Tuesday, December 15, 2009

Qwest Communications (NYSE:Q): A Strong Contender for 2010; Upgrade to Buy - UBS

UBS is upgrading Qwest Communications (NYSE:Q) to Buy from Neutral with a $5.50 price target (prev. $3.80).

UBS believes Qwest is well-positioned to outperform the market in 2010. They believe fundamentals in the business and wholesale markets are likely to improve in 2010 after less than stellar results in 2009. These revenues make up 64% of Qwest’s topline and have caused investors to largely disregard the exceptionally strong free cash flow generated by the company.

They believe improvement in revenue trends will cause the Street to refocus on the cash, which they expect to remain strong through 2011. When fundamentals are deteriorating, highly levered companies typically see the most pain. However, given their outlook for improvement the firm believes the most upside will come from levered companies such as Qwest. Additionally, continued debt paydown in 2010 should be accretive to equity holders if the company is able to maintain its attractive 4.6x 2011 EBITDA multiple. Based on UBS FCF estimates, this alone would drive 15% upside from the current price.

UBS has increased their 2010 revenue estimate slightly to $11.7B from $11.6B, reflecting a 4.9% decline in 2010E vs. a 8.6% decline expected in 2009E. They now believe that 2010 EBITDA will decline by 3.9% to $4.20B (prev. $4.06B), reflecting a 35.8% margin (prev. 34.9%). They have also slightly lowered their 2010E capex to $1.64B (prev. $1.69B), equating to 14% capex as a percentage of sales. This coupled with their revised EBITDA number helps lift firm's 2010 FCF estimate to $1.55B (prev. $1.43B). UBS now estimates 2010 EPS of $0.31 (prev. $0.29) and 2011 EPS of $0.38 (prev. $0.29).

Balance sheet under control – may even provide source of upside. Qwest will continue to restructure its balance sheet throughout 2010 and the company has stated that it plans to refinance regulated debt and pay off unregulated debt. Applying UBS ex-dividend 2010 FCF estimate of $1B to net debt reduces their 2011 EV/EBITDA multiple to 4.3x from 4.6x. Looking at it another way, if the company maintains its 4.6x multiple, the lower debt level would lead to ~60 cents of equity accretion, or 15% upside from the current price.

Unemployment data points to upside in business market Non-farm payroll losses have improved dramatically since peaking at 741K jobs lost in January 2009. Payroll losses for the month of November came in at just 11K vs. the 111K lost in October and 139K in September. UBS believes the non-farm payroll reading coupled with recent optimistic comments from several of the companies they cover confirms that business revenue is in the early stages of recovery. With roughly 41% of its total revenue exposed to business, Qwest will be a prime

Qwest as a takeout candidate? Aside from UBS' belief in the sustainability of Qwest’s cash flow, its improving revenue trends and attractive valuation, they believe the final leg to the story comes in the form of M&A. Despite its much larger size, they believe Qwest could become a takeover candidate for one of the RLECs (CenturyLink or Windstream) looking to gain scale.

Notablecalls: I think UBS has created an interesting situation with their upgrade this morning. I'm sure you have seen the action in some of the single-digit telco plays like Sprint (S). There have been some surprisingly big moves.

When it comes to Qwest (Q) the overall analyst sentiment has been neutral-to-negative (lots of Hold/Sell ratings). With UBS blessing the stock with a Buy and a nice $5.50 price target we may see some buy interest in the name today.

For reference check out the stock's reaction to J.P. Morgan's upgrade on May 26. The stock gapped up 5% ($0.20) and ended up 8-9% for the day. I suspect we may see something similar today.

I'm guessing the stock will trade up to $4.30-4.35 range today.

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