How do you make a $6.7 billion deal look like a $5.3 billion bargain? The investment bankers working on Verizon Communications Inc.'s VZ) purchase of MCI Inc. (MCIP) apparently think they've found a way. And if they pull it off, they'll likely encourage a string of copycats -- all of whom will owe a note of thanks to President George W. Bush for pushing through the 2003 tax cut on dividend income.
To understand why, start on Feb. 14, when Verizon and MCI execs announced their deal. While MCI shareholders would get $6.7 billion if they agree to the sale, Verizon said the purchase would cost its shareholders only $5.3 billion. To make up the difference, MCI agreed to pay its shareholders the extra $1.4 billion, or $4.50 a share, in dividends. The money would come out of MCI's own cash before Verizon ponies up its $5.3 billion and actually takes over. Adding to the fog over the true value of the deal: a second slug of cash, $488 million, would be part of Verizon's payment; moreover, MCI shareholders were already scheduled to receive 40 cents of that suddenly plumper dividend. "We are offering...a total package of about $6.7 billion. But it is $4.8 billion of Verizon equity, and the rest of it is in a variety of cash distributions that come from MCI's cash hoard," said Verizon Chairman and CEO Ivan G. Seidenberg in a conference call held with MCI Chief Executive Michael D. Capellas on the morning of the deal.
Some major MCI shareholders are complaining bitterly, particularly now that details of the much richer bid by Qwest Communications International Inc. (Q) have been made public. Excluding the special dividend, Verizon is offering MCI investors $16.25 a share in stock and cash, while Qwest's offer, which does not include an extra dividend, totals $23 a share in stock and cash. "It is a slick use of words," says Bruce R. Berkowitz, CEO of Fairholme Capital Management LLC, which holds about 3.5% of MCI stock. Berkowitz says the cash payouts amount to nothing more than handing back to MCI shareholders their own money. He is talking with two other major shareholders, Leon G. Cooperman of Omega Advisors Inc. and John Paulson of Paulson Investment Co. (PLCC), about what, if anything, they can do to get a higher price from Verizon. Together they own roughly 10%. Berkowitz says he's eager to know where MCI's kingpin shareholder, Mexican magnate Carlos Slim Hel?, who owns a 13.8% stake, stands. Slim could not be reached for comment.
Capellas began meeting with Berkowitz and other shareholders on Feb. 15 to make his case. He argued, according to a spokesman, that if Verizon were not taking over MCI, the company would not be able to turn over so much cash. The plan is to call for a vote on the deal in May and pay the dividends shortly afterward. Verizon spokesman Peter Thonis says the offer "is a very good deal for MCI shareholders."
With those dividends as an incentive -- and the promise of quick payment -- execs and their bankers hope to appease dissidents and boost the odds of getting the deal approved. Indeed, without the early payment, MCI investors would have to wait until the deal clears federal and state regulators before they'd see any money. That could take as long as a year.
Another aspect of the deal's structure could be enticing. The dividend would be taxed at only 15%, less than half the short-term capital-gains tax rate that investors would pay on profits from stock bought within 12 months, says Robert Willens, a tax and accounting expert at Lehman Brothers Inc. (LEH). Verizon's Thonis says the deal wasn't structured specifically to get the tax advantage. Still, it makes things juicier for short-term holders.
The fallout could go far beyond Verizon and MCI. The 2003 dividend tax cut clearly makes such a pre-close dividend more valuable since that 15% rate is the same as the one that applies to long-term capital gains. As a result, many short-term takeover speculators could save on taxes by taking profits in pre-close dividends. "Now this will probably be a staple of pretty much every merger," predicts Willens. In fact, the Verizon-MCI deal resembles a smaller pre-close dividend that was tucked into SBC Communications Inc.'s (SBC) bid for AT&T (T) just two weeks earlier. As part of that deal, AT&T announced it would pay a $1.30 per share special dividend just prior to the deal's closing. That's a slower payout and amounts to only about 7% of the $16 billion that AT&T shareholders will get in the SBC deal; by comparison, the MCI dividend represents 21% of the $6.7 billion payment to investors.
When deals are structured to save taxes, sellers won't demand as much money from buyers for their companies. If, in turn, buyers find they can do deals by paying less, they'll likely do more deals. How many more is speculation. But even one is probably one more than Congress or the President imagined when they changed the tax law.
By David Henry in New York, with Brian Grow in Atlanta