U S West's Tempting Spread

The spreads in the Qwest-U S West deal offer a lucrative opportunity -- and thanks to Nacchio's maneuvering, not a lot of risk.
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Now that Deutsche Telekom (DT) - Get Report has walked away from negotiations to buy both Qwest (Q) and U S West (USW) , aren't we back to exactly where we were a week ago?

Yes, and no. U S West and Qwest remain about four or five months away from receiving the state regulatory approvals necessary to close their merger. Both companies say they continue to move forward with the integration, and the risk of Deutsche Telekom breaking up the union has disappeared. Yet the spread, based on a 1.72 share exchange ratio (meaning a minimum of 1.72932 shares of Qwest for each share of U S West) is running at $18, three times the level of $6 or so that existed a week ago.

An $18 spread on this friendly deal translates to a 60% potential annualized return to an investor over five months, much greater than virtually every non-Internet merger pending. A spread that wide signals a distressed deal. It shows that permanent damage has been done to the market's perception of the safety of this transaction by the events of the last week, and it signals that the spread on the deal will probably remain at extraordinarily wide levels until the eve of its closing.

The extra $12 of spread can all be attributed to the behavior of Qwest CEO,

Joe Nacchio

. He clearly would like to sell Qwest to Deutsche Telekom and is annoyed that U S West refuses to allow him to negotiate a deal. U S West has veto power over a transaction by virtue of its ironclad merger agreement with Qwest. Nacchio has made numerous remarks in several venues that make it clear he would like to extricate Qwest from the U S West deal if possible. What once seemed like a good idea has become an albatross that uglies up the Qwest story.

But Nacchio has grossly overplayed his hand. It seems that U S West would have happily agreed to have been taken along in a merger with Deutsche Telekom as long as it did no worse than it would have under the Qwest merger. Based on press reports of the offers made by Deutsche Telekom to both Qwest and U S West, there was approximately $120 billion of value to divvy up.

Qwest could have struck a deal that would have gotten it $73 in value, a large premium over today's $51 price, while still respecting the bargain to which they agreed with U S West. That deal would have been worth $125 to U S West under the 1.72 ratio, certainly enough to induce U S West's board to support a three-way merger, even with the delay a resetting of the regulatory clock would entail.

But this wasn't enough for Nacchio. The deal had to be done on the back of U S West holders, with a shift of tens of billions of dollars in value from U S West holders to Qwest holders. And now Nacchio is indignant that U S West wouldn't meekly roll over and pay him his tribute. The Qwest press release announcing the termination of talks with Deutsche Telekom whines on about U S West being unreasonable. The real story is that Nacchio is being a greedy pig. Now he's stuck with a U S West merger he doesn't want but can't get out of.

Qwest's best bet to break the deal is to sandbag the state regulatory process. But with the litigation record he has created for U S West by his behavior and statements over the last week, he has delivered to U S West a slam-dunk court case for near-limitless damages if his bad faith causes this deal to crater.

The deal is sufficiently tarnished that an $18 spread is a rational outcome. Arbs are badly bruised by losses, the bad blood between U S West and Qwest is palpable and five months is a long time to wait. But the merger agreement offers solid protection, and the regulatory issues are insignificant.

This circumstance spells opportunity: the $18 spread is an attractive opportunity by itself. Or, to look at it another way, U S West stock is a much cheaper proxy for Qwest shares if purchased outright.

When you cut through the rhetoric, one conclusion is clear. This unhappy couple is headed to the altar -- despite what the groom wants.

David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital was long U S West shares, had a short position in Qwest shares, a long position in Qwest put options, and a short position in Qwest call options, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at

dbrail@thestreet.com.