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Morningstar | More Than Friends as TPG Telecom and Vodafone Answer Each Other's Calls

Just 16 months after announcing its intention to disrupt the mobile industry as a new operator, TPG Telecom now plans to tie up with Vodafone, the third-largest player in the space. The sudden impetus to merge is also unexpected given the two companies have been working closely together since 2015, be it TPG building dark fibre for Vodafone, or acting as a Vodafone mobile reseller.

In our view, the abrupt decision to take the relationship to the next level is a tacit recognition of the current competitive intensity in the mobile market, even before the entry of a new challenger. While a combined Vodafone-TPG will be a formidable entity, the status quo of just three mobile operators is still better for competitive dynamics than having an aggressive, price-led challenger such as TPG invading the market with its own network. It is also possible that TPG has had second thoughts about the feasibility of building a viable mobile network, using predominantly small cells, with just AUD 600 million, at a time when the incumbents are spending AUD 600 million to over AUD 1 billion a year just to maintain their mobile infrastructure.

We believe these positive industry implications (at least compared with previous fears) have played as much a part as the actual merits of the merger in lifting shares in TPG to over 50% above our AUD 6.10 fair value estimate. Our intrinsic assessment for the narrow-moat-rated group is unchanged because the proposed merger is still subject to conditions (including competition regulator's approval), while details are scant on potential synergies from the combination, on both the operating and capital expenditure front.

Still, the 70%-plus rally in TPG shares from July 2018 has presented an opportunity for those shareholders wishing to crystallise some gains from the proposed merger before it is consummated, without having to endure the risks. At current prices, TPG shares are trading at 12 times forward EBITDA versus global average of 7.

The risks are not insignificant. First, the deal needs to obtain Australia Competition and Consumer Commission, or ACCC, approval. Management understandably trumpeted the size, scale, and strength of the merged entity to continue to invest and compete against incumbents and innovate for the benefit of consumers across all telecom segments (mobile, fixed-line, corporate). However, there is no hiding the fact this deal will ensure the mobile industry remains a three-player market and that a player (Vodafone) will also be eliminated from the fixed-line broadband market. Furthermore, management's radio silence on potential capital expenditure synergies from combining the entities is sensible, as it is certainly not appropriate to outline these at a time when the ACCC will be scrutinising the competition effect of the proposed merger.

Second, the vastly different cultures of TPG and Vodafone should not be understated. TPG has grown to its current size with a modus operandi premised on an extremely lean cost structure and an entrepreneurial spirit more akin to a private, nimble company. Vodafone on the other hand is a stereotypical, buttoned-down corporate entity with its attendant hierarchy and multi-layered decision-making processes. How these two cultures will gel as a single company will be complicated by the fact that TPG executive chairman David Teoh will likely step back from day-to-day operational involvement, something that is likely to disappoint his longtime supporters in the market.

As for some details on Vodafone Hutchison Australia, or VHA, it is Australia's third largest mobile provider, with 6 million customers. The company is a joint venture, 50%-owned by Vodafone Group Plc, which has over 400 million mobile customers making it the world's fourth largest telecom company. The other half is owned by Hutchison Telecommunications, a subsidiary of Hong Kong tycoon Li Ka-Shing's CK Hutchison Holdings. The merged company will operate 27,000 km of fibre networks, 5,000 mobile sites leading to about 20% share of the mobile market and 22% share of fixed line services in Australia. This places it as the third largest telecom operator in Australia, after Telstra and Optus. In terms of branding, both TPG and Vodafone will operate under separate brands.

Combined pro forma EBITDA is estimated at AUD 1.86 billion, with an estimated net debt/EBITDA of 2.2. This should support the targeted investment-grade credit rating, with leverage expected to decrease in the medium term to the target range of 1.5 to 2.0 times. Dividends are expected to be paid at 50% of underlying net profit after tax, after restructuring costs.

The merged firm will be 49.9%-owned by existing TPG shareholders and the rest owned by VHA shareholders. Current TPG directors have unanimously recommended its shareholders to vote in favour of the proposed deal. If implemented, TPG shareholders could receive a special dividend, being the difference between TPG's actual net debt just before implementation is lower and its target implementation-date net debt of AUD 2.0 billion.
As for management of the merged company, TPG's current CEO and Chairman, David Teoh will become the nonexecutive chairman and VHA's current CEO, Inaki Berroeta, will take the role of Managing Director and CEO. In addition, the board will include two directors from each of TPG, Vodafone, Hutchison as well as two new independent directors.

Finally, TPG announced that its fiscal 2018 EBITDA is likely to be around AUD 840 million, above its previous guidance to AUD 825-830 million. This is also marginally above our AUD 830 million forecast, and we will revisit our estimates on Sept. 18.