M2 enters battle for iiNet

M2 Group was caught on the hop over the weekend, with the AFR breaking the news that it has been talking to iiNet about a proposal to trump TPG Telecom's $1.4bn cash bid.

This has forced M2 to announce the broad terms of its proposal, while iiNet has batted its eyelashes and demurely stated that it will consider the new proposal in its own time, before either dismissing it or giving TPG the opportunity to improve on it.

M2's terms are for $0.75 cash, plus 0.803 M2 shares, per iiNet share, which would make a total of $10 a share – a 16% premium to TPG's $8.60 cash offer. M2 also tries to bump this up to $11.37 by including 42% (iiNet's theoretical share of the enlarged group) of $538m in estimated merger synergies (which it calculates via a discounted cash flow model, based on $60m or so of savings a year). The deal would be consummated by way of a scheme of arrangement.

There was a time when cash was preferred to shares as a takeover currency, and it goes against the grain for M2 to be trying to talk up its bid by including some of the enhanced value of its shares. There may indeed be some value in this, but there is also risk, and iiNet shareholders could happily take TPG's cash and invest in their own risky ventures. We'd suggest iiNet shareholders focus on the $10 per share figure.

Standalone business

M2 also hasn't fully explained how it's going to extract those synergies given that it plans to run iiNet as a standalone business. The answer is probably that by standalone it means integrate it fully, apart from keeping 'dedicated sales and customer-facing support teams for the iiNet brand'. The language seems a little disingenuous, but the strategy makes sense because the iiNet brand has plenty of value.

In its hastily prepared presentation, M2 management cites scale, complementary product and geographic portfolios as strategic rationales, but really the deal would be about the synergies, which management expects to result in 'high single digit underlying' earnings per share accretion for M2 shareholders (see James Greenhalgh's recent article Protect yourself from M&A disaster for a discussion of this).

Despite our cynicism, though, the deal would probably create value for M2 shareholders, although it would also increase the risks of indigestion, with the company just having announced a deal to buy New Zealand's Call Plus. The stock has fallen 5% since today's announcement, putting it down 4% since our update on Call Plus, although it remains 82% above our original Buy recommendation. We'd emphasise our 4% recommended maximum portfolio weighting and our 'High' risk ratings, but recommend you continue to HOLD.

If iiNet recommends M2's proposal, then the odds look fair that TPG will come back with a better offer, so iiNet shareholders are sitting pretty and should continue to HOLD, even following its 12% rise today.

The bargain that TPG thought it was getting looks like it may have been ripped away and this is reflected in its 6% share price fall, but we'd say it has a good chance of ending up winning the battle, albeit after paying a bit more. We'd trust the company's excellent (and founding and share-owning) management to make sure it's worth it. HOLD.