PRG-SKE Combined-Co: Some Pro Forma Numbers

The is quite a bit of talk and conjecture about at what price for SKE stock a transaction might be concluded, so I thought I would try to wrap some numbers around the entire situation.

Firstly, thoughts about how likely - or unlikely - an agreement between the two boards might be:  Because the “prize” of combining SKE and PRG businesses is material, I think that there is a high degree of probability (80%, say) that some deal will be done, but I'll preface the evaluation work that follows by stating that I think that the PRG board hold the strategic higher ground.

Put simply, I think SKE needs PRG for more reasons right now, than the other way around.  And I say that as a SKE – and not a PRG – shareholder.

Following on from that, I will also state upfront my view that, from the point of sharing in the accretion benefits of a merger, forget about PRG paying anything near $1.80 for SKE.

On my calculations, at that sort price level for SKE, the accretion to PRG is a mere 5% to 10% (excluding any re-rating benefits for larger market cap, greater stock liquidity, and improved earnings diversity).

My modelling arrives at a figure of closer to $1.56 at which the benefits of any combination of these two businesses is equally shared between both sets of shareholders.

The underlying analysis is as follows:

CAPITAL STRUCTURE:
Market Cap:   PRG = $304m / SKE = $323m
Net Interest Bearing Debt: PRG = $25m / SKE = $185m [FY16 year-end forecasts]
Therefore, Enterprise Value: PRG = $329m / SKE = $507m

(Comment: While PRG and SKE have similar market capitalisation, PRG’s capital structure is far more conservatively set, while SKE is quite aggressively geared, meaning that SKE’s EV is significantly higher than PRG’s. So this is not at all a “merger of equals”, despite the media and analysts describing it that way. It’s a merger of two companies will equivalent market valuations, but with quite different levels of indebtedness, and therefore, Enterprise Values.)


FINANCIAL METRICS (FY16 forecasts):
EBITDA:   PRG = $64m / SKE = $80m
EBIT:   PRG = $53m / SKE = $65m
NPAT:   PRG = $34m / SKE = $40m


SOLVENCY METRIC (FY16 forecasts):
NIBD-to-EBITDA:   PRG = 0.4x / SKE = 2.3x

(Comment: Clearly, PRG’s balance sheet is in far better shape than SKE’s. In fact, I believe I is almost a certainty that SKE’s board will have to cut dividends in order to reduce the company’s debt. Either that, or there is a chance that the company will need to raise new equity capital. For context, the last time SKE raised equity, namely in 2011 when $70m of equity capital was raised, the company’s NIBD-to-EBITDA was 2.2x.)


VALUATION METRICS (FY16 forecasts):
P/E:   PRG = 8.9x / SKE = 8.1
EV/EBITDA:   PRG = 5.1X / SKE = 6.4X
(Comment: While the P/E multiples of the two companies are quite similar, there is a big difference in their respective EV multiples, a reflection of SKE’s higher level of debt.)


Now onto the financial maths relating to a possible combination of the two businesses (COMBINED-CO):

COMBINED-CO CAPITAL STRUCTURE:
Market Cap:   $627m
Net Interest Bearing Debt: $209m
Therefore, Enterprise Value: $836m

(Comment: $627m of market capitalisation, while probably bordering on “mid-cap”, will still be considered by the market as a small cap stock and there is little likelihood of index implications, other than proportionally higher weightings in the ASX Small Cap Index and the ASX200 Index. But I don’t think the creation of a new company will induce any major additional index-related buying.)


COMBINED-CO FINANCIAL METRICS (FY16 forecasts):
EBITDA:   $164m
EBIT:   $138m
NPAT:   $88m

(Comments:
1.  Diligent readers will note that EBITDA, EBIT and NPAT for COMBINED-CO are higher than the sum of these individual values for PRG and SKE on a respective standalone basis. The reason for this is that I have incorporated the full value of the $20m in synergy benefits which should arise from a combination of the two businesses, as cited by PRG, and acknowledged by SKE. NPAT has been adjusted by the $20m figure, net of 30% corporate tax)
2.  This $20m synergy number is, I believe, the driving force behind the likelihood of a deal occurring. The reason I say this is because it is clearly a material quantum in the context of the pro forma merged financial metrics for the two companies. Specifically, to save readers from doing the maths, incorporating the synergy figure results in EBITDA, EBIT, and NPAT for COMBINED-CO being 14%, 17% and 19% higher, respectively, than they otherwise would be.

