And they say you can’t time the market. Two days ago, in There’s a Lott to like about Tatts, we said ‘Potential merger talks have surfaced on at least three occasions over the past 10 years, but they have always ended over price rather than a lack of strategic merit, which gives us hope that a deal will one day be struck.’
Fast forward 48 hours, and a deal is now on the table. Unfortunately, it’s not quite the one we were hoping for. Tabcorp has made a takeover bid for Tatts, in which Tatts shareholders will receive 0.80 Tabcorp shares and 42.5 cents in cash for each Tatts share held. At Tabcorp’s current share price of $5.06, the offer values Tatts at $4.47 a share.
Had Tabcorp offered to buy just Tatts' wagering division – which accounts for a bit over a fifth of operating earnings – we’d probably be cheering the stocks to the finish line. We believe the current deal, however, significantly undervalues Tatts' lotteries business.
Deal undervalues Lotteries
Combined wagering divisions will be stronger
$130m in cost cutting synergies
Tatts and Tabcorp sit at different ends of the quality spectrum. Almost three-quarters of Tatts' earnings before interest and tax (EBIT) is from operating all the lotteries in Australia, except those in Western Australia, where the Government runs the show. As we explained in The lottery that always pays, this division is a regulated monopoly and offers a stable, growing income, while earning extremely high returns on tangible capital.
Tabcorp, on the other hand, derives most of its income from tote and fixed odds betting through TAB outlets, hotels and on-track totalisators in NSW, Victoria and the ACT (it also has small Keno and Gaming services divisions). Tatts has a similar wagering operation, though only around one-third the size and with licences for Queensland, South Australia, Tasmania and the Northern Territory.
The trouble with both Tatts and Tabcorp’s wagering businesses is that they are both losing market share to online operators such as Sportsbet (owned by Paddy Power Betfair), which have lower-cost business models and can therefore almost invariably offer better odds.
This is an industry where scale really matters, which is why the merger – at least from the perspective of Tabcorp shareholders – makes perfect sense.
On completion, the combined business would have revenue of over $5bn and earnings before interest, tax, depreciation and amortisation of more than $1bn. More importantly, management estimates that around $130m in duplicate costs can be cut from the combined business, which should eventually flow through as better odds and offerings for punters. This may help to stem the long-term migration of customers away from Tabcorp and Tatts and towards lower-cost alternatives.
Both companies’ boards of directors support the merger and Tabcorp chief executive David Attenborough is expected to head the combined company if shareholders approve the deal.
Takeovers take a while to play out, and this one may take longer than usual. Given the heavy regulation of the gambling industry, the merger will need to pass various regulatory conditions, as well as get approval from the courts and the wagering and lottery regulators in each state.
Approval from the Australian Competition and Consumer Commission (ACCC) might also pose a hurdle because the combined entity would be the only bricks-and-mortar tote and fixed odds wagering operation in Australia. Though Tatts and Tabcorp don't directly compete in any individual state due to their exclusive licences, the difference between two large wagering outfits and one mega-bookie may rub the ACCC the wrong way.
In any case, completion isn’t expected until mid-2017 and we’ll keep you up to date as things develop. With a forward price-earnings ratio of 23, Tatts’ current share price is below the implied offer price and below our estimate of intrinsic value. Without a material increase in the offer price – probably unlikely – we think the deal favours Tabcorp rather than Tatts. For now, Tatts is a HOLD.
Tabcorp shareholders will come out with a stronger company thanks to added scale and new markets. It would also get one of Australia’s best businesses – Tatts’ Lotteries monopoly – for a reasonable price. With an underlying price-earnings ratio of 21, we continue to recommend you HOLD.
Disclosure: The author owns shares in Paddy Power Betfair PLC.