash flows.

Gains for Verizon

The deal offers several benefits for Verizon Communications. First, the service provider will have full control over the operations of Verizon Wireless and will have access to the latter’s future free cash flow (FCF), which stood at $28.6 billion in 2012-13. Industry analysts say that the debt funding undertaken for the acquisition of the remaining stake in Verizon Wireless can be repaid without major issues given Verizon Wireless’s significant FCF.

For the quarter ended September 2013, Verizon Wireless posted an 8.4 per cent year-on-year growth in service revenues to $17.5 billion and a 10.7 per cent increase in earnings before interest, taxes, depreciation and amortisation to $8.9 billion. The additional revenues will improve Verizon Communications’ profitability without the company having to expand operations and launch new services, especially when the US telecom market is witnessing stiff competition and margins are under pressure.

Moreover, Verizon Communications’ fixed line services business is witnessing a slowdown and is likely to make limited contribution to overall revenues going forward. Thus, wireless operations would significantly improve its profit margins and offset the decline in revenues from the fixed line business. Analysts are of the view that the deal will result in an FCF of over $14 billion in 2014, as against $7.5 billion for 55 per cent ownership. As per Nomura, Verizon’s earnings per share would increase by 13 per cent and the FCF per share would grow by 14 per cent in 2014.

Verizon Communications also stands to benefit in terms of its service offerings. The operator will be able to offer integrated mobile, fixed line and TV services to its customers and implement a single billing system to charge for all services. This will reduce the cost of providing these services as well as attract customers who prefer service providers with integrated offerings. Convergence services would give Verizon an edge over its cable TV competitors including DirecTV, Cablevision and Time Warner Cable.

Further, Verizon Wireless has completed its long term evolution (LTE) roll-out and is providing 4G services to 97 per cent of the country’s population. Going forward, with a rapid increase in data usage as well as growing LTE-enabled device adoption (141 per cent year-on-year growth to 36 million devices as of end-September 2013), revenues from 4G services are expected to surge, which will drive profitability in the near term.

 Windfall for Vodafone

Vodafone will receive about $59 billion in cash from the deal. The operator has stated that it will give about 71 per cent of the overall sale proceeds to investors, which implies an outgo of about $84 billion in the form of cash ($23.9 billion) and stocks ($60.1 billion). As Vodafone intends to retain only limited Verizon Wireless stocks, its ability to pay high dividends in the future may be affected. Also, Vodafone’s revenues are expected to decline considerably, given that about 31 per cent of the service revenues for the six-month period ended September 2013 were contributed by Verizon Wireless (even though Verizon’s five-month revenues were accounted for as the deal was signed on September 2, 2013).

Though selling stake in the highly profitable Verizon Wireless will deprive Vodafone of future dividend payments and profits, the remaining cash received from the deal would help it in expanding global operations and reduce its debt burden. Vodafone is planning to aggressively strengthen its footprint in emerging markets, especially India (which is a priority market after Germany), under its Project Spring, as the company’s growth in the Southern European market is slowing due to increased competition (revenues declined 10.3 per cent year on year to £2.2 billion for the quarter ended September 2013).

Under the £7 billion project, Vodafone intends to augment its network in major markets and focus on data services and the enterprise business by March 2016. Vodacom, Vodafone’s South African subsidiary, will augment its 3G network in Tanzania under the project. Similarly, Vodafone has earmarked $3 billion for strengthening its Indian operations over the next two years, which is in addition to the capital the company would invest in increasing its stake to 100 per cent and for acquiring spectrum.

Meanwhile, the company will use the funds to strengthen its service offerings by bundling fixed line, wireless and TV services in Europe. The company bought Germany’s largest cable company Kabel Deutschland for $10 billion in June 2013 and is reportedly planning to purchase Italian cable operator Fastweb. Besides inorganic growth in the fixed line segment, Vodafone intends to invest about £1 billion in rolling out optic fibre cable infrastructure in other operational markets in Europe.

Conclusion

Overall, the deal seems to be a win-win for both parties. Verizon Communications will now have more flexibility in decision-making regarding Verizon Wireless’s operations and can offer converged services to gain market share and increase revenues in its domestic market.

Vodafone, on the other hand, intends to use the funds to improve its networks across global markets and focus on enhancing data offerings and the enterprise business. However, some experts have asserted that following the deal, Vodafone will become a smaller telecom player and may become an acquisition target, with companies like AT&T already weighing the option of buying the former in order to foray into the European market and emerging markets like India.