So the synergy benefits are clearly highly accretive for both sets of shareholders, and the boards of both companies would, I am certain, be aware of it, and the significance of this is why I think some or other deal will ultimately be struck. Indeed, both sets of shareholders would be aware of this, and I strongly suspect it is why the companies have resumed talks about a coming together.)


COMBINED-CO SOLVENCY METRIC (FY16 forecasts):
NIBD-to-EBITDA:   1.3x

(Comment: While SKE standalone is over-geared, PRG’s current capital structure is arguably lazy, that of COMBINED-CO would be far more optimal. This is another factor in favour of a merger.)


COMBINED-CO VALUATION METRICS (FY16 forecasts):
P/E:   7.1x
EV/EBITDA:   5.1x


CONCLUSION:

Clearly, the pro forma P/E multiple of COMBINED-CO is at a significant discount to the current PRG multiple of 8.9x P/E (The reason the PRG multiple is used as the reference point is because the PRG entity will be the listed vehicle for the combined company, presumably.)

Which means that – if PRG effectively acquired SKE at today’s share price - the value accretion to PRG shareholders is 25% (derived by: 8.9 divided by 7.1).

Of course, the PRG board might argue that SKE’s share price is where it is today exclusively due to the approach made by PRG and that, in the absence of such an approach, SKE would be trading closer to $1.20, where it was before the PRG approach. That means valuation accretion to SKE shareholders of 15% ($1.38 divided by $1.20).

So, doing the deal current share prices, means that PRG shareholders receive a disproportionate share of the upside from a merger, compared to SKE shareholders (24% vs 15%)

The equilibrium point - i.e., where both sets of shareholders benefit equally - is at a transaction price for SKE of $1.46/share.

Of course, this analysis ignores the potential for any upwards re-rating of COMBINED-CO, due to greater operational scale, larger market capitalisation and improved stock trading liquidity, as well as improved earnings diversity.

In my experiences of these situations the market often affords a 10% to 15% higher P/E multiple to the rating of the merged company, so instead of PRG’s P/E of 8.9x, it might reach 10.0x post-merger.

In this case, if the transaction was to be concluded at current share prices of the two companies, the value accretion to PRG’s shareholders would be a whopping 40%. (10.0x divided by 7.1x).

And in this higher P/E multiple rating case, the theoretical equilibrium point (where both shareholders benefit equally) is a share price of $1.57 for SKE. That would deliver ~30% valuation uplift for both shareholder groups.

The good news is that this tells me that there is scope for the PRG board to agree to a bid sweetener (of some 10% to 15% from the current SKE share price), without opening itself up to criticism of excessive value transfer to SKE shareholders.

But getting back to the $1.80 takeover figure bandied about (which equates to 50% valuation increase from SKE’s $1.20 price, pre-approach), plugging that figure into my COMBINED-CO valuation template yields 7% valuation uplift for PRG shareholders (assuming no upwards re-rating) and 20% value enhancement assuming a re-rating to 10x P/E.

I think the PRG board will get crucified by its shareholders if it agrees to transfer that much wealth to SKE’s shareholders, at $1.80/share!

And at $2.00/share the relative value accretion is just 13% for PRG shareholders, compared to 67% for SKE shareholders. Forget about this possibility. It is simply never going to happen.


[Note: Like all exercises of this nature, its findings are intended to be prescriptive, rather than definitive, as merger accounting can be complex and defining who needs who more in such a situation invariably involves highly subjective opinions.

The analysis is quite simplistic and the assumptions quite general.

So please don’t hold me to account if things transpire differently to any of the assessment conducted above.

Hey, the PRG board might even experience a rush of blood to the head and pay up more for SKE than the $1.57 full value price scenario I envisage. Or the SKE board might get desperate and agree to a lower price. In fact, they entire deal might not occur at all, although, as I have explained, I think the odds of this are low given the prize is in terms of valuation accretion is somewhat juicy, potentially.]