PORTFOLIO POINT: The acquisition of Primus Telecom will undoubtedly be a transformational deal for Melbourne-based telco M2 Telecommunications.
Almost by definition, a 'transformational deal’ has the ability to make or break a company. As much as these deals are potentially value-accretive, they can also be highly value-destructive.
At the big end of town, these transactions have a tendency to deliver universally negative outcomes. You may consider prime examples such as:
- The ill-fated wine business acquisition spree by Foster’s (Southcorp and Beringer) from which it never really recovered; the brewer was eventually demerged into separate wine and beer businesses almost a decade later.
- Toll Holdings’ 'win at all costs’ acquisition of Patrick Stevedores also ended in tears for shareholders and led to the eventual jettisoning of most of the Patrick business (in the form of Asciano).
- Rio Tinto’s pre-GFC, top-of-the-market, debt-fuelled tilt at Alcan that had to be bailed out by a deeply discounted rights issue at the height of the downturn and left management more than a little gun-shy.
On the other hand, and for a variety of reasons, deals on the positive side of the ledger seem to be frequently transactions in the small-mid cap universe. While it is very difficult for a multi-billion dollar company to find and effectively execute a transaction of enough scale to be transformational, small-mid cap companies are often able to identify and successfully integrate significant mergers or acquisitions, predominantly due to their relative size.
And investors have just been offered what I consider to be a great case study of a transaction that I believe will fall firmly on the positive side of the 'transformational deal’ ledger. Melbourne-based telco M2 Telecommunications (MTU:ASX) has recently completed what may end up being a company-defining deal in the acquisition of its hamstrung peer, Primus Telecom. MTU is paying just under $200 million (around half its current market capitalisation) in order to grow its EBITDA from $60 million in FY12 (pre one-month Primus contribution) to an estimated $115 million in FY13.
This is certainly a 'transformational deal’ from a financial viewpoint.
So why do I believe in this deal? I will get to the MTU business model and deal metrics in a moment, but a good place to start the analysis is to look at MTU’s recent acquisition history.
Since its IPO in 2004, MTU has been an unabashed industry consolidator, with its main focus on 'bolt-on’ acquisitions from distressed or disinterested vendors; indeed, in the last five years alone it has made about 10 business/asset acquisitions. But nothing compares to the deal MTU did in mid-2009, at the height of the GFC, when it acquired the business of People Telecom and the telecom assets of Commander. As a result of these acquisitions, MTU’s revenues doubled, its staffing levels tripled and its business complexity jumped exponentially. But most tellingly (and to management’s credit), its key profitability measure, EBITDA margin, grew from 7.5% pre-deal to 15% post-deal (and continues to hold around these levels, presently forecast to be 15% in FY12).
So, regarding the question of whether management has the ability to execute a transformational deal, I give them a BIG tick.
Then what of MTU’s business model and how is the deal with Primus going to add value for MTU shareholders?
MTU is a network independent provider of retail and wholesale fixed-line, mobile and data services, specifically targeting small-medium business (SMB) enterprises in the Australian and New Zealand markets. MTU is essentially a reseller of these services and considers itself to be the pre-eminent challenger in the SMB market.
Primus provides similar services but is focussed on the residential and larger corporate markets, and adds two keys factors that MTU looks for in any acquisition – capability and scale. Primus comes with 165,000 customers and a complimentary set of business assets and offerings.
At a headline level, MTU is paying net $182 million for the acquisition of FY11 EBITDA of $40 million. This pegs the transaction at around a 4.5x EBITDA multiple (historic) and is estimated by management to initially be 8.6% earnings per share accretive. However, the turnaround at Primus under its recently-installed management over the past 10 months has been quite remarkable and is ongoing. Along with cost synergy benefits (estimated at a cumulative $5 million p.a. over the first three years) and cross-selling opportunities, MTU management believes the Primus business could be earning closer to $60 million EBITDA inside three years, pegging the transaction multiple at closer to 3.0x EBITDA (forward).
Some of the low-hanging Primus fruit for management to target post-acquisition will include:
- Consolidation of network backhaul links (both within, and between, capital cities);
- Efficient management of bandwidth and consolidation of IT infrastructure and applications;
- Improved billing and cost reconciliation within the Primus business and enhance buying leverage; and
- Corporate and technical costs rationalisation (head office premises, management, IT/engineering department duplication).
To put the scale of the transaction into perspective, MTU (currently ranked seventh in terms of market share) will combine with Primus (currently eighth) to leap into the number five slot to challenge iiNet (presently at number four), but is still a way off the top three gorillas in the zoo: Telstra, Optus and AAPT.
The Primus acquisition is the largest in MTU’s history and one of the more sizeable transactions in the sector for a number of years. MTU management’s track record, as illustrated above, should leave investors in no doubt about its ability to achieve the financial and business objectives of this acquisition. I see this transformational deal as falling firmly on the positive side of the ledger and believe there is still ample upside for investors to enjoy over the coming years.
Robert Calnon is portfolio manager at OC Funds Management.