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Analysts say the network overlap between Qwest and MCI might hurt vendors, should a merger occur

Qwest/MCI Could Chill Gear Sales

Light Reading
News Analysis
Light Reading
2/8/2005
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On the heels of SBC Communications Inc.’s (NYSE: SBC) agreement to buy AT&T Corp. (NYSE: T), Qwest Communications International Inc. (NYSE: Q) has entered talks to buy MCI Inc. (Nasdaq: MCIP), and, while far smaller, Qwest/MCI could prove to have as great an impact on equipment vendor sales.

The two deals are markedly different. SBC and AT&T spend an estimated 20 percent of carrier capital expenditures (capex) nationwide, while Qwest and MCI account for only 7 percent, analysts say.

But where the network overlap between SBC and AT&T is small, the overlap between Qwest and MCI (both are in the long-distance business) is considerable. That means Qwest/MCI could have more opportunity in the long term to squeeze redundant spending from the network, negatively affecting equipment vendors.

Lehman Brothers analysts believe Qwest and MCI separately could be expected to spent a total of $3 billion during 2005, but could eliminate “a few hundred million dollars” of that by consolidating.

Contrast that with SBC and AT&T, which separately would spend a combined yearly capex of around $7 billion, but are expected to save only $100 to $200 million as a result of consolidating (see SBC/AT&T: How Painful for Vendors?).

Carriers spent roughly $50 billion on capex in North America during 2004.

Qwest reportedly has made a $6.3 billion offer, but MCI has yet to respond.

Jefferies & Co. analyst George Notter expects “modest negative impact” on equipment vendors from a Qwest/MCI merger, and expects that it could depress equipment sales in two different ways and at two different times.

A first effect is felt while the companies merge operations. “Naturally, not much capex spending occurs while employees of the two entities wring their hands over who will remain with the organization, who will get rationalized, and who their new bosses will be,” Notter says.

After the two networks are merged, the combined entity has both more purchasing power and the chance to realize “synergies” from the combined network, Notter says. Both of these exert downward pressure on equipment prices.

The Lehman Brothers analysts say Ciena Corp. (Nasdaq: CIEN) and Sonus Networks Inc. (Nasdaq: SONS) could be at particular risk because of an increased dependence on revenue from the potentially merging companies. “Vendors in our coverage with significant exposure (more than 10 percent of sales) to either Qwest or MCI include Sonus and Ciena while the combined company could also become much more material,” the analysts wrote in a research note today.

Sonus’s name also came up as a company that could be negatively affected by the SBC/AT&T merger. But Sonus’s outlook brings to focus the fact that merging huge telephone companies takes time, and the vendors that serve them will not be immediately left out in the cold.

“With the flurry of merger talk recently there has been much speculation on the effects on Sonus,” says Legg Mason Inc. analyst Timm Bechter in another brief issued last week. “If it [Qwest/MCI] happens at all, we believe that it would be premature at this point to view this potential merger as a negative for Sonus, given the time it will likely take to be completed.”

Meanwhile, MCI and Verizon Communications Inc. (NYSE: VZ) continue to hold exploratory conversations, but Verizon hasn’t decided whether to enter a bid (see Takeover Talks Take Over).

— Mark Sullivan, Reporter, Light Reading

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