Can TPG buy Vodafone?

Can TPG buy Vodafone?

When you’re in the markets, you hear a lot of ‘talk’ and it’s an interesting exercise to work through the numbers of some of that ‘talk’ – particularly when you can show that the ‘talk’ is probably on the wrong track.

Recently we’ve been hearing rumours that TPG may make a bid for Vodafone’s Australian business. I took the time to run through the numbers and see whether it was a likely event.Vodafone Hutchinson Australia is a joint venture currently owned by Vodafone Australia and Hutchinson Telecom (whom each have a 50 percent stake). We have the following statistics:

Note: the GBP/AUD exchange rate when this analysis was compiled late last week was 1.87x. Slight changes won’t impact our findings.

• $3,552m AUD revenue
• $5b AUD of debt (according to the company)
• 490m GBP EBITDA (converted to AUD, approx. $916m)
• Rumored valuation of 2,940m GBP (converted to AUD, approx. $5.5b).

On a fundamental basis, we know that Vodafone own a little over half of what Telstra (ASX: TLS) has in terms of spectrum quantity, a national array of mobile towers and offices etc. Vodafone currently has about 2.9 million mobile subscribers, but this has been in decline for several years.

We note that Vodafone recently said in a statement that it was open to potential changes to its worldwide portfolio however it had no current plans to sell (see here). This includes their Australian operation. Of course, it would be unwise for them to indicate a willingness to sell (given this may drive down the price) but it may also mean that they expect a premium for the business.

We now examine TPG’s capacity to buy this business based on the rumoured valuation.

TPG

• Revenue: $970.9m plus $395.5m from AAPT (assuming no growth), totaling $1,366.6m
• EBITDA: $363.7m in FY14, FY15 guidance for $450m-$460m
• Operating cash flow: $300.5m in FY14
• Free cash flow (ex acquisitions): $230.5m in FY14
• Capex (ex acquisitions): $70m in FY14, guidance for $100m-$120m in FY15.
• Current interest expense: $10.8m, expect >$13m in FY15 given borrowings for AAPT
• Cash: $23.8m
• Total Borrowings: $347m

Firstly, looking at Hutchinson Telecoms balance sheet (the joint venture partner), it appears that almost all of the $5b debt is sitting on Vodafone’s balance sheet. So TPG would take on this debt on top of any debt they use to acquire the firm.

Assuming they only acquire 50 per cent of the business that Vodafone owns, they’d be paying approx. $2.75b, 50 per cent of the estimated price of $5.5b AUD. This would provide TPG with $458m EBITDA to help service the debt.

Assuming they borrow the entire consideration, TPG would need to source the $2.75b from its creditors as well as taking on $5b of debt from Vodafone’s balance sheet. This works out to a Debt/EBITDA ratio of 8.5x – or in others words, this is a fairly high amount of leverage so the transaction may be unlikely to happen. I used TPG’s expected FY15 EBITDA in this calculation.

TPG may alternatively go down the route of raising capital via equity in order to complete the transaction. The firm currently has 793.8m shares outstanding and is trading at $6/$7 per share. Raising just the acquisition price would require 400m-460m of new shares – a fair amount of dilution.

This is before we even consider how TPG would manage Vodafone’s additional debt on its balance sheet. Putting this aside, if you consider TPG currently trading its current 11x EBITDA multiple, adding in Vodafone’s $458m of EBITDA generates a market cap of approximately $10b for FY15.

On an undiluted basis, this gives an expected share price of $12.58. Adding in say dilution of 430m shares (to the current 793.8m shares) gives a price of $8.16. In the diluted scenario, you still have a Debt/EBITDA Ratio of 5.5x. This is more palatable but still pushing it.

In terms of synergies, it’s tricky at this stage. Major lines of expenditure for a telco usually include personnel expense and telecommunications expense.

TPG currently resells Optus’s services so immediately there would be a likely improvement in the gross margins of this business line (since you now own the assets that run the service rather than paying a 3^rd party).  However mobile for TPG is quite small, delivering $79m in revenue, so the benefits may be marginal.

It’s also debatable how much could be saved on personnel expense given that Vodafone already has call centers in the Philippines (i.e. less propensity for savings from offshoring jobs).

Vodafone does use third party fixed line operators to help manage its mobile data downloads (i.e. to download/upload from and to the internet) which has a considerable cost attached to it. This is potentially a worthwhile synergy but as far as I know, how much Vodafone is paying for this expense is not disclosed.

On the capex side, we know that Vodafone’s market share has declined over the past few years and they intend to turn this around by investing in network capacity (i.e. improving the performance of the mobile network). This is a function of network assets with insufficient capacity and being behind the technological curve relative to Telstra and Optus. To solve this problem will likely require a lot of capex – and whilst it’s difficult to come up with estimates for Vodafone, consider Telstra spending $500m over FY15 in their network and Optus’s recent $1.4b commitment to catch up to Telstra.

We can infer from Optus’s numbers and past tests of the Vodafone network that Vodafone’s capex would likely need to be at least in the ballpark of that of Optus.

On the whole, these businesses thrive on scale and being the number 3 player in the market can be a difficult proposition given Australia’s small population.

To sum it up:

1. Vodafone may be open to a sale for a fair offer.
2. The level of debt in order to acquire Vodafone would be a large strain on TPG’s balance sheet.
3. In addition, more than a billion dollars would likely need to be spent upgrading the network to compete effectively with Telstra and Optus.

Whilst our thinking on this issue is quite clear, we’d recommend that you form your own opinion and seek professional advice where appropriate.

Scott Shuttleworth is an Analyst with Montgomery Investment Management. To invest with Montgomery, find out more.