Is TPG-Vodafone partnership a prelude to future merger?

In less than a month since tipping that a merged TPG/iiNet (ASX:TMP) would start eyeballing mobile networks to become a fully integrated telco, it has announced a $1 billion 15-year deal with Vodafone Hutchison Australia. With the partnership likely to deliver strong synergies between Vodafone's telecommunication towers and the fibre networks of TPG and its recently acquired iiNet, there's growing speculation that it's the first step towards an eventual merger between both companies.

Despite managements' insistence that this is not the case, it's understood that TPG's founding executive chairman, David Teoh, has been in dialogue with Vodafone UK about selling its 50% stake in its Australian subsidiary. The remaining 50% of Vodafone Australia is controlled by Hutchison Telecommunications Australia, a subsidiary of CK Hutchison Holdings which is part of the empire of Hong Kong-based Li Ka Shing's Cheung Kong Holdings, and there's growing speculation that the Chinese billionaire is a possible seller.

A merged TPG/Vodafone would create a strong competitor to Telstra and Optus – with compelling offerings in both the mobile and fixed-line markets and substantial cross-selling opportunities. Best estimates suggest that the Vodafone acquisition could cost TPG around $4 billion – or around half its current market cap.

Following swiftly on the heels of announced plans by M2 Group (ASX: MTU) and Vocus Communications (ASX: VOC)  to merge into Australia's fourth-largest telco worth $3 billion, the quickly-inked deal between TPG and Vodafone should remind investors of the need for both combined entities to improve all important scale – through further industry consolidation – to realistically fight against Telstra, and Singtel-Optus.

The need for scale also explains why Teoh is so fixated on extending the company's fixed network footprint before the NBN comes online.

Under the terms of the agreement between TPG and Vodafone, TPG will build around 4000km of new fibre to Vodafone cell sites across Australia, at a cost of $300 million to $400 million.

TPG expects the project to deliver minimum revenue of $900 million over the next 15 years.

The 'dark fibre' – aka unused high-capacity fibre optic cabling that can be leased to customers – will cover two-thirds of Vodafone's network, boost capacity, potentially deliver cheaper prices to Vodafone's 5.25 million users, and allows it to significantly cut the costs associated with moving data on the network. However, from Vodafone's perspective the partnership has more to do with securing the future of the network than fixing any gaps in coverage.

The partnership will also see TPG migrate its mobile wholesale customer base of 320,000 users from Optus to Vodafone, in what is one of the largest ever Mobile Virtual Network Operator arrangements in the local industry. However, customers of TPG's recent acquisition, iiNet, will not move to the Vodafone network, and Optus is currently working with TPG on revised wholesale arrangements.

Based on TPG's healthy balance sheet – which includes strong long-term cash flow relative to reported profits, a cash flow ratio of 1.7 and modest net debt-to-equity – a cleverly constructed acquisition of Vodafone proportions, appears at face value doable.

However, assuming any future acquisition of Vodafone is debt-funded; TPG is likely to want to pay down the $1.56 billion iiNet transaction first. Watch closely for future revelations on this deal coming to fruition and the impact of future capital raisings or borrowings on shareholder value.

The TPG share price has put on 50c following market conjecture it's eyeballing Vodafone, however it could as quickly unravel, should this rumour prove to have no substance.