Ladbrokes (LSE: LAD) has confirmed that it is holding talks with Gala Coral about a merger deal, news of which has pushed up the equity valuation of Ladbrokes by 10% in early trade on Tuesday.
My take: upside over the short term could be much greater if Ladbrokes management negotiates favourable terms for its shareholders. Over the long term, though, much of its fortunes depend on whether the market leader, William Hill (LSE: WMH), will react to Ladbrokes’ move.
Merger Terms
There’s no certainty that the deal will go through, but if it does, one element becomes very important to determine the value of the combination, and is partly contained in the statement released by Ladbrokes.
“Ladbrokes (…) may undertake a non pre-emptive equity placing to strengthen the balance sheet of the combined entity,” it said.
How much, though?
It’s all about managing expectations about the structure of the merger at this point in time.
The balance sheet of Ladbrokes doesn’t look too bad, but its income and cash flow statements have been under the spotlight for some time, given that flat revenues and lower profits have characterized the last few years of trade.
Why A 10% Rise?
The rise in its stock price today reveals the possibility that negotiations will lead to assign to Ladbrokes stock a significant premium against Coral based on the relative valuation that each company may fetch.
Ladbrokes has a stronger track record and is a listed company. A large premium — one higher than today’s 10% rise, say 20% or more — could be justified in the light of Coral’s growth profile and its higher net debt pile, which implies net leverage in the region of 13x (Ladbrokes targets net leverage of between 1.5x and 2x).
A back-of-the-envelope calculation suggests that to bring net leverage down to a more appropriate level of 5x, the combined Ladbrokes/Coral entity would have to raise new equity of between £500m and £700m, but that amount could be up to £100m lower, assuming synergies at between 5% and 10% of Coral’s revenues.
The low end of that range would equate to 30% of the enterprise value of Ladbrokes.
William Hill
Ladbrokes appears to be in the driving seat, and it seems unlikely that regulatory hurdles — which prevented a deal between the two in the late 90s — will scupper its ambitious plans. Also consider that if it doesn’t strike a deal with Coral, it could easily approach William Hill, although such a move would be less appealing for its shareholders and may require regulatory scrutiny.
Inevitably, the spotlight is now on William Hill (+0.8% on Tuesday), given that the combination between the second and the third largest betting players in the industry would place a huge amount of pressure on the market leader, whose shares have benefited from troubles at its smaller rivals in the aftermath of the credit crunch but have traded in the 350p/400p range for a couple of years now.
Based on its growth pattern, fundamentals, trading metrics and other key variables, William Hill looks priced around fair value right now, I’d argue.
Will it seek partners if rivals join forces?
If so, Paddy Power would become the obvious target. A couple of analysts I talked to this morning pointed out that a Ladbrokes/Coral tie-up could change the dynamics of the betting industry, but I still have to be convinced that the risk associated to the investment is worth the pain — in fact, Ladbrokes may not be worth your money if Coral fights hard to receive a premium valuation.