Is AGL’s Bid For Vocus A Game Changer?

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As earnings levels peak, AGL Energy has sought a tie-up with telco infrastructure, making an offer for Vocus Group.

-AGL is filling a prospective earnings “hole”, amid lack of growth options in core business
-Investors query whether this is the best use of AGL's capital
-Risk that AGL sparks a price war in broadband, potentially spilling to electricity, gas
 

By Eva Brocklehurst

Interest in the link between energy and telecommunications infrastructure is heightened as AGL Energy ((AGL)) becomes the latest suitor for Vocus Group ((VOC)), filing a proposal just weeks after Sweden's EQT Infrastructure pulled its offer. This is the first time an energy company has made a bid public for Vocus. AGL's $3bn cash offer, at $4.85 a share, is less than the $5.25 offered by EQT and there is now four weeks of exclusive due diligence.

Ord Minnett estimates AGL Energy is offering a multiple of 9.5-10.0x enterprise value/operating earnings (EBITDA) and assesses this to be "full", because earnings accretion would depend largely on a lower cost of debt. While there are cost savings and revenue benefits from the combination, the proposal also highlights the lack of growth available in AGL's core business and the broker is concerned that other parties have conducted due diligence and decided against a transaction.

Citi estimates the acquisition could be 4-14% accretive to FY22 earnings, based on AGL Energy being able to deliver on consensus earnings forecasts for Vocus, before considering further growth in the assets in the longer term.

Several brokers assert AGL Energy is intent on filling an earnings “hole”, as earnings are at a peak. This creates revenue synergy around retail growth and a new avenue for growth in enterprise and wholesale data, Macquarie explains. The latter enables AGL, as one of the main four network providers in Australia, to avoid being a second or third-tier player in the telco space.

Balance Sheet Utilised

Headroom in the balance sheet is now fully utilised, e.g. new acquisitions in upstream gas would require equity, and Citi believes consensus expectations have some way to fall in FY20. The broker points out investors are concerned about whether this is the best use of capital.

While execution risks are high – this acquisition is outside the company's core competency — Citi believes they are manageable, asserting that the defensive nature of fibre earnings as well as the lack of correlation to wholesale electricity prices reduces the risk.

Macquarie expects buybacks are likely to become a distant memory, as AGL Energy seeks to develop a telco business. In justifying the company's viewpoint, standing still is not an option. The broker expects net profit will fall to $750-850m over the next five years, from $1.01bn, as the benefits of the LREC contribution and Liddell power station decline.

At the same time super profits from legacy gas and coal contracts will end and there will be tighter regulation around power prices. A capital return would, therefore, add value but not address the fundamental challenges.

Credit Suisse retains an Underperform rating, noting the outlook is for diminished capital returns, should the bid eventuate, which compounds an already weak earnings outlook. Macquarie agrees the risk is significant, although migrating Vocus retail customers is logical and relatively low risk. The main issue is migrating enterprise customers from 6-7 individual platforms to a single platform.

Morgan Stanley believes this bid is the latest to highlight the strategic value in telco infrastructure assets, increasing its conviction in a non-consensus Overweight call on Vocus and Superloop ((SLC)). There is unlikely to be a foreign investment risk in this transaction, which was a potential hurdle in the EQT bid. Macquarie points out the ACCC (Australian Competition and Consumer Commission) will still review the transaction, although it is hard to find signs of market concentration.

Synergies Long-Dated

Credit Suisse assesses earnings accretion is easily achieved because of AGL Energy's willingness to permanently increase gearing while retaining a Baa2 credit rating. The company is opting to acquire exposure to data at scale, while the value-creating synergies appear to be a secondary driver.

Aside from some portion of corporate expenses, immediate cost synergies appear limited and Credit Suisse considers the only other true value driver is revenue/margin synergies from bundling energy and telco services. Hence, the bid should be viewed as a customer retention/lifetime value opportunity.

Diversifying from peak earnings in energy markets is probably, in Citi's view, a good move and there are international precedents for telco/energy integration, such as TrustPower in New Zealand, where multi-product offerings reduced churn significantly. The risk, the broker suggests, is more around whether a return above hurdles can be achieved.

Leveraging billing systems should add little to the cost of servicing a customer but, while this sounds simple, Macquarie points out it is the equivalent of 12% of NBN market share shifting, or being converted.

Historically, this would spark a price war, squeezing minor players and pushing other larger operators to discount. All up, Macquarie cautions that synergies will be hard to deliver and typically take time. And there is a real risk that AGL does spark a price war in broadband that potentially spills over into electricity and gas.

Citi also notes the AGL share price did not react materially to the bid. As Loy Yang A is an issue for the first half of FY20, Citi argues it should be capitalised by the market, as investors question the ongoing reliability of ageing coal plants. The broker reduces earnings estimates materially, on the back of the Loy Yang A utilisation levels as well as higher spot coal prices, and maintains a Sell rating.

FNArena's database shows two Hold ratings and six Sell. The consensus target is $19.68, signalling -0.1% downside to the last share price. Targets range from $17.78 (Citi) to $22.25 (Deutsche Bank). The dividend yield on FY19 and FY20 forecasts is 5.8%.

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