Pacific Consortium may have plan B for Tatts takeover

Tatts board members at its recent annual meeting. Pic: Adam Armstrong

The Macquarie-led Pacific Consortium’s opportunistic attempt to spoil the proposed merger of Tatts group and Tabcorp has failed to get through the starting gates, which isn’t surprising.

Tatts, having spent a little over a week evaluating the consortium’s “unsolicited, non-binding, indicative and conditional proposal,’’ announced today that it had concluded that it wasn’t superior to the Tabcorp merger proposal and could not reasonably be expected to result in a superior proposal.

It has, therefore, decided it won’t grant the consortium access to due diligence or engage in any discussions over the proposal.

While the board’s stance doesn’t rule out the possibility that Macquarie and its partners — a Morgan Stanley-advised fund, KKR and First State Super — might return with a new offer, unless they fundamentally change the structure of their proposal it seems unlikely that they could convince Tatts to alter its opinion.

The problem with the consortium proposal is that it envisaged buying the very attractive Tatts lotteries business for cash while de-merging the rather unattractive wagering and gaming business. It would take the upside of the lotteries business away from Tatts shareholders while exposing them to the downside of a wagering business that has been steadily shrinking.

By contrast, the Tabcorp proposal would see Tatts shareholders gain a majority share of the merged business — 58 per cent of it — and not only maintain their exposure to the lotteries but also to the estimated $130 million a year of synergies from combining the two companies. In what is effectively a reverse takeover they would be paid a premium to end up with a disproportionate share of the merged group.

The Pacific Consortium’s proposed offer was $3.40 a share of cash, including Tatts’ 9.5 cents a share interim dividend — and a share in the de-merged wagering and gaming business that it valued at between $1 a share and $1.60 a share, with the latter value dependent on it being acquired with a control premium.

Tatts, in its evaluation of the proposal and the key assumptions underlying it, concluded that the consortium had over-estimated the earnings of the lotteries business, overvalued the wagering and gaming business, underestimated Tatts’ net debt levels and wasn’t clear about the assumptions it had made about the cost of separating the lotteries and wagering businesses or what the ongoing costs of operating the wagering and gaming entity might be.

Excluding Tatts’ own interim dividend, it said the $3.305 cash share proposed offer for the lotteries unit was inadequate, given the unique and “highly strategic’’ nature of a franchise underpinned by a number of long-term licences that should provide a stable and growing annuity-style income stream well into the future.

Given the nature of the consortium — the members are all financial players rather than industry participants with, unlike Tabcorp, no operational synergies to extract — it was self-evident that their valuation of the lotteries had to be on the low side for them to make the kind of eventual capital gains that players like Macquarie and KKR expect.

Similarly, the $1 to $1.60 a share valuation of the wagering and gaming business looked too high from the outset, given the declining earnings the business has experienced in recent years and the $378 million of debt — plus an undrawn $139 million facility to fund Tatts’ NSW gaming rights payment next year — the consortium envisaged it carrying.

The top end of that range was dependent on the business receiving a takeover bid. Apart from the reality (and one that Tatts noted) that the consortium wasn’t offering a control premium for that business, there could be no certainty that there would be an offer for the business after a demerger.

Tatts made the point that it hadn’t received an approach from a bone fide buyer for either the wagering or gaming businesses in the past two years.

The consortium’s assumption that Tabcorp would gobble up a separately-listed wagering and gaming business to grab the synergies is weakened by the reality that Tabcorp could have approached Tatts to acquire those businesses at any time in the past two years, but didn’t.

It can’t be assumed that it would see paying a big premium for them post a demerger as an immediate and compelling opportunity. Tatts described the consortium’s estimated control price for them as “speculative’’.

Tabcorp’s own proposal, while benefiting from bringing the two wagering and gaming businesses together, is also driven by the diversification of revenue streams and the bulking up of the combined businesses that a largely share-swap merger would create. It wants the lot, not a consolation prize.

In the wake of the Tatts’ assessment of the Pacific Consortium proposal, it would seem that, if it wants to continue to pursue the lotteries business, it would need to do two things.

One would be to significantly lift its valuation of the lotteries business and the other would be to buy the wagering and gaming businesses outright, paying a control premium for them and taking on the risk of offloading them subsequently to an industry buyer.

Even then, given that, unlike the mainly-scrip Tabcorp offer, the absence of capital gains tax rollover might deter many of the largely retail shareholders on the Tatts share register.

There are some smart and determined people within the consortium and they may well have a “Plan B’’ up their sleeve.

If they can’t convince Tatts’ board that their proposal is sufficiently attractive — sufficiently superior to the Tabcorp alternative — to win access to due diligence, however, their attempt to gatecrash what is arguably the most logical and obvious “pure’’ merger in this market is most unlikely to get past the starting post.