On June 7, 2017, Kohlberg Kravis Roberts & Co. (KKR) made an unsolicited proposal to purchase 100% of Vocus Group Limited's shares for $3.5 per share in cash. The plan makes several assumptions such as the net debt for 30th June 2017 is less than $1.1 billion and the earnings before interest, taxes, depreciation, and amortization are between $365 and $375 million. The board of directors established an independent board Committee to evaluate the proposal and develop a response strategy for both the board and the shareholders. Vocus group is a telecommunications firm that operates mainly in Australia and New Zealand. It offers data network solutions, cloud services, and unified communications solutions. The company has two business units: the corporate wholesale unit which deals with organizations while the broadband and consumer units offer internet solutions to individuals. The company also participates in international business by providing internet protocol services and connects Singapore and the U.S with submarine cable capacity.
KKR sees an opportunity to revive the fortunes of Vocus Group. Vocus Group over the two last years has merged with Amcom, M2 Group and recently acquired Nextgen. However, the company has faced challenges in integrating the entire business. As a result, its earnings have been adversely affected, and the investors’ expectations have not been met causing the stock price to drop. Vocus Group has a broad set of assets: the fiber infrastructure in the main Australian cities, the data centers, and the expanding international business. Therefore, given the well-developed infrastructure, KKR sees an opportunity to drive growth in the company by improving management’s efficiency.
Valuation Analysis
The dividend discount model estimates the intrinsic market value of Vocus Group Ltd. equity shares at $2.7699. The residual model gives an estimate of $3.5852. The free cash flows to equity discount model give an intrinsic value of $60.09. The price/earnings multiple intrinsic value is $5.1967, the price/book multiple gives a value of $3.8844, and the price to sales multiple gives an intrinsic value of $5.1407.
From this information, the valuation range for Vocus equity share is between $2.7699 and $5.1697. The average valuation is $4.1100, the mid-point valuation is $4.9698. Therefore, Vocus Group shares trading at $2.86 is within the stock’s valuation range. The reasonableness of the $3.5 offer price is assessed using the acquisition multiples and bid premium. The price based on the offer price/earnings per share multiple is $4.4369, the price/book multiple gives the value of equity as $6.8650, and the bid premium offers a price of $3.5993.
From the acquisition multiples, the offer price of $3.5 is lower than the indicative range of $4.4369-$6.8650. Also, the offer price is less than the intrinsic value of the company’s equity shares, and therefore, the offer price is “not fair.” Just over one year ago, the share price was $8.52, and this makes the offer by KKR appear as being too low. Such a low bid price makes a person forms the conclusion that Vocus group is a company on its deathbed but as the financial analysis in the next section will show, the company still has massive growth opportunities in Australia and New Zealand.
The bid-premium offered by the tender price also appears less than the average acquisition premium of 25.6405%. Also, the offer price of $3.5 is lower than the notional offer price with a mean premium of $3.5993. The implication is that the bid premium provided by KKR falls behind the industry average. A reasonable price must be relatively similar to previous acquisition premiums, and in this case, the $3.5 falls short of the sector’s premium of 25.6405%. Therefore, this suggests that the offer is “not reasonable.” The overall recommendation after combining these two elements is that the cost offered in the acquisition proposal is: “not fair and not reasonable.”
Performance and operational analysis
The negative share return and price earnings ratio as well as decreasing market to book value evidences declining market valuation for Vocus Group. The negative gross profit margin, net profit margin, return on assets, and return on equity is an evidence of declining performance. Vocus group financial risk is low as evidenced by the declining ratio of the total liabilities to total equity as well as the ratio of long-term debt to the total assets. The increasing ratio of the share capital to total equity is increasing is evidence that the company places greater reliance on using equity as its source of external financing. However, the declining current ratio and quick asset ratio may point out to liquidity problems in the future as Vocus Group may fail to meet its short-term obligations.
The increase in the ratio of property, plant, and equipment (PPE) to the total assets indicates that the company has been building up investments its PPE, and such include data centers and fiber infrastructure. The total asset growth exceeds the revenue growth, and this is an evidence of declining asset efficiency, a fact supported by the asset turnover ratios which are less than 1 (shows that assets are not generating sufficient revenues). Also, the significant increase in the ratio of operating expenses to the income indicates declining efficiency in the core operations/activities of the company.
The negative ratio of free cash flows to total assets is an indication of weak management over the capital expenditure as well as the existence of the directorate related agency problems. Therefore, the low market to book ratio, low asset efficiency, increasing ratio of operating expenses to revenues, are indicators that the management is inefficient and underperforming. These underperformance indicators represent the source of value creation for KKR, and it should embark on replacing the underperforming managers, putting in place monitoring mechanisms, and introduce internal control reforms to improve asset management and process performance. Also, KKR should resolve the management agency problems as well as the agency conflict between the shareholders and Vocus Group.
Appendix
Valuation
Discounted Dividend Model
D2017=0.06
D2018=0.06*(1+0.05)=0.063
D2019=0.063*(1.05)=0.06615
Long-term growth in dividends=5%
Risk free rate=2.675%
Vocus Beta= 0.61
Market return=0.09976
Ke=0.02675+(0.09976-0.02675)*0.61=0.07129 (7.129%)
PV of dividends after 2019 (P2020)=(0.06615*1.05)/(0.07129-0.05)=$3.2624
P2018=(0.063/1.07129)+(0.06615/1.071292)+($3.2624/1.071293)=$2.7699
Residual Earnings model
Long-term growth in earnings=4%
BV of Vocus group equity at end of 2017=$2,303.124 million
RE2018=(0.25*670)-( 0.07129*2303.124)=$3.3103 million
PV of future residual earnings after 2018=(3.3103*1.04)/(0.07129-0.04)=$ 110.026million
V2018=$2,303.124+(3.3103/1.07129)+(110.026/1.071292)=$2402.084
P2018:25402.084/670=$3.5852
Discounted Free cash flow: Free cash flows to equity
net income
-1,439,202,000.00
less (capital expenditure plus depreciation)
-305,978,000.00
less change in non-cash working capital
76,050,000.00
add new debt issued
202,567,000.00
less debt repayment
0.00
Free cash flows to equity
-1,259,741,000.00
Equity value per share = [FCFE/Ke-g]/number of shares
Ve=[1259741000/(0.07129-0.04)]/ 670 million=$60.09
2016
2017
non-cash working capital
-195,509,000.00
-119,459,000.00
Valuation Multiples Technique
Price earning multiple (market capitalization/net profit)
Price/book value
Price/sales
MNF Grp
25.3136899
4.653331
1.65860695
Spark NZ
30.4875088
4.25106
1.90973186
Telstra
12.104708
3.453618
1.97364854
TPG Telecom
14.8080119
8.186332
2.02541951
Average
20.6784797
5.136085
1.89185171
Valuation of Vocus Group using overall average (However, for the P/B, the Australian average of 1.113 is used)
P/E multiple: P2018=20.6785*0.25=$5.1697
P/B: P2018=1.113*(2303.124/670)=$3.8844
P/S:=1.8919*(1820.5770/670)=$5.1408
Outcomes across the various models
Discounted dividend valuation = $2.7699
Residual earnings valuation = $3.5852
Discounted Free cash flows from equity=$60.09 (ignore)
P/E multiple valuation = $5.1697
P/B multiple valuation = $3.8844
P/S multiple valuation = $5.1408
Valuation range; $2.7699 to $5.1697
Average valuation: (2.7699+3.5852+5.1697+3.8844+5.1408)/5=$4.1100
Midpoint valuation: (2.7699+5.1697)/2=$3.9698
Acquisition multiples
The average acquisition multiples and bid premiums will be used to assess the reasonableness of the $3.5 offer. The expectation is that the acquisition bid for Vocus Group will be priced at a similar level to the past acquisitions
Target company
Offer price/book value
Offer price/ (earnings per share) EPS
Bid premium offered
Clever Communication
1.57
10.187
28.574%
Inabox Group
2.632
13.866
15.55%
M2 Group Ltd
1.28
26.014
28.651%
BigAir Grp Ltd
1.91
20.923
29.787%
Average
1.848
17.7475
25.6405%
Offer price/EPS multiple: P2018=17.7475*0.25=4.4369
Offer price/book value= 1.848*(2303.124/670)=$6.3525
Based on the average bid premium, P: 2.86*1.256405=$3.5933
Performance and Financial Analysis
performance indicators
2013
2014
2015
2016
2017
Share return (%)
126.6667
21.21849
47.66031
-60.446
market/Book value
2.2523
3.1550
2.9845
1.4179
0.9072
Gross profit margin (%)
33.41
36.05
38.37
28.30
-64.32
Net profit margin (%)
13.14
14.85
16.63
12.62
-79.05
ROE (%)
12.2944
9.9392
12.6239
3.3051
-62.8912
ROA (%)
5.2101
6.4342
6.4623
2.2350
-34.500
P/E ratio
18.2610
32.8280
23.4680
42.8140
-1.4520
structural indicators
2013
2014
2015
2016
2017
current ratio
0.70
2.13
1.03
0.83
0.83
quick ratio
0.70
2.13
1.03
0.80
0.83
PPE/total assets (%)
30.28
29.92
53.38
11.13
36.99
Total liabilities/total equity (%)
135.9721
54.4748
95.3455
47.8764
81.1277
Long-term debt/total assets (%)
33.9806
19.7954
30.7710
18.5850
25.5494
Share capital/total equity (%)
64.8225
71.90134
73.50425
97.68304
163.9006
Growth and efficiency indicators
2013
2014
2015
2016
2017
Revenue growth (%)
28.10
32.89
42.90
80.97
53.26
Total asset growth (%)
81.05
26.31
80.97
1,124.49
-11.13
Asset turnover
0.3965
0.4332
0.3887
0.1768
0.4364
Operating expense/revenue (%)
64.20
64.24
64.70
72.39
164.31
Free cash flow/total assets
6%
-1%
4%
6%
-25%
