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TTS/TAH – Now Tatts what I call a premium

After failing to agree on terms for a nil premium merger in November last year, it looks like Tatts Group has secured a much better outcome for its shareholders.

For that reason, TTS shareholders should consider taking some of that premium off the table once the special dividend has been paid.

The formula of 0.8 TAH shares plus 42.5cps fully franked dividend, plus a pre-deal 20cps fully franked special dividend (to TTS shareholders), plus a post-implementation $500m share buyback suggests that plenty of lolly has been thrown at TTS to get the Board to agree, which they have done.

The new group believes there will be little reason for the ACCC to disallow the takeover as they believe there is very little overlap between their operations and customers (presumably on a geographic basis) and that there has been a significant increase in competition from international online gaming businesses in recent years.

Although TAH will only have approximately 42% of the combined group, it will appoint its Chairman Paula Dwyer and its MD/CEO David Attenborough to the respective positions in the new business. TTS’s chairman Harry Boon will stay on the new Board but it is unclear what TTS CEO Robbie Cooke will do once his role in the integration is finished. That’s a shame because Cooke has been an excellent operator for TTS. Expect to see him snapped up by another large corporate at some stage.

A fair amount of attention is being given to the expected EBITDA synergies between the two businesses, now nominated by TAH/TTS as being at least (their emphasis) $130m per annum, mostly from cost-related factors such as reducing duplication, setting up a single wagering platform, and some associated capex reductions.

This area will attract huge scrutiny from the market as previous discussions have never suggested such a large figure.

Based on TTS’s FY16 EBITDA of $495m ($345m lotteries, $133m wagering, $65m gaming services, -$50m Bytecraft/Talarius/other), its 30 June 2016 net debt of $1,041m and the implied takeover  market cap of $5,273m (at $4.34 per TTS share), the implied multiple of EV/EBITDA is a very big 15.0x, before the value of any synergies is applied.

Adjusting for the $90m cost of the transaction and the $624m of cash being paid to TTS shareholders, the new group will have net debt of approximately $2,626m ($870m TAH + $1,041m TTS + $90m transaction fees + $624m cash paid to TTS shareholders = $2,626m). At the current respective share prices, the combined market cap is about $10,175m. The combined enterprise value is therefore a heady $12,805m.

Before adding in the expected synergies of $130m pa, the EV/EBITDA (FY16) ratio is around 12.6x and 11.2x if you are brave enough to include the full synergy benefit.

In the context of where the casino gaming companies trade at around 9.0-9.5x EBITDA, and comparing it to almost a decade of takeover multiples in the Australian gaming sector averaging around 9.0x, then investors are being asked to expect a lot from the new group in terms of value creation.

Perhaps the most relevant transactions were the 2006 takeover of UNiTAB by TTS at 9.5x EBITDA and the 2004 acquisition of TAB by Tabcorp at 9.7x EBITDA. Admittedly, things have changed considerably since then but it is a large multiple nonetheless.

The TAH/TTS presentation values the synergies at $1.4 billion using a multiple of 9.1x TAH and 12.4x TTS for the consensus FY17 EBITDA forecasts across the market.

At first glance, the earnings multiples being applied and assumed suggest that TTS has extracted a full takeover premium this time around and is understandably recommending the deal to its shareholders.

The Racing Industry is probably a winner from the deal as well. TAH and TTS are saying that at least $50 million of additional funding will flow to the industry as a result of the creation of a national footprint for pari-mutuel pooling, more investment across a single wagering platform and other benefits.

The presentation seemed to suggest that the TAH wagering business was substantially superior to the TTS business. TTS had only recently tried to rejuvenate its wagering business through the creation of a single brand, Ubet. Will much of that effort go to waste or can the new group enhance it further?

There is little doubt that the entry of some big international gaming businesses in online betting and fixed odds has greatly altered the landscape for punters. Both TAH and TTS have felt the impact in their wagering businesses in recent years.

TTS has put a huge amount of time, effort and money into consolidating the lotteries industry across most of Australia. The lotteries business has been good for TTS and it has harvested some solid earnings from the low volatility of arguably the most socially acceptable form of gambling in Australia.

After the transaction is implemented, the combined group will conduct a $500 million share buyback. Is this a carrot to entice TTS shareholders to remain invested in the new group? A target of 3.0-3.5x gross debt to EBITDA is being adopted with investment grade credit rating and 90% payout ratio of net profit (before significant items) as its dividend policy. Presumably the buyback will not prejudice any of these factors.

In my view, it looks as though TAH has forked out the extra cash ($624 million) as a sweetener to get the deal across the line for TTS shareholders. The combined group, under mostly TAH leadership, is now relying heavily on the large value of synergies plus a balance sheet that will carry a reasonable amount of debt.

Looking back at the history of these two companies, there is a shared affliction of regulatory and legislative pain. The tenth of April 2008 sticks out in infamy when the Victorian Government unilaterally ended both companies’ electronic gaming machine licenses (on expiry in 2012) thus slashing a combined $4 billion of market value in one fell swoop.

Neither company was successful in winning very substantial compensation payments for the loss of those licenses despite spending considerable time and money in court for the purpose.

It would be fair to say that the licensing regimes across their combined businesses are complex, susceptible to change (greyhound racing, for example) and therefore a big risk factor. It is clear that every state government sees the gaming industry, in all its forms, as an easy target for revenue collection and they often act in haste to plunder it.

It is also clear that the online gaming industry has made large indents into traditional betting products and platforms. The new TAH/TTS will need to muscle up against this new competition if it wants to sustain its wagering hegemony.

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