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TPG Telecom – Two Lego Blocks

I got it wrong. Writing on TPG a year ago, I wondered if acquiring iiNet was on TPG’s agenda but thought it wasn’t the right fit at the time.

It also looked like the $1.5 billion price tag would have been a bit of a stretch for TPG but a year later, things have changed.

Today it seems they are like two lego blocks just waiting to be pressed together.

There has been plenty of action in between.

Vocus Communications has cozied up to Amcom Telecommunications which looks like it will go through to completion. Optus and Telstra have thrown more and more money at their mobile networks and M2 Telecommunications has extended its spree of activity across the sector and beyond.

There has also been the small matter of the National Broadband Network creeping its way across the country.

The telecommunications landscape is still changing but we may be getting into the tail end of the consolidation phase, at least as far as the larger transactions are concerned.

The Australian newspaper reported that TPG executive chairman David Teoh had shared a breakfast with iiNet chairman Michael Smith during which the question was popped.

Referring to Mr Teoh’s takeover offer, iiNet chairman Michael Smith summed it up when he said: “He’s bought a brand with a million or so customers.”

That’s how I see it too and while it sounds simplistic, the combination of the two businesses has a great deal of growth still ahead.

There are several aspects that deserve consideration in this regard.

Synergies are sizeable

Firstly, the synergies between the two companies relate to the cost and revenue sides of the business and these will both be substantial. Think selling and marketing, administration, occupancy and so on.

Various estimates in the market suggest the total synergies of the transaction between $70-90 million but TPG has yet to quantify this aspect. Offsetting this major plus for the deal is the knowledge that both brands will be maintained requiring a double-up in marketing and brand promotion although the greater media-buying power of the group could help.

The dual-brand strategy should give it a premium and a budget price approach which can be cross-marketed in the geographies where each was underrepresented. TPG/IIN still appears capable of taking market share from Telstra and/or Optus without cannibalising its own footprint though this announcement will surely rattle some cages.

TPG’s infrastructure advantage

As TPG has built a substantial amount of its own network infrastructure, the cost of carrying traffic is significantly lower than iiNet and is the primary reason why TPG’s operating margin is much higher.

In FY14 for example, iiNet’s gross profit margin after deducting network and carrier costs was 46% while its operating margin (EBITDA) was 19.1%. The same metrics for TPG Telecom were 62% and 37.5% respectively.

There is a very big opportunity for TPG to not only migrate iiNet’s 266,000 off-net customers onto its own infrastructure but also to lower the average cost of carrying traffic across its entire customer base.

Telstra’s FY14 fixed data revenue of $2.2 billion included an estimated $300 million of high-margin wholesale revenue. Telstra reported its margin on fixed data at 44% which suggests broadband prices are still too high in Australia and that there is a large opportunity for challengers like TPG to take further market share.

Other factors

The debt funded acquisition will push TPG’s gearing to 3.1x net debt to EBITDA but the likely cash flow from the extended group should rein this metric in within a reasonable timeframe.

The combined market share of the Australian broadband market of about 27% will leapfrog over Optus’s 15% but it will be some distance behind Telstra’s 45%. On that basis alone, I don’t think the ACCC will have any bother approving the takeover.

The $8.60 per share price for iiNet puts the acquisition on a multiple of 9.1x calendar 2014 operating earnings, according to the company arithmetic.

TPG will have picked this number to be sufficiently high to persuade the iiNet board to agree while dissuading any potential counterbid from the likes of Optus or M2 although we must wait for any potential response

The special dividend, yet to be announced by iiNet, will be worth approximately 15-20 cps and this will reduce the price paid by TPG.

Value?

Just prior to the announcement of the transaction, the approximate market capitalisations of iiNet and TPG were $1.1 billion and $6 billion respectively.

iiNet reported 975,000 broadband subscribers as at 31 December 2014 while TPG (yet to report its interim result) has about 760,000 subscribers.

The difference reveals the large amount of value attributable to TPG’s strategy of acquiring (PIPE, AAPT) and building its own infrastructure.

There is plenty of detail to be released by TPG to the market about this transaction, encompassing the issues discussed here, and it will dominate the interim result discussion due soon.

The deal is not yet across the line but the early elements of it appear to be positive for the combined group. TPG has demonstrated it can deliver on promised synergy gains from previous acquisitions which makes this aspect quite bankable.

Regulatory approval aside, it will also be interesting to watch for any competitive responses in the broadband market.

In summary, this deal provides TPG with another substantial step up the telecom ladder in Australia and propels it into the big league in the broadband market.

Investors should stay aboard.

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