Fool's Eye View

[ June 23, 2000 ]

Is There Life After Freeserve?

By Stuart Watson (TMFTiger)

Great Titchfield Street, London -- On Tuesday next week Freeserve (LSE: FRE), the UK's leading Internet Service Provider (ISP), should deliver its first set of full year results. That would normally be enough to generate considerable investor interest. But this is also the date when its majority shareholder, Dixons Group (LSE: DXNS), is freed from the agreement, made when Freeserve floated, not to sell any further shares in the UK's largest ISP.

Many other companies who have spawned 'new economy' babies like this, National Grid (LSE: NGG) with Energis (LSE: EGS) is a good example, have slowly dribbled shares onto the market as and when they can. Dixons is considering a more radical move and has reputedly put its entire 80.1% holding on the auction block.

Back to the beginning

You don't have to go back far to find the start of the Freeserve story. It begun life as a division of Dixons back in September 1998 and came to the market with a valuation of £1.5b in July 1999. The shares have had a roller coaster ride, falling as low as 135p last October before soaring to a high of 920p this March. It was about this time that the first sale rumours began. World Online, the European ISP, was the mooted predator. This company had its own, less than successful, flotation later that month. Its shares have lost two-thirds of their initial value since then, leaving World Online on a total market value of £2.5b. It is no longer a potential predator and has retreated into a quiet corner to lick its wounds.

Speculation raised its ugly head again in May. Rumours hit the market that Dixons wanted to get rid of its stake in Freeserve. It issued a statement saying that it was considering its options which may or may not mean a sale of all or part of its holding. In other words it was hanging a 'For Sale' sign out. Since then there have been numerous press stories about an auction for the group although no details have been formally confirmed by any party involved.

Who are the potential buyers?

The two names that keep on cropping up are the German ISP T-Online, where Deutsche Telekom is the majority shareholder, and the cable company, NTL. Initially a price tag of £6b was being talked about, or 600p per share. But expectations have dropped in the last few weeks. Freeserve is currently valued at around £4.5b. Could this sale follow the pattern laid out in the merger of America Online and Time Warner? In this instance the former's pre-merger share price was considered a bit too rich when it come to the cold, hard, financial crunch of bashing out the merger details.

With every day that passes Freeserve's position in the Internet market, which is global by definition, is looking more and more isolated. Being a national operator isn't really a viable long-term strategy. However, there are few companies that are in a position to afford to pay Dixon's likely asking price and that really need to buy Freeserve. T-Online is attempting to cement its position in Europe and NTL is taking a scattergun approach of expanding to as many platforms as possible. Dixons has effectively become a forced seller as the market is coming round to the realisation that it has to get rid of its stake at some point. When you are forced seller and there are few buyers it is unlikely that you will receive a great price.

So what does it mean for Dixons?

From Dixons point of view, Freeserve's share price has come to dominate its own share price movements. At some points in the last year, its core retail operations have effectively been valued by the market at zero or even less. The current situation is a little better. Dixons' stake in Freeserve is worth £3.6b at the current price, and Dixons itself is valued at £5.5b implying a valuation for its retail businesses of £1.9b. A similar analysