Stockwatch: what can we learn from seemingly cheap TalkTalk deal?

The price underlines a trend of opportunistic takeovers at the likes of GoCo and Codemasters.

We have recently seen Future Publishing's (LSE:FUTR) bid for insurance group GoCo (LSE:GOCO) and video game firm Electronic Arts trump Take-Two's (NASDAQ:TTWO) bid for game developer Codemasters (LSE:CDM). Two private equity groups are bidding for the AA (LSE:AA.), the terms of which its largest shareholder has criticised as “derisory”. 

Now, hedge fund Toscafund and private equity group Penta have agreed a 97p per share cash offer for TalkTalk Telecom Group (LSE:TALK). This 97p in cash offer values TalkTalk at £1.8 billion, including £967 million debt. Yet market price has ticked up to 100p, as if the consensus anticipates a higher offer.

Traders such as Odey Asset Management have made a quick 20% - at least - in Codemasters, so might TalkTalk be an interesting takeover speculation?  

Is a near-19% potential improvement built in?

Downside is declared limited at 97p. But, perhaps to protect their own reputations as well as shareholders’ interests, the independent TalkTalk directors have agreed to accept the 97p offer unless a third party bids at least 115p a share. Sir Charles Dunstone, a co-founder, has committed to this in respect of his 30% stake. 

The 115p level is the one at which TalkTalk demerged from Carphone Warehouse – now Dixons Carphone (LSE:DC.) – a decade ago, and is also below a late 2019 indicative offer made by Toscafund at 135p a share. 

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This detail broke in an independent news report last July, which included confirmation from a Toscafund official. Then, 135p was said to have undervalued the group. 

Yet if anything, the marketing grist from TalkTalk as the cutting-edge value provider is enhanced now BT (LSE:BT.A), Three and Vodafone (LSE:VOD) have declared price rises in 2021. Investors have lately re-rated BT shares since its own interim results to 30 September, after it guided up profits amid vigorous take-up of fibre-to-the-premises plans. 

Telecoms are going through major upgrading and customer churn as people seek to upgrade broadband connectivity. Another driver is the move from landline phone packages to mobile, which are often twinned with broadband marketing. There looks to be a huge opportunity ahead. 

Enterprising investors such as Toscafund and Penta seek superior returns, not mainstream ones, and likely see a major prize ahead. From TalkTalk’s operational highlights: “The importance of fast, reliable and affordable connectivity has never been clearer”. 

I wager that in five years TalkTalk will have been re-floated or sold on, for handsome profits, unless a rival bidder joins the party before February. 

Debt does not explain drop in Toscafund’s valuation 

The case in support of 97p is that you have to consider debt. The same is being said at AA. And yes, both situations show how ramping up corporate debt – or “optimising balance sheet structure” as bushy-tailed financial advisers would say – is liable to damage shareholder interests.  

Yet TalkTalk’s net debt has risen only 1.4% in the 12 months to the end of September, where it stood at £967 million. That is said to be due to required cash payments linked to a business sale, as well as purchases by an employee share ownership trust.  

Recent financial dynamics not dissimilar to BT 

Both companies have a similar narrative: “we have not been immune to effects of the pandemic”. TalkTalk has seen interim revenue ease nearly 7% to £740 million. Operating profit was down 31% to £20 million, after £9 million costs broadly related to Covid-19. This compares with BT’s 8% interim revenue decline with profit figures typically 20% down.  

It may not be reasonable for TalkTalk to omit full-year profit guidance “due to uncertainty created by Covid-19”. After all, BT – a far larger, more complex group – was able to be specific about upgrading its outlook and its intention to reinstate dividends. 

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It is always tricky from the outside looking in, but the case for 97p being fair might assume the consensus forecast for net profit of around £60 million in the year to March 2021. It would also imply that implied earnings per share of 5.3p means an exit price to earnings ratio of 18.3x. 

Negative net tangible assets but no industrial unrest

Defenders of 97p might also say TalkTalk’s balance sheet has hefty goodwill and intangibles. As such its debt means negative net tangible assets of £326 million, or 28.4p a share, against minus figures of £455 million or 39.7p in September 2019. Yet BT’s balance sheet is shot even worse by intangibles. 

TalkTalk does not appear afflicted by the industrial unrest soon to hit BT, where an indicative ballot for industrial action has received 98% support. If it becomes protracted then it could jeopardise BT’s cost-cutting drive that is central to its investment case. Not least the promise of progressive dividends which imply a base case yield of 5.6%, with its stock currently 138p. 

Toscafund has lurked for over two years

In July 2018 I actually drew attention to a buyout scenario evolving, though reality shows just how long bids can take. 

Toscafund had raised its equity stake from 11% through 16%, and with the chairman having also raised his stake over 30% they both had a powerful combined interest. I suggested TalkTalk was in a timely stage for a buyout following its ‘re-set’. Despite high debt I thought “existing shareholders should remain patient for benefits of the new management/strategy”. 

Indeed, the financial summary table shows a firm turnaround from a £100 million net loss in the March 2018 year. That July I also noted five consecutive quarters of net customer growth, rolling out a network to over three million homes and businesses as “Britain’s leading value provider of fixed connectivity”. Brokers’ analysts were also cautiously optimistic, saying the company had reached the end of its downgrades’ cycle and the narrative had scope to surprise on the upside. 

Remarkable lack of guidance as takeover bid looms

When boards decide they want to remain independent they rarely have any problem marshalling justification for upgrades and why an offer should be improved. 

TalkTalk, GoCo, Codemasters and AA: they all beg the question whether boards are getting complacent at the long slog of building shareholder value. A disturbing trend seems underway of selling out for modest near-term premium. Recent share prices suggest owners are getting some kind of benefit, but over a five-year context TalkTalk fell from 260p to a September 2020 low of 72p.  

My hunch is Toscafund possibly nursing a modest paper loss but seeing an opportunity to regain that and more – by taking control with a private equity partner at what could be a market price nadir. 

Finely balanced, albeit scope for rival offer 

It would appear to depend on whether say a European telecoms company wants to develop a springboard – but obviously Britain is leaving the EU, albeit on currently uncertain terms. A possible alternative is an offer from a US group, if Britain and America are due to forge closer long-term business relations.

A difficulty is Toscafund and Sir Charles Dunstone owning 60% of the equity, quite a hurdle for rebels to thwart the required 75% shareholder approval. It really does depend on a ‘left-side’ industry intervention that I find it hard to judge. 

I did, however, tilt cautiously regarding Codemasters. Yet a 20% higher rival offer has appeared. Traders might therefore do well to watch the Form 8.3 disclosures, where at Codemasters various hedge funds cottoned on to the gaming industry coming up with better terms. There is plenty of time yet, so if the smoke signals portend well then consider a speculative ‘buy’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.