Stockwatch: A mega-merger worth backing

Which shares are performing well in the 2016 rout? A general sell-off is always interesting to highlight perception of improved fundamentals. January did see some retreat in the shares of high street bookmaker Ladbrokes, from 123p to 115p, but in the last fortnight they recovered to test 127p and are currently at 122p.

The recovery trend since last October is intact, as if a further vote of confidence in the £2.2 billion merger with Gala Coral Group, after 96.4% of voting shareholders approved it last November.

No fresh news on trading has been released, the next item in the calendar being prelims on Tuesday 23 February. But in December the chairman bought 30,000 shares, and another non-executive director 50,000 at prices just over 116p, underlining their belief the deal will deliver value.

Brokers upgrade forecasts

The conservative approach in such a situation is to await trading results, if not proof the alleged merger benefits will flow. But from the range of broker upgrades, it appears market opinion is improving, overall. Figures behind consensus forecasts in the Company REFS table range widely and originate since August.

However, on 15 January, Investec Securities issued a 'buy' note looking for £97.8 million pre-tax profit in 2016, for earnings per share of 8.65p and a dividend of 3.9p - i.e. a price/earnings multiple of 14 times and 3.2% yield. This followed Numis Securities upgrading from 'hold' to 'buy', with a price target of 150p, and Credit Suisse upgrading from 85p to 130p.

On the flipside, however, Liberum Capital has initiated coverage with a 'sell' stance targeting 106p. So, opinion remains mixed if generally supporting the non-executive directors' confidence.

Regulator inquiry

On 11 January the merger was referred to the UK's competition regulator for a more detailed investigation, with a "statement of issues" due anytime now and completion by 24 June.

The Competition and Markets Authority (CMA) had initially said the tie-up risked "a substantial lessening of competition" in fixed odds betting on the high street and will now investigate the effect on sports betting in shops. The operators' defence has been to emphasise a shift to online gambling, as if competition between shops is too narrow a focus - and closing a proportion of them will meet any regulatory concerns.

Attention, therefore, is on how many shops the CMA stipulates to be sold - recent speculation being 400 to 500 - which would mean some reduction in synergies from the merger. Ladbrokes Gala Coral would still become the UK's largest gambling group, with possibly 4,000 shops, relative to William Hill with about 2,300. So there is an element of regulatory risk to the deal finalising, albeit manageable.

Perception of debt improves

Scepticism has existed as to whether the merger mainly benefited Coral's private equity owners to exit gracefully after saddling that company with debt (as they do).

According to last July's presentation on the merger, illustrative operating cash flow for the enlarged group was put at £280 million versus nearly £1.3 billion net debt and, last October, Ladbrokes signed a £1.35 billion facility with a syndicate of banks enabling a progressive drawdown of tranches to June 2019, saying: "we believe this facility will provide sufficient liquidity to an enlarged group following the merger."

Coral's chief executive Carl Leaver has claimed that debt will reduce as a result of strong cash flows, and his annual results to September 2015 showed a net £240 million net cash inflow from operations, up 17%, while Ladbrokes' first-half 2015 results saw a previous £35 million net cash outflow become a £516 million inflow. The presentation anticipated "rapid deleveraging", with a medium-term target of net debt being 1.5 to 2.0 times operating profit.

Huge profit predicted by 2018

The hope is a dual Ladbrokes/Coral brand achieving faster online growth and also cross-marketing. Strong operations in Italy, Belgium in Spain - also rapidly growing online in Australia - look like a platform for international growth and at least £65 million of estimated annual cost savings. A £500 million operating profit is targeted for 2018, too.

All this obviously takes some leap of faith and not all mergers deliver what they promise, but the steady rise of Ladbrokes' shares this year shows increasing confidence in this scenario.

Meanwhile Ladbrokes' last trading update for June to September showed 2.0% progress in group revenue, within which a 10.5% growth in digital offset a 4.6% fall in European retail, while UK retail edged up 1.1% - all this involving adjustments for the effects of the June 2014 World Cup.

Otherwise, like-for-like operating profit slumped from £33.0 million to £14.3 million, on group revenue down 0.7%. It was the kind of release that begged more radical action, in part justifying the Coral tie-up. Organically, Ladbrokes said it was in the early days of a plan to aggressively invest in growing customers, that there had been higher staking. However, operating profit had been hit by higher taxation, besides increased marketing spend.

Shares demand leap of faith

Ladbrokes and the intended merged entity do not have sufficient net tangible asset backing or (as yet) extent of dividend yield support, to limit downside risks. Yet the true prize lies ahead of current forecasts and price targets - both quantitatively and time-wise - as gambling consolidates into fewer global businesses, mainly online.

So, while it's possible to pick flaws in this merger and the accounts look complex to put together, strategically it appears the right move. It's why the non-executive directors have backed it with their own money and Ladbrokes' share price is in a rising trend despite the wider bear market.

It's a sketchy prospect, but if the merger works then the stock has plenty more upside. The shares are worth watching, therefore, for opportunities to accumulate in a volatile uptrend.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.