Rule of Three
The Australian telecoms landscape is on the cusp of a major shakeup it would seem following the announcement of the merger between TPG Telecom (ASX:TPG) and Vodafone Hutchison Australia. The deal will see the sector move into line with the global “Rule of 3” with the merged entity a fully-fledged telecom operation with strength in both fixed line and mobile business.
Having previously traffic lighted TPG’s shares, we believe that the investment case has been de-risked by the ‘merger of equals.’ Particularly as TPG’s previous growth plans will be turbo-charged as it leverages Vodafone’s existing infrastructure. There are some risks involved, but we see the necessary regulatory approvals being attained, and given an ongoing consolidation shift globally in the sector. Accordingly, we now rate TPG Telecom as high risk, long term, buy.
Recap and What’s new?
Before we move on to the details of the deal, we want to provide a recap on the coverage of this aggressive (and familiar) telecom player.
Long-time Members following our take on the Telecom sectors would recognise TPG Telecom (ASX:TPG) as one of our more profitable recommendations which we initially added the shares back in 2006 under a different incarnation (SP Telemedia). A series of aggressive of takeovers and acquisitions then saw the creation of the TPG group.
We previously issued a take profits recommendation (for a 1140% gain) back in September 2015 (FAT-AUS-741). Our exit was predicated on the group’s burgeoning debt load and a stock that had become “priced to perfection” and which could see significant downward pressure in the event of a negative catalyst (which proved the case).
We subsequently cast the spotlight on the shares earlier in the year, with the valuation much more modest than when we exited previously. We passed on recommending the shares around the $6 mark, citing a growing debt load, and as TPG sought to become the fourth network operator in Australia. While getting in at a lower price would have been preferable, we were dealing with what was in front of us rather than what ‘might be’ – the investment case now has in our view been de-risked by the ‘merger of equals’ between TPG and Vodafone Hutchison Australia. Particularly as TPG’s growth plans will be turbo-charged as it leverages Vodafone’s existing infrastructure.
A Merger of Equals
Around two weeks ago, there was significant media speculation about a possible merger in the works which pushed shares of both TPG (ASX.TPM) and Hutchison Telecom (ASX.HTA), which owns half of Vodafone Australia, to multi-year highs. This was subsequently followed by a confirmation of both parties that they were in “preliminary discussions”.
A week later (30 August 2018), both companies, with the unanimous support of their respective Boards, then announced the agreement to combine both firms in a “merger as equals” – where shareholders of both firms will ultimately surrender shares and receive new securities from the “Merged” business. This would combine Australia’s No.2 Broadband Player and the No.3 mobile operator. This transaction is illustrated below:
Source: TPG Telecom (ASX:TPG) 30 August 2018 Company Presentation
As shown in the graphic above, the new company that will result from this merger will still be listed in the ASX and will retain the TPG Telecom (ASX:TPG) name with it receiving a 10-year licence to continue using the Vodafone brand on products.
TPG shareholders (provided the deal is approved) will own 49.9% of the new entity and the investing public, outside very large shareholders such as the reclusive TPG Founder David Teoh and investment firm, Washington H. Soul Pattinson and Co, will own the remaining 20.2%.
The deal will be largely cashless with it being in scrip (read: shares) and will include a planned fully franked Cash Special Dividend to TPG shareholders, though yet unspecified as it is depends on TPG’s net debt levels. Another factor inclusive of the deal is that TPG will spin-off its Singapore business to existing TPG shareholders, and management notes that this business will be “appropriately capitalised”.
The new company’s leadership will largely remain intact as the founder Mr David Teoh (pictured below, right) will take on the role as Chairman from his current TPG CEO role and Mr Iñaki Berroeata (pictured below, left), who is currently the CEO of Vodafone Australia, will don the CEO hat in the new business.
Image Credit: Vodafone Website, Daniel Muñoz
However, we wish to remind Members that this isn’t entirely a done deal as it still requires approval from regulators such as the Foreign Investment Review Board and the Australian Competition and Consumer Commission (ACCC). Though the ACCC did note in a public announcement (30 August) that their review process would take about 12 weeks. Both Vodafone and TPG noted that they expect implementation sometime next year.
Before we give out our stamp of approval, we explore the various pros and cons though note that this is not exhaustive but is intended to cover what we view as the most salient points:
Benefits
In a nutshell, the merger will create a much stronger (financially and operationally) challenger to the Telecom Incumbents (Telstra & Optus). Note that Vodafone has a nationwide network with over 5,000 mobile network sites and covers over 6 million mobile subscribers whereas TPG’s strength is in its 27,000 km of fibre optics allowing it large point of presence to have over 1.9 million subscribers in Fixed line Broadband. In effect, we see this as complementary businesses and making it the 3rd largest player in the sector.
The combination is illustrated below:
Source: TPG Telecom (ASX:TPG) 30 August 2018 Company Presentation
Combined, this should ramp up the new company’s ability to regain market share and in a much earlier time frame. The enlarged entity will realise significant synergies from shared infrastructure and investment savings.
