Is there sufficient blue-sky to re-rate a merged Vocus/M2 entity?
In addition to providing the necessary scale to compete with its bigger rivals, the decision by the telco sector's (relative) minnows M2 Group (ASX: MTU) and Vocus Communications (ASX: VOC) to merge – to become Australia's fourth-largest telco – cleverly minimise dilution of shareholder value through capital raisings or additional borrowings.
Avoiding further strains on balance sheet after over a decade of growth-by-acquisition, the merged entity – which will earn around half its revenue from consumers and half from business – expects to deliver synergy benefits of $40 million by full year 2018.
Following on the heels of last month's $1.6 billion tie-up between TPG Telecom and iiNet, the Vocus/M2 merger will enable M2 to shift customers onto Vocus fibre and decouple from its dependency on Telstra's network in order to deliver broadband services.
Assuming the deal is approved by the regulator, under a proposed scheme of arrangement, M2 shareholders – who will own around 56% of the combined group – will receive 1.625 Vocus shares for each M2 share, which implied a 25% premium for M2 based on the closing prices of both stocks.
Unsurprisingly, M2's board is unanimously recommending shareholders back what it regards as a 'compelling opportunity' when they vote early 2016. However, given the Vocus offer only implies a price of $10.55 per M2 share, shareholders may choose to hold out for a slightly better deal.
Given that the deal is entirely based on share swaps rather than cash, any fall in Vocus' price will have a direct impact on the value of the offer.
With a vertically integrated product portfolio, including retail internet, electricity and gas; corporate and wholesale internet and IP voice; data centre and cloud services; international and domestic bandwidth; and dark fibre the merged entity is expected to be looking for revenue of around $1.8 billion and EBITDA of around $370 million in full year 2016.
The merged company will be run by M2 CEO Geoff Horth, while CEO and founder of Vocus James Spenceley will continue on the combined board as executive director, Executive director and founder of M2, Vaughan Bowen, will also continue on the combined board and focus on strategic acquisition opportunities.
The market responded favourably to what it regarded as an excellent fit between Vocus' infrastructure and corporate customer base and M2's expertise in the consumer and SME segments. This staunched the down-trend M2 shares have been on since late July and saw it surge by around 23.28% to $10.38, before bouncing back to around $9.48.
Arguably, a smart move ahead of the NBN rollout, the Vocus/M2 deal is expected to mark the last big fixed line merger in the Australian telco industry. While the ACCC does not plan to oppose the merger, it has made it clear that any further consolidation between the biggest broadband players won't be approved. Assuming that's the case, rival TPG is unlikely to succeed with any future play for Vocus down the track.
Having made nine acquisitions in five years, Vocus owns more than 1600km of fibre infrastructure in Australia and 4300km in NZ, and in June signed off on its $1.2 billion merger with Amcom Telecommunications – which saw the Vocus share price jump12%. M2's flagship Australian products are the Commander and Engin brands for business and Dodo and iPrimus for consumers.
With a combined market cap over $3 billion, a merged Vocus/M2 entity will easily sit within the ASX 100 and this should add underlying support to the share price with many large cap funds prompted to buy the stock.
Given the deal between Vocus and M2 is all about broadband, NextGen Networks is mooted as the next potential acquisition to provide fibre optic cabling across the country and further cut costs. Meantime, NZ mobile provider 2Degrees is another potential acquisition for the combined entity.
Both stocks have experienced exceptional earnings per share (EPS) growth over the last five years and are expected to go on doing so. And while both stocks have reasonably good balance sheets, M2 is currently carrying a net debt-to-equity of $132.49%.
Assuming the merger proceeds, watch closely how future acquisitions will be funded.
There's sufficient blue-sky for the market to get excited about a merged entity – that's about to entrench itself as Australia's fourth-largest telco – and this should be sufficient to re-rate it going forward.
With Vocus trading at a 62% premium to its intrinsic value (IV), M2 – trading close to IV – appears to present a more attractive means of playing the merged entity's upside, especially if Vocus needs to put a bit more money on the table to get the deal over the line.