TPG’s Offer For iiNet: Just The Beginning?

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-Network savings, lower overheads
-Outright ACCC opposition unlikely
-Potential for higher or rival bid
 

By Eva Brocklehurst

Suspicions regarding heightened M&A activity in the months ahead have been borne out by the announcement by TPG Telecom ((TPM)) of a bid at $8.60 a share for rival iiNet ((IIN)). The all-cash offer represents a 25% premium to iiNet's volume weighted average price (VWAP) but just 3.6% to its December 2014 high of $8.40 a share. The acquisition is viewed by brokers as highly synergistic, with opportunity for reduced network and corporate costs.

The iiNet board has unanimously recommended the offer and flagged it may pay a fully franked special dividend, subject to a favourable tax ruling and dependent on the level of retained earnings and franking balance. UBS estimates up to 90c is possible. The broker also envisages material benefits from network savings and, assuming $50m of synergies versus iiNet's cost base of $900m, this would deliver an earnings uplift of around 20% to TPG.

Most brokers consider that, ultimately, the Australian competition regulator, the ACCC, is unlikely to oppose the bid. TPG already owns 6.25% of iiNet and will fund the takeover of the remainder with debt. Credit Suisse notes the broadband market is highly concentrated and the ACCC's decision will depend on how it defines the market. Still there are a number of reasons why approval is likely to be granted, including a complementary geographical split, as the merged entity will not have significant concentration in any specific city.

Furthermore, Telstra ((TLS)) has a significant market share lead and an argument could be made that a larger number two rival would be better positioned to compete. JP Morgan suspects the deal may not pass the ACCC's market concentration test but that the ACCC will also consider the impact of the NBN on future competition, which should increase through lower barriers to entry. This may provide the ACCC with enough comfort to approve the deal.

Credit Suisse considers the offer is, intuitively, too low given the substantial synergies available. The increase in TPG's market cap in response to the $1.4bn takeover offer implies a market view that TPG is getting a bargain. Hence, Credit Suisse believes TPG could pay substantially more, given the synergies, and estimates that an increase in the offer price to $10 a share would only result in a drop of 4.0% in accretion.

Interest from a rival bidder, such as M2 Telecommunications ((MTU)) could mean a competitive process plays out. Moreover, if the ACCC chose to flag competition issues then M2 Telecom might not have the same problem as TPG, given its smaller market share and, in that sense, Credit Suisse suspects it makes a rival bid for iiNet more attractive. The offer appears to be fair value, in Citi's view. The broker also contemplates scope for a counter offer from Singapore Telecommunication's ((SGT)) Optus, given the strategic importance of the iiNet customer base.

JP Morgan believes the reaction in TPG's stock price implies an overly optimistic assessment of synergies and maintains an Underweight rating on both stocks. The broker believes a counter bid is unlikely. However, to UBS, either SingTel or M2 Telecom could be a counter bidder. Strategic benefits to SingTel include scale, operating leverage and bundling. M2 has proved acquisitive in the past but the broker questions whether it could extract the same amount of synergies as TPG, given its lack of infrastructure assets.

 All up, Credit Suisse considers there is substantial benefit for Australian investors in the TPG deal and upgrades iiNet to Outperform from Neutral. The broker increases TPG's target price to $9.67 from $7.42 but maintains a Neutral rating on the stock, given the deal accretion has now been priced in.

Morgan Stanley also upgrades iiNet to Equal-weight from Underweight, noting the merged group would have a 27% retail broadband share, still well behind the leader Telstra, with 45%. Optus, current number two, maintains a 17% share. Morgan Stanley assumes that, with the share price of iiNet near the bid price, there will not be a higher competing bid while no unsurmountable regulatory hurdles will be posed to completing the deal. Should the bid fail, the broker envisages 29% downside to its bear case valuation of $6.00.

While it may be argued that iiNet's 2014 earnings were negatively affected by expansion costs, Deutsche Bank estimates the TPG offer is still attractive when evaluated on FY16 earnings and assumed cost savings. The broker does not expect much change in the competitive landscape in the short term, as TPG intends to retain both brands, and therefore expects most of the synergies will come from savings rather than revenue benefits.

TPG is known for its leadership on costs while iiNet offers a different service proposition. The latest deal caps off two years of consolidation in the telecom sector with TPG acquiring AAPT in December 2013 and M2 Telecom acquiring Dodo in May of that year.

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