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Morningstar | AGL Loses Focus, Makes Non-Binding Bid for Vocus

While it makes sense for narrow-moat-rated AGL Energy to diversify away from electricity generation and retailing, where it is under constant government attack, we doubt using all its firepower buying underperforming telecommunications roll-up Vocus Group is a good idea. AGL made an indicative, non-binding AUD 4.85 per share takeover proposal and will spend the next month conducting exclusive due diligence before deciding whether to commit. Morningstar’s standalone fair value estimate for narrow-moat Vocus is AUD 3 per share, well below the indicative bid price.

Separately, AGL announced that Unit 2 at its massive Loy Yang A power station is undergoing extensive repairs and will be out of action for seven months, detracting AUD 60 to 100 million from fiscal 2020 NPAT. We adjust our forecasts but maintain our AUD 21 per share fair value estimate. At current prices, AGL is trading at an 8% discount to fair value and offering an attractive 5.9% mostly franked dividend yield.

The main problem with the acquisition is that it is large and will sap AGL’s financial strength, potentially leaving it too highly geared to pursue other, more attractive opportunities. Vocus has an enterprise value (net debt plus market cap) of AUD 4 billion at the bid price. Should AGL fund the acquisition without raising equity, as appears likely, AGL’s net debt/EBITDA will rise from a conservative 1.1 times to a relatively aggressive 2.5 times.

With what investment bankers derisively call a lazy balance sheet, AGL is under pressure to make an acquisition. We’d rather the firm hold on to its pristine balance sheet, focus on investing in its own business and paying attractive dividends while waiting for more compelling acquisition or development opportunities.

Vocus is a serial acquirer, being an amalgamation of 10 purchases, including M2 in 2016 which itself was a serial acquirer. Unsurprisingly, there have been integration difficulties.

Combined with tough competition and roll out of the National Broadband Network, bottom line profits have fallen for the past couple of years. Vocus has a new CEO and is early in a turnaround plan. Additionally, Vocus’s financial health is relatively poor, with net debt/EBITDA of 3.1 times as at December 2018. We don’t think embracing this hot mess is a good idea for a company with no telecommunications experience.

AGL would argue that the acquisition would be more expensive if problem-free and that it has good experience integrating retail businesses. Additionally, management expects material cost and revenue synergies, and with AGL’s financial support, Vocus would be able to invest in high returning projects it couldn’t previously fund. On balance though, we think the risks outweigh the positives.

Before synergies, Vocus would increase AGL’s EBITDA by around AUD 360 million, or 16%. Assuming the bid is fully debt-funded, at a 4% interest rate, and ignoring amortisation, the acquisition would add about AUD 100 million, or 10%, to AGL’s NPAT. Assuming an interest rate closer to historical averages around 6.5% would result in the acquisition adding nothing to profit, in the absence of synergies.

Cost synergies would come from leveraging billing and customer service systems across a larger number of customers, as well as head office savings from removal of duplication. AGL would also hope for cross-selling opportunities--selling gas and electricity to Vocus customers and selling Vocus telecommunications services to AGL customers. Another key benefit is that bundling telecom with energy should reduce customer churn, which then flows through to lower costs to retain customers. If AGL progresses with the acquisition, it will provide guidance on what cost synergies it expects.