Is BT Group plc’s EE Deal Off The Table?

According to talks in banking circles in the City of London, BT Group (LSE: BT-A) (NYSE: BT.US) is finding it more difficult to strike a deal with EE… although the odds are still short that the tie-up “will likely be completed in the next 30 days,” I hear.

It is important that BT wraps the deal as soon as possible at a fair price, or its equity valuation may come under pressure in coming weeks. Even then, I reiterate my stance that I would not buy Vodafone (LSE: VOD) (NASDAQ: VOD.US) instead!

12.5 Is Not The Magic Number

The purchase price of £12.5bn for EE is not in the best interest of BT shareholders, as I argued last month. That view was shared by analysts at Deutsche Bank, who argued that BT’s proposal for the UK mobile network operator was “more expensive than expected” soon after the possible tie-up was announced.

Sources now suggest that BT management haven’t ruled out a takeover of O2, which would cost at least a couple of billion less than EE. Is this good news?

Surprise, Surprise!

The best way for BT to surprise investors — and for its shares to appreciate fast, of course — would be to announce to have agreed a deal with EE at £10bn, which would be a fair take-out price based on EE’s fundamentals and the implied valuation of the target, excluding possible cost and revenue synergies. 

Since EE’s indicative proposal was announced in mid-December, BT stock has gone nowhere and has traded broadly in line with the market. It’s clear investors are not willing to bet on BT if it splashes out £12.5bn for a target that would allow it to become a fully fledged quad play, but would also heighten the risk associated to the investment case as well as the risk that dividend growth may slow in the future after a stellar growth rate in the last few years. 

Valuation

This week, French broker Societe Generale argued that BT — whose stock trades at about 400p — could be worth 480p share. Such a valuation of BT’s equity stands between the average price target (436p) from brokers and top-end estimates (525p). A price target of 440p/460p makes a lot of sense in 2015, but only if BT pays a fair price for EE, I’d argue. 

BT shares currently trade at a price-to-earnings ratio of 15x and 14x for 2015 and 2016, respectively, which says a lot about why BT may have to splash out top dollar to secure EE’s earnings and synergies potential in the next 24 months — although, based on adjusted cash flow multiples, a 20% discount to EE’s mooted takeover price should be warranted. 

Elsewhere (still talking about premiums), Vodafone trades at a 20% premium versus BT, based on adjusted operating cash flow. The average price target from brokers for Vodafone is 233p, just 7p above Vodafone’s current stock price. If bullish estimates are right, however, upside could be as much as 26%, for a price target of 285p a share.

I think most analysts underestimate the challenges that Vodafone will have to face in months ahead, so I reiterate the view that I’d add the stock to my portfolio only if it drops to 180p.