Mitel, Polycom: Don't Buy The Merger Yet

| About: Mitel Networks (MITL)

Summary

Mitel Networks is acquiring Polycom in a deal which brings much needed scale.

The company will be able to reduce relative leverage ratios, as the deal takes place at relative appealing valuation multiples.

While investors in Mitel should applaud the deal given the synergies, improved positioning and reduced leverage, I still have some concerns.

This follows the fact that the company remains relatively small in a competitive landscape, as technological developments bring risks as well.

Mitel Networks (NASDAQ:MITL) agreed to acquire Polycom (NASDAQ:PLCM) in a near $2 billion deal. With the deal, the combination will gain much needed scale in an industry which needs to consolidate, at least according to activist investor Elliott Management. It is Elliott who urged for these two players to combine their operations. This followed the fact that the activist announced an equity stake in both firms, back in October of 2015.

While improved scale is much needed for both of these firms, I am not tempted to buy into this merger story despite the anticipation of sizable synergy estimates. Fierce competition and rapid changes in the technological landscape make that I remain cautious, for what is still a smaller player.

The Deal

Mitel has agreed to buy Polycom in a $1.96 billion deal. Investors in Polycom stand to receive $3.12 in cash and 1.31 shares in Mitel for each share which they currently own, equivalent to a $13.68 per share purchase price.

It is very clear that the main rationale behind the deal is increased scale, inspired by Elliott´s involvement. Mitel´s management recognizes the very intensive competitive environment and the fact that technologies and markets are no longer subject to barriers, as has been the case in the past. Following the deal, the combination should be able to more effectively operate in the converging markets for seamless communication and collaboration.

This is exactly the reason why Mitel itself has been active with regards to acquisitions in the past. In the period 2013-2015, Mitel bought PriarieFyre, Aastra, Oaisys, Mavenir and TigerTMS.

This dealmaking and organic growth allowed Mitel to expand its revenue base from $400 million in 2006 towards $1.1 billion at the moment. While growth looks appealing, Mitel has issued a lot of shares and debt in order to finance this growth, a key reason why investors have not benefited from this growth. Shares still trade below the levels at which shares traded immediately following the IPO back in 2010.

What About The Deal Multiples?

Mitel reported revenues of $1.16 billion for 2015, up modestly compared to the year before. The lack of scale, restructuring charges and competitive environment has pressured the profitability of the firm. As a matter of fact, Mitel reported a GAAP loss of $21 million. It should be said that this number did include some amortization charges as well as restructuring costs of $55 million. Excluding these and other items, adjusted EBITDA came in at $168 million.

Past dealmaking has resulted in a leveraged balance sheet. Mitel ended last year with merely $92 million in cash and equivalents while total debt stood at $645 million. This net debt load of roughly $550 million translates into a 3.3 times leverage ratio in comparison to reported adjusted EBITDA. If you take into account $127 million in pension liabilities, the leverage ratio approaches 4 times.

The 125 million shares outstanding traded at around $8 before the deal has been announced. This translates into a $1 billion equity valuation, thereby valuing the entire business at roughly $1.6 billion if you include the net debt load. This is equivalent to 1.5 times sales and roughly 10 times EBITDA.

While Mitel is the surviving entity, it is more or less clear that this deal is a merger, given that Polycom´s nearly $2 billion price tag surpasses the enterprise valuation of Mite. Polycom posted sales of $1.27 billion for the year of 2015, although these sales are coming under pressure. Full year sales fell by 6%, with revenue trends accelerating for the worse as fourth quarter sales fell by 9%. Unlike Mitel, Polycom remains solidly profitable as lower restructuring costs were the driver behind an increase in earnings, with the bottomline showing a $69 million profit. The company reported adjusted EBITDA of around $200 million last year.

While the reported deal tag comes in at $1.96 billion, it is important to realize that Polycom has a very strong balance sheet. The company holds $620 million in cash, equivalents and marketable securities while debt levels stand at merely $230 million. This net cash load reduces the effective purchase price towards $1.57 billion. Based on this number, Polycom is valued at 1.2 times sales and roughly 8 times adjusted EBITDA.

The Pro-Forma Business

If you simply add up the financial performance of both businesses, the new Mitel will post sales of little over $2.4 billion per annum, with adjusted EBITDA amounting to $370 million. Based on the modest losses of Mitel, and the profits reported by Polycom, net earnings are seen at little less than $50 million per annum.