We also expect to see cross-selling benefits as the new company would have the capability to provide attractive fixed-mobile bundled services due to the almost instantaneous access to a nationwide mobile network from Vodafone. While Vodafone’s team can easily cross-sell into enterprise accounts due to TPG’s existing exposure to Small and Medium Enterprises at better margins compared to buying wholesale from the National Broadband Network (NBN).
We also expect incremental gains from shared services (back office, call centres) leading to cost outs – management, however, notes that “there won’t be significant lay-offs” though likely as a way to keep morale. There are also benefits from a share marketing platform and budget.
Most importantly, the deal will also lead to a much stronger financial position (as both firms have accumulated a sizable debt profile) for the new company. According to the filing, management expects a conservative debt size of $4.05 billion based on TPG FY18 target debt of $2.02 billion (1H18: $1.39bln) while Vodafone Australia management has noted that some $4.8 billion will be shaved off and assumed by its parent company, leading to an ultimate contribution of $2.02 billion as well.
Source: TPG Telecom (ASX:TPG) 30 August 2018 Company Presentation
This level of debt is circa 2.2x expected EBITDA and a much smaller share of its planned $15.0 billion capital structure (prior to the deal) implying an investment grade for its credit profile. That said, this will lead to a much stronger cash flow which has prompted the management to note an expected payout ratio of 50% of NPAT going forward.
Risks
This doesn’t come without its share of risks, however, and we expect it to be plenty but nevertheless manageable.
We are fully cognisant that both businesses have different business models with TPG looking at keeping a lean organisation largely relying on its online channel, telephone sales and dealers while Vodafone’s approach is on providing greater value to its customers and having a larger focus on customer service leading to a more cumbersome sales force.
This adds a layer of complexity, though this can be mitigated by the fact that both TPG and Vodafone teams have largely worked together in the past and even now. A case in point is the $1 billion deal both firms made in 2015 where TPG connected Vodafone mobile sites to its fibre network leading to cost savings.
That aside, an interesting development here is that both companies have also announced a Joint Venture (JV), on top of the merger proceedings, last week where they will bid for a licence for the Government’s auctioning of the 125 MHz of 3.6 GHz band spectrum (5G) in late November.
The 5G spectrum is an absolute necessity for the future of both companies and this move augurs a strong indication of a shared future. That aside, the JV will have broad mandate and is not limited to just holding on to spectrum assets.
Moving back to risk, the largest obstacle in our view is the ACCC. As we’ve noted above, the merger is still subject to regulatory approval and it seems that this deal will come under greater scrutiny due to its impact on competition.
In fact, ACCC Chair Rod Sims, in a Press event last week, expressed his concern that the merger may change the market dynamics considering that TPG is a “new… and aggressive low-cost player” (which benefits consumers) in the Mobile market. The “loss” of TPG’s aggression in the market may lead to inefficiencies and unfavourable outcomes to consumers.
On the other hand, Vodafone Australia CEO, in an extended interview with Elysse Morgan at ABC News, “guaranteed” that the they will maintain competitive prices due to both company’s “spirit of a challenger” and it’s “in the DNA of the companies to be aggressive”.
We have reason to believe, though, that the regulator accepting the merger is a distinct possibility. There is a tendency for many markets to consolidate into the 3 largest firms as just the “right” amount with enough competition and stability, as supported by research from academic and consulting circles.
Regardless, considering the high degree of uncertainty here, we will be closely looking at developments from the ACCC as this will greatly define the direction since most shareholders are already expected to vote in favour of the deal.
Turning to the daily chart, the charting structure has turned definitively more positive. A decisive break has occurred above the 50-day (green line) and 200-day (red line) moving averages at $5.94 and $6.39 respectively. From a medium-term momentum perspective, this remains in favour of the bull-camp, as backed by the bullish moving average crossover last month. This is when the 50-day moving average (red line) crosses above the 200-day moving average (green line).
With reference to the monthly chart, support held at the September 2017 low of $4.86. A sustained break above the March 2017 high of $7.03 has been positive, as has a move above the 61.8% Fibonacci retracement at $7.86. Resistance at the 50% and 38.2% Fibonacci retracements of $8.78 and $9.71 respectively have held firm but remain in focus. A breach of the higher buttress would open the way for a move back to previous all-time highs at $12.70.
Summary
The ongoing media buzz in the telecom sector is the announced merger between TPG Telecom (ASX:TPG) and Vodafone Australia. This combination is expected to turn the merged entity into a full-fledged and stronger (financially and operationally) telecom operator with strength in both fixed and mobile business.
Having previously traffic lighted TPG’s shares, we believe that the investment case has been de-risked by the ‘merger of equals.’ Particularly as TPG’s previous growth plans will be turbo-charged as it leverages Vodafone’s existing infrastructure. There are some risks involved, but we see the necessary regulatory approvals being attained, and given an ongoing consolidation shift globally in the sector.
Accordingly, we now rate TPG Telecom (ASX:TPG) as high risk, long term, buy.
TPG Telecom (ASX:TPG) is held in the Fat Prophets Concentrated Australian Share and Small & Mid Cap managed portfolios.
