M2 And Vocus Join Brave New NBN World

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-Merger substantially broadens service offer
-Superior counter bid unlikely
-Underpins success in an NBN world

By Eva Brocklehurst

Consolidation activity continues apace in the telecommunications sector with M2 Telecommunications ((MTU)) and Vocus Communications ((VOC)) the latest to announce a merger deal. This will expand M2 Telecom vertically and create a full services trans-Tasman telco, combining the fixed infrastructure and wholesale offerings of Vocus with the retail offerings of M2 Telecom. This latest deal book-ends three years of major acquisition activity in the sector, kicking off with M2 Telecom's acquisition of Primus in 2012.

Under the agreement, which is couched in terms of Vocus conducting the takeover, M2 Telecom shareholders will be offered 1.625 Vocus shares for every share they hold. M2 Telecom shareholders are expected to end up owning 56% of the combined entity. The M2 Telecom board has unanimously recommended the proposal, subject to no superior proposal being offered and the independent expert report.

As this is a vertically integrated merger, Citi envisages no obstacles for the Australian Consumer and Competition Commission. The ACCC announced in its review of the recent TPG Telecom ((TPM)) and iiNet merger that a future merger between the four major suppliers of fixed broadband – Telstra ((TLS)), Optus ((SGT)), TPG Telecom and M2 Telecom – would raise serious competition concern, so this probably limits the likelihood M2 Telecom would be acquired by one of its larger competitors.

Both merger partners expect around $40m in synergies can be achieved by FY18, with the potential to use the Vocus fixed infra assets to on-sell M2 Telecom's services. The combined group will have a market cap of $3bn and become the fourth telco in Australasia by market cap. Around 18% of FY15 proforma revenue would be from New Zealand.

Several brokers suspect the deal was structured this way to limit potential interference from TPG Telecom, which holds a 7.9% stake in Vocus. Overall, the combined group should offer significant operating scale and network. UBS suspects Vocus will use M2 Telecom's distribution network to penetrate existing on-net buildings, potentially with a dual brand strategy to avoid cannibalising the existing Vocus offering, which is positioned below Telstra but above TPG Telecom.

At current prices the market is valuing the merged company on a FY16 price/earnings ratio of 17, which looks cheap for an integrated telco, in the broker's opinion. To compare: Telstra trades on a ratio of 16 times and TPG Telecom on 27.5 times. UBS expects the deal will be around 10% earnings dilutive to M2 Telecom shareholders in FY16 and 37% accretive to Vocus shareholders, but acknowledges this is of limited relevance given the difference in the nature of the earnings streams. UBS, like Morgan Stanley, awaits the relevant approvals, including the NZ Commerce Commission, before factoring the deal into forecasts.

UBS believes it unlikely a third player will trump the proposal. TPG Telecom may be a candidate on first glance but it is already geared up following the acquisition of iiNet and the ACCC would likely to be wary, given the company is the number two player in the consumer fixed market. The deal should cement the combined group's success in a post-NBN world, where scale, extent of infrastructure assets and a differentiated product offering will be necessary.

The deal makes strategic and financial sense, in Morgans' view. This broker, too, concludes that the only way TPG Telecom could block the deal is via a full takeover of Vocus and, given the iiNet merger has just happened, the company's balance sheet is stretched. Morgans reduces M2 Telecom's rating to Hold from Add on the back of the news but makes no changes to forecasts. The combined business would generate around $370m in earnings on a FY16 proforma basis, with M2 Telecom bringing mass market appeal with its Dodo brand and business sales through its Commander sale force. Vocus brings strength from its substantial network footprint.

The downside risk is mostly around share price movements in Vocus, because of the all-scrip bid. Every 5c reduction in the share price removes 8c or 1.0% from the value of the offer, from M2 Telecom's perspective. Longer term, Morgans suspects some risk/reward in respect to the supplier relationship with Telstra and this will need to be managed carefully to ensure continuity of carriage. The only potential suitor outside the other big three, in the broker's opinion, could be Vodafone, or an energy distributor. Longer term, Morgans also suspects the $40m synergy target will be superseded. For example, the TPG Telecom bulls expect up to $200m in savings after the acquisition of iiNet.

Macquarie also considers it unlikely a second bidder will emerge. The broker expects the combined entity will improve competition in the consumer and business market by creating another scaled up player in a market dominated by the other three majors. The combined group will have 510 DSL enabled exchanges in Australasia, a submarine cable capacity connecting its network to the US, Hong Kong and Singapore and complete coverage of NBN in Australia and UFB in New Zealand.

FNArena's database has two Buy ratings and four Holds for M2 Telecom. The consensus target is $9.85, signalling 9.4% downside to the last share price. This compares with $9.92 ahead of the announcement.

 

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