If you take into account the $550 million net debt load of Mitel and the $390 million net cash position of Polycom, the pro-forma business operates with a net debt load of $160 million. Mitel has however agreed to fork over $3.12 per share in cash to investors in Polycom, equivalent to roughly $400 million. This jacks up the net debt load towards $560 million, or nearly $700 million if you include pension obligations.

With $370 million in combined adjusted EBITDA, the combination operates with a leverage ratio of roughly 2 times adjusted EBITDA. This does not take into account the anticipated synergy benefits resulting from the deal.

Mitel will need to issue some 180 million shares in relation to the deal, a move which will dilute the shareholder base to roughly 300 million shares outstanding. At around $8 per share this boils down to a $2.4 billion equity valuation, or $3 billion if you include debt. The real accretion from this deal has to come from scale, something which could result in $160 million in synergies by 2018, at least according to executives. I must say that this synergy estimate looks quite aggressive as it is equivalent to 6% of the pro-forma revenue base.

If the synergies could be achieved, the EBITDA multiple of the combination drops towards 6 times. These savings could easily boost after-tax earnings by some $130 million per annum based on a 20% tax rate, boosting earnings to $175 million. This would translate into a 13-14 times earnings multiple, at least if all goes to plan. Given that Mitel´s shares dropped from $8 towards $7 in response to the deal, that multiple drops to little over 12 times anticipated 2018 earnings.

The Market Disagrees

The rationale behind Elliott´s push to merge is fair. Both companies are too small to survive in fast changing markets, as both companies compete with much larger and financially stronger competitors, such as Cisco Systems (NASDAQ:CSCO).

While Elliott has put real money on the line by acquiring stock in both firms, it failed to make any money on this investment, at least until now. While the deal looks good on paper, the market reacted negatively towards the deal. Shares of Mitel fell by 10% in response to the announcement, translating into a decline in market value of roughly $225 million on the back of a near $2 billion deal.

Part of the reason behind the disappointing market reaction might be the fact that Mitel released a little inspiring outlook for its first quarter of 2016. The company sees first quarter revenues of $270 to $280 million, accompanied by adjusted EBITDA margins of 7.5 to 9.5%.

This is disappointing as pro-forma first quarter revenues totaled $277 million in the same period last year, indicating no growth. Worse, adjusted EBITDA came in at nearly $33 million in the first quarter last year, as this profitability number is expected to drop to just $23 million in the first quarter.

Final Conclusions, Avoid

While Elliott is seeing the merger which it has wished for, the market is not enthusiastic. This is despite a very strong track record of Elliott with regards to investments in technology companies.

While Mitek is improving its balance sheet, profitability and is gaining scale with the purchase of Polycom at fair multiples, investors are not happy.

This is despite the promise for sizable cost synergies in the years to come. The negative reaction in response to this deal is therefore surprising, but indeed could relate to the disappointing outlook for the first quarter. This is certainly the case as margins are expected to come under further pressure, hurting the bottom line even more.

While the new $3 billion business has doubled its revenues to $2.5 billion overnight, it remains very small compared to Cisco which posts $50 billion in sales. If you exclude Cisco´s net cash balances, it trades at about 2 times sales which is a premium compared to the pro-forma revenue multiple of 1.1 times for Mitel.

This is explained by superior margins, as EBITDA multiples are quite similar actually. Note that this might not even by the worst kind of competition as technology shifts have created a whole other set of competitors. This includes of course the emergence of Microsoft´s (NASDAQ:MSFT) Skype, as well as a string of apps which allow for easy communication.

So if all goes well, Mitel should trade at 12 times pro-forma earnings in 2018, based on aggressive synergy estimates. That is actually quite similar to market leading firm Cisco which operates from a much stronger position in terms of scale and its balance sheet. There is a reason why Cisco trades at lower valuation multiples as well, and that might very well be the fact that emergence of technologies renders parts of its business to become obsolete in the future, just like Mitel.

Small yet improving scale, a still somewhat leveraged balance sheet, suboptimal margins and worries about long term threats make me cautious on the prospects for the combination. That being said, strong execution has the potential to improve the investment case, although the company will need to deliver on many good things in the years to come. I will keep an eye on the story from the sidelines with an interest, potentially reconsidering my neutral stance as we move along.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.