November 19, 2000

Bidding for Eircom without looking under the bonnet

Posted in Banks ·
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“Pristine condition, 12,000 miles, one elderly lady owner, garaged all winter, a must view for quick sale”. Yeah right, one owner, elderly lady, where have I heard that before?

Oddly enough, a leveraged buyout (LBO) in the corporate world — where one company borrows significantly to take over another one, such as Denis O’ Brien’s bid for Eircom — is not a million miles away from buying a used car.

Eircom’s annual report can be regarded as a classified ad. Like ads, company reports try to paint as flattering a picture as possible, although a savvy buyer knows that the numbers can convey almost anything a clever accountant desires.

The car buyer needs to find out much more than what the ad tells him. He needs to go around to the owner, kick the tyres and have a look under the bonnet. Typically, he’ll bring his mate, who knows a thing or two about cars, for a test drive, have a gander at the breaks, engine, panels and wheels.

Likewise, a corporate takeover specialist needs to have a similarly thorough look at the target company. He needs details about how much debt the company can bear, where cuts can be made, what divisions to close down and which parts of the business can be sold to pay off debts.

In the case of a used car, the buyer has to make a calculation as to how many miles are left in the motor. How long will it last him? What spare parts are needed, how much maintenance is involved? He needs to estimate what the resale value might be somewhere down the line.

The same goes for the takeover specialist. His margin of error is so fine that the financial equivalent of a faulty gear-box will be enough for the bank to call in his loan. In an LBO situation, one over optimistic forecast is enough to fell the buyer in a avalanche of debt.

Going back to Eircom, we see Denis O’Brien putting in an offer without even kicking the tyres. The little old lady won’t allow him near the garage, let alone under the bonnet. Eircom’s management, by refusing to cooperate with O’Brien, has ensured that he’s buying straight from the classified ads. It is the management who knows precisely where all the financial bodies are buried and where the company can be squeezed. The mangement is on the inside and, in this type of deal, information is king. In many ways Denis O’Brien is on the outside looking in and, if Tony O’Reilly does get involved, he’ll also be on the outside.

However, both men have a couple of aces up their sleeves. They could always buy off the present management to get on the inside. Typically, in leveraged buyouts, a significant amount of stock is set aside for management over a three-year lock-in period.

Despite the fact that Alfie Kane and his team have been much criticised, it is difficult to see what they could have done when faced with fickle financial markets turning against the telecom sector. Just look at the bombing share prices of Deutsche Telekom, BT and KPN for example. It is a decent management team and it might be in the predators’ interests to keep the team sweet prior to a bidding war. Expect some juicy packages to be waived under a few noses in the weeks ahead.

Another ace is the cheap price. Experts say the company is going for a song. Valuations are notoriously difficult to get right, but Dublin brokers indicate that Eircom’s earnings before tax, interest and depreciation — Ebitda in the jargon — is around �850 million.

This implies that O’Brien’s bid of �2.5 billion would allow him, if he wanted, to pay all the debt out of profits in a little over three years. Even if O’Reilly came in and a price war ensued, the price of Eircom still compares favourably with that of Eircell; on current earnings, it will take Vodafone 22 years to get its money back from the Eircell deal.

Therefore, it seems that the markets, with their mobile infatuation, have got it wrong by being wildly optimistic as to the prospects of Eircell and profoundly pessimistic about Eircom. Only time will tell, but it is clear that the “cheapness” of Eircom depends on how long you think the fixed-line company can continue making bundles of lolly. This largely depends on whether it can keep the competition away from its fixed-line infrastructure.

Although technically there is an increasing amount of competition (termed “unbundling the local loop” in jargonese), Eircom can still obstruct this process by refusing to cooperate.

In the US, to prevent the incumbent company obstructing a new entrant’s access to the existing fixed-line infrastructure, the regulator appoints a referee who can “red card” the incumbent if it is seen to be prevaricating.

However, no such on- the-spot referee has been appointed anywhere in Europe. Unless our regulator reacts and appoints a referee, O’Brien and O’Reilly may well see Eircom making buckets of cash for some time yet.

Finally, since an LBO is all about borrowing as much as possible — typically 80 per cent of the entire transaction — the predators’ cost of capital is hugely important. Here again, O’Brien/O’Reilly might have luck on their sides.

Despite a huge increase in debts incurred by telecom companies across Europe, such companies have hardly been downgraded by the credit rating agencies which seems very odd, particularly as the finance industry describes the debt of European telecoms companies as junk bonds.

Arguably, the interest rate that telecoms companies are charged is much lower than it should be. O’Brien and O’Reilly probably know this. Even if they borrowed extensively for Eircom, they might be able to engineer junk bond financing at investment grade interest rates.

Even Michael Milken, king of the late 1980s US junk bond market, would be proud of such a stroke.

Despite all these permutations, when the gloves come off, the bid will still be like a used car sale. Everyone knows what’s in the classified ads but only insiders have a feel for possible nasty surprises.

O’Brien knows this game and with the management not yet playing ball, is it any surprise that O’Reilly is rumoured to be waiting for a big industry insider to come on board before he reveals his hand?