Stockwatch: Tie-up is best option for this share

Is this the best way forward for Ladbrokes, out of a corner, or wishful thinking in a bullish context for mergers and acquisitions, without sufficient regard to the regulatory hurdles? It's a risky situation, but merits attention for trading opportunities and a longer-term gamble if a deal happens. Initial signs are, the city reckons a combination makes sense: the shares jumped from about 120p to 140p on news of merger discussions. However, they then slipped to about 132p as doubts crept in - if the two sides can initially agree, this will take time to get any approval from the competition authorities.

I drew attention four months ago at 117p sing the rationale that a 7.8% prospective yield was risky but helped make the stock interesting even with a reduced payout. The crux was Ladbroke's strategy going forward, with a review underway. A radical aspect to this review is talking to Gala Coral, a similar bookmaker owned by Candover Investments (CDI), the listed private equity group which will likely prefer a sale than trying to float Coral independently. Ladbrokes' outgoing chairman had been in touch with Coral's, this is no impulsive move by a new CEO (Ladbroke's previous chief of digital).

Need for industry rationalisation favours a deal

The businesses are of fairly similar size where Ladbrokes achieved nearly £1.2 billion of sales last year relative to £1.6 billion for William Hill, also in the Mid 250 index. A Ladbrokes/Coral merger would create the UK's biggest bookmaker owning about 4,000 of the country's 9,000 betting shops - with scope to cut head office costs, share platforms/marketing, and close shops where there is high street overlap (a means also to gain regulatory approval). Both firms need better scale online where the future largely rests, e.g. a combination would boost online marketing spending where the trick is to capture customers via sports betting and tempt them into higher-margin casino games.

Merrill Lynch estimates that a 5% saving in the combined operating cost base would equate to 20-25% of the firms' combined 2014 operating profit. While only a teaser that needs proper context, it implies a boost to medium-term profit. There is talk how "applying a William Hill type valuation" (i.e. a forward P/E multiple in the mid-teens) derives a share price target of 150p.

Substantial debts imply share issue

A "merger" would likely involve a reverse takeover of Ladbrokes by Coral with a share issue to mitigate debt: Coral is estimated to have net debt around £840 million versus £420 million for Ladbrokes, whose end-2014 balance sheet had £742 million goodwill and intangibles relative to £391.7 million net assets. So with interest rates possibly rising in 2016, the combined entity would need extra equity - a risk being that institutions knock down any placing price, especially if taking on the majority of Candover's stake in Coral.

Probably an open offer would be avoided on grounds it would take too much time, additional to getting regulatory approval. Institutions might therefore "average down" on the current market price for Ladbrokes and take it down a notch also, while private shareholders would be frozen out. While a cynical view this may be realistic, and why individuals might be better to take a "hold" stance for now and see what gets proposed. With patience it is possible Ladbroke's shares (or those of a combined group) are worth accumulating, respecting financial benefits from a merger.

Wider context favours odds of cutting a deal

Financiers will already be attuned. Takeovers are a means to address tougher regulation and taxes on the industry, e.g. last December's levy on online bets placed in the UK. The wider business cycle is maturing into a classic phase of mergers and acquisitions as firms look for additional means to bolster revenues, and buoyant stockmarkets enable equity financing without excess dilution. The second quarter of 2015 saw global M&A nearly match the record set in the second quarter of 2007. So if the two companies can't strike agreement now and get it past the regulators, they never will.

Near-term shorting opportunity

Traders who are sceptical might consider a short position as Ladbrokes' stock would likely drop in response to "talks off". Forecasts have been clipped since the end of April - first-quarter 2015 results noted "some encouraging customer metrics", but sporting results favoured customers and the CEO admitted: "We need to change the way we run the business, build scale, primarily in Digital and respond faster to the customer and changes in the market place."

The 2014 consensus pre-tax profit expectation has slipped from £82.3 million to £66.4 million, with earnings per share down from 7.9p to 6.6p and the dividend from 8.5p to 8.2p - an unrealistic payout for the longer run, on current evidence. Mind that within the consensus, Peel Hunt looks for only a 3.1p total dividend this year, rising to 3.7p in 2016 (yet this broker still advocated 'buy' when publishing on 4 June), while Numis Securities looks for 8.9p in both years ('hold' stance, 23 June). In the short to medium term, much therefore depends on the dividend for defining a support level.

It also puts a lot of emphasis on the strategic review - presentation currently deferred - if merger talks fail. Details are leaking out nevertheless, such as using wi-fi enabled betting shops to sell online offerings, investing in the better-performing shops and improving the marketing of digital products. While probably beneficial, these measures are piecemeal compared with the riskier, more opportunistic tie-up with Coral. That seems the best gambit for a financial breakthrough.

For more information see ladbrokesplc.com.