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Why Is Windstream Acquiring EarthLink?

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Deal rationale

Windstream Holdings (WIN) announced that it has agreed to merge with EarthLink Holdings (ELNK) in a $1.1 billion all-stock transaction, including debt. EarthLink shareholders will receive ~0.82 Windstream shares for each EarthLink share owned.

The deal, which is subject to both companies’ shareholder votes and regulatory approvals, is expected to close in the first half of 2017. If the deal closes, Windstream shareholders will own 51.0% of the combined company.

EarthLink will provide Windstream with enhanced fiber network capacity and allow it a larger penetration into enterprise communications services for customers. Windstream is expected to generate cost and tax synergies of more than $125.0 million over a three-year period.

Windstream management expects the deal to be significantly accretive to adjusted FCF (free cash flow) in the first year and improve over time with synergy realization.

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Windstream’s adjusted revenue in the past few quarters

In 3Q16, Windstream’s adjusted revenue fell ~8.3% year-over-year to reach ~$1.3 billion, from ~$1.5 billion in 3Q15. The fall was mainly due to declining wholesale, small business CLEC (competitive local exchange carrier), and regulatory revenues.

The company’s 3Q16 performance suffered from seasonal headwinds that led to increases in cost of services, which primarily impacted consumer and small business ILECs (incumbent local exchange carriers). The overall adjusted OIBDAR (operating income before depreciation, amortization, and rent) margins were 34.6% in 3Q16 compared to ~36.8% in 3Q15, a fall of 220 bps (basis points).

Windstream faces significant cable competition from Charter Communications (CHTR) and Comcast (CMCSA). The deal is positive for Windstream since it would increase its scale and fiber footprint as well as improve its leverage, FCF profile, and dividend payout ratio. As a result, Windstream would be able to compete better with its rivals.

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