NZCC hangs up on Sky Network TV merger

Facing growing threats, Sky Network Television (ASX:SKT) will likely appeal the rejection of its proposed merger with Vodafone New Zealand. 

Sky Network Television (Sky, ASX: SKT), New Zealand’s largest pay-TV operator, is facing the same headwinds buffeting Foxtel and foreign cable-TV companies such as ESPN, owned by Disney (NYSE: DIS).

Cord-cutting, unbundling and the rise of Netflix (NASDAQ: NFLX), Amazon (NASDAQ: AMZN), Stan, and even Google parent Alphabet’s (NASDAQ: GOOG) Youtube are all providing consumers with more viewing options at lower prices.

Sky has responded by offering customers more flexible packages and cheaper options such as NEON and FAN PASS but these are less profitable than its traditional subscribers.

Total subscribers have starting falling and, albeit to a lesser extent (so far), average revenue per subscriber (or ARPS) is also falling. Sky downgraded its estimated 2017 EBITDA to around NZ$278m in December 2016.

Should this trend continue as I expect, with the cost of content – and in particular, sporting rights – continuing to increase, this has ominous ramifications for Sky’s bottom line.

So on a standalone basis, at 6.2 times historical earnings before interest, tax, depreciation and amortisation (or EBITDA) and a PER of 13, I’d steer clear.

Proposed merger with Vodafone NZ

But Sky’s Board has sensibly aimed to diversify by purchasing Vodafone New Zealand, the country’s largest mobile provider, with 2.4m customers, and second-largest broadband provider.

Vodafone’s main attraction is exponentially increasing data use, either via mobile or fibre, while the combined entity will also be able to provide more attractive bundles – combined internet, TV and phone service – to its customers.

Sky will issue 405m shares to Vodafone’s parent and also NZ$1,250m in cash, meaning it will be paying around NZ$3.44bn on an enterprise value basis or 7.1 times estimated 2017 EBITDA. (The new shares have an assumed value of NZ$5.40 under the merger’s terms).

Unfortunately, the New Zealand Commerce Commission (NZCC) has knocked back the deal, on the basis that it couldn’t be satisfied that the merger wouldn’t substantially lessen competition. Sky and Vodafone have taken legal action to preserve their right to appeal once the regulator releases its full reasoning.

Sky shares shot up from NZ$4.47 to NZ$5.25 when the merger was announced in June 2016, but have since slipped back to NZ$3.88 on the rejection of the merger and further declines in subscriber numbers.

In the price?

With Sky shares falling to NZ$3.78 after the merger was rejected, it seems the market is assuming the merger won't go ahead. And as noted, I wouldn’t recommend owning it on a standalone basis.

However, at current prices, Sky is effectively purchasing Vodafone NZ for around 5.8 times 2017 EBITDA. The merged entity will trade at around 6.1 times estimated 2017 EBITDA of NZ$762m. By contrast, comparable stocks outside New Zealand sell for at least 7 times EBITDA. 

Moreover, while it always pays to be sceptical about estimated synergies, the NZ$0.52 per share in cost synergies from the merger appear to be achievable.

Regulatory risk

So if the NZCC’s decision is successfully appealed, then I’d expect a decent rise in Sky’s share price. Perhaps to NZ$4.40 – where they were trading before the merger was rejected – or even higher as investors acknowledge the benefits from the deal.

Unfortunately, I can't estimate the chances of the merger ultimately being approved with any degree of accuracy.

Each case is different and so historical rates at which NZCC decisions have successfully been appealed aren't much use. 

Making things even more difficult is that the NZCC hasn’t yet released the detailed reasoning behind its decision, which may show that its reasoning is incorrect and open to challenge.

An intelligent speculation?

This means any purchase now on the assumption that the merger goes ahead would amount to a speculation rather than an investment.

However, while I'll pass, a little intelligent speculation may not necessarily be a bad thing. Perhaps comprising 1% of a portfolio at most, this may be a speculative opportunity for investors who clearly understand the risks and whose portfolios can cope if the speculation proves unsuccessful.

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