iiNet takeover not over yet ... But it has lit a fuse

The audacious all-cash $8.60 (plus a 10.5c fully franked dividend) per share bid for second-tier telco iiNet (IIN) by fellow traveller TPG (TPM) would have come as no surprise to Eureka Report subscribers.

Several times over the past two years I've written about the high likelihood IIN would become a target in a customer land grab ahead of the NBN's rollout (see Beyond Toll: More takeover targets to watch, February 18).

Prior to announcing this bid, TPM already owned 6.25 per cent of its target's shares. And a strategic shareholding by a competitor has long been my number one predictor of future merger activity.

As I said earlier: “While there is some nervousness about the future of the National Broadband Network (NBN) should the Coalition win the upcoming election, such fear is unwarranted. Shadow Communications Minister Malcolm Turnbull is a big fan of fast broadband, and once built, either version of the NBN will allow second and third tier telcos to compete on a relatively even footing with giants like Telstra and Optus. Soon there will be a land grab for customers, and both IIN and Macquarie Telecommunications could well become prey.” (See Our top 10 takeover targets, August 14, 2013.)

Today we look at both how the bid for IIN will play out, plus where to from here with respect to other players in the consolidating telco sector.

Will TPM's bid for IIN succeed?

TPM's all-cash offer of $8.60 per IIN share is a solid price, representing a 26% premium to the target's pre-bid share price. Having said this, it's by no means a knockout blow. As recently as late last year IIN shares traded around $8.50 before a disappointing interim profit announcement.

On one hand the IIN board led by chairman Michael Smith described the bid as a “significant premium” for his shareholders. On the other hand, rival telcos such as Singtel Optus (SGT) and M2 Telecommunications (MTU) will certainly be running the ruler over TPM's metrics to see if they can make a higher price stack up.

In addition to this, IIN's balance sheet has a substantial franking balance. These credits could be used to sweeten the existing bid on an after tax basis by replacing some of its capital component with a large and fully franked dividend. While this wouldn't necessarily change the headline cash nature of the deal, for super funds and other investors on a low tax rate, extra franking credits can be very valuable.

On the negative front, the ACCC has announced it will investigate the deal to ensure it doesn't lessen competition. While I expect the ACCC conclusion to take between two and three months, I doubt the regulator will find any real concerns.

Overall, I expect IIN shareholders will sit tight right now. Their company is in play, the existing bidder can pay more and potential rival bidders are waiting in the wings. At these price levels the market is beginning to price in a counter bid or at least a substantial distribution of franking credits.

Further deals beyond TPM/IIN

Assuming this merger goes ahead, TPM will have 1.7 million broadband customers. This will cause it to leapfrog current number 2 Singtel-Optus (1 million subscribers) and sit behind market giant Telstra (approx. 3 million).

TPM will then be a very serious player in our market. Usually when one company makes a large cash bid for another, shares in the predator entity fall – but not this time. Since announcing the merger proposal TPM shares have leapt from $7.74 to about $8.70. This means that the deal make sense, and that a merged TPM/IIN could still remain a target, with the aforementioned SGT a likely buyer.

Such a deal would, of course, require ACCC approval which can never be guaranteed.

Other smaller players to watch include M2 Telecommunications (MTU) and Vocus Communications (VOC)/Amcom Telecommunications (AMM), with this latter pair already pursuing a merger together. The share prices in each of these companies leapt last Friday when the TPM/IIN deal was announced. Such excitement is normal, but best avoided.

I expect investors will wait until the prices of MTU and VOC/AMM subside a little before buying in anticipation of further M&A activity.

Once the NBN is built all Australian telcos, including Telstra, will have essentially the same fixed line product offering at roughly the same price. This is because NBN will own the fibre-optic network and sell access to it on an equal basis to all retailers.

It will become harder and harder for the different telcos to lure broadband customers away as their service and value offerings should be very similar. As a result the time to grab consumers is now.

Expect more telco merger activity over the next 12 to 24 months.

Tom Elliott is a director of Beulah Capital and MM&E Capital.