FEBRUARY 24, 2005

By Christopher Palmeri and Brian Grow

Qwest's Quest for MCI Gains Traction

As more shareholders nix Verizon's offer, Qwest is stepping up the pressure in a fight it can't afford to lose

Opposition to Verizon Communications' $6.7 billion takeover of MCI continues to mount. Elliott Associates, a hedge fund that owns 2.7 million MCI shares, said on Feb. 23 that it would not vote for Verizon's deal as currently structured, citing the greater potential value of a rival offer from Qwest Communications. Elliott urged the MCI (MCIP ) board to reconsider a Qwest (Q ) merger.

Two consumer groups, Consumers Union and Consumer Federation of America, have called on senators to closely examine the Verizon (VZ ) proposal for potential anticompetitive repercussions. In a letter, the consumer advocates said Qwest has pursued a "much more competitive strategy" than Verizon.

Qwest continues to jockey for position. Chairman and Chief Executive Richard Notebaert plans to meet Feb. 24 with Federal Communications Commission officials to gauge how much time they would need to review a Qwest-MCI combination, according to people familiar with the matter. It's all part of his new -- and dogged -- plan to line up the best possible counterproposal to sway MCI's board.

LITTLE ROOM.  By week's end, Notebaert is expected to tweak Qwest's own $7.8 billion bid by agreeing to give MCI shareholders additional Qwest stock should the shares drop in value before a merger is completed. That's music to the ears of some MCI shareholders. Verizon CEO Ivan Seidenberg "said that MCI is a beachfront property, so let's get a beachfront property price," says Bruce Berkowitz, founder of Fairholme Capital Management, which owns about 3.5% of MCI's shares.

Notebaert has little choice but to keep slugging it out. The smallest of the remaining Bells, and still lumbering under $17.2 billion in debt, Denver-based Qwest has far fewer prospects for growth than its telecom rivals.

Qwest spun off its wireless telephone business years ago. Now, it resells wireless service using Sprint's network. And its 155,000-mile fiber-optic network, which supplies long-distance data and voice services to businesses, has been a major money loser. The massive network build-outs of the 1990s left a glut of fiber-optic capacity that sent prices sharply lower. And big established long-distance carriers such as AT&T (T ), Sprint (FON ), and MCI have locked most major customers, leaving little opportunity for upstarts.

Buying the larger company would allow Notebaert to use some of MCI's $5.5 billion in cash flow to pay down Qwest's debt. It would also give him access to MCI's thousands of business customers, which could help fill Qwest's fiber network.

CONTRACT CREDENTIALS.  Without a merger, Notebaert will have to keep defending his shrinking base of local-phone customers while hoping for an end to the vicious price wars that have made the business market so tough.

On Feb. 15, Qwest announced it had lost nearly $1.8 billion on sales of $13.8 billion for 2004. "MCI is a lot more strategically important to Qwest in the long term than to Verizon," says Timothy Gilbert, a fixed-income analyst at Qwest bondholder Principal Financial Group.

Notebaert won a small victory on Feb. 22. The U.S. General Services Administration determined that Qwest remained a suitable contractor for government work. It had been under review since allegations of accounting chicanery surfaced three years ago. Qwest settled related charges with the Securities & Exchange Commission last year, paying $250 million in fines without admitting guilt.

SWAYING SHAREHOLDERS.  According to MCI executives, the board considered the risk that a ban on Qwest's ability to bid for government contracts would be a big impediment to a merger. MCI provides services to 75 government agencies, which accounted for more than 10% of its $24.4 billion in revenue in 2003. It will report fourth-quarter and full-year 2004 earnings on Feb. 25.

Now, Notebaert has to win on some other fronts. After coming up with a new bid, he'll likely start lobbying MCI shareholders and board members to reopen merger talks. Notebaert will likely argue that by owning about 40% of the combined company, MCI shareholders would have a greater share of any cost savings the merger produced than if they merged with the much larger Verizon.

Already, several large MCI shareholders say they have spoken with Qwest executives about a new offer. And prospects for a bidding war between Qwest and Verizon have driven up MCI shares nearly 10% in the last week, to $22.96, or $2 more than Verizon's offer of $20.75. "Verizon is a big company, and they have the wherewithal to raise their bid. But Qwest is a smart company," says John Paulson, president of Paulson & Co., a New York-based private-equity firm that owns about 11 million MCI shares.

DELAYING TACTICS.  Qwest may have the momentum. Beaten up by angry shareholders who accuse it of leaving $1 billion on the table, MCI's board will almost surely have to consider a new, more lucrative Qwest bid, say analysts. In turn, the board is likely to ask Verizon to revise its own offer. It could easily increase its bid because it has more than $30 billion in cash on hand.

Notebaert has a handful of options. He could fight it out to the end, rallying shareholders to vote against the Verizon merger when it comes up for approval at MCI's annual meeting in May. And he could try to sway MCI's largest shareholder, Mexican billionaire Carlos Slim Helu, to back Qwest's bid.

For now, Slim has said he's reviewing the offers and has declined to comment further. Notebaert is also likely to challenge the Verizon merger with the Justice Dept. and the FCC. That route probably won't stop the deal, but it may delay it and force the divestiture of some assets, such as local switches in New York City, which Qwest could then snap up.

STAY TUNED.  MCI Chief Executive Michael Capellas has already been making the rounds of his company's big shareholders, arguing that MCI's customers prefer a merger with the financially stronger Verizon. Its large wireless business, he says, will help MCI retain customers, as more of the telecom business leaves the traditional phone network.

But many investors remain unconvinced. "All those are interesting issues, but they don't address the main point: What's the best value?" says Bill Miller, the Legg Mason  money manager who's a big shareholder of MCI and Qwest. Miller, along with an increasingly vocal core of fellow MCI shareholders, is hoping Verizon will improve its offer for MCI. Regardless of how the auction is resolved, it's a good bet that Verizon's offer, as currently structured, won't be the final say in the matter.


Palmeri is a correspondent in BusinessWeek's Los Angeles bureau, and Grow is a correspondent in the Atlanta bureau
Edited by Steve Rosenbush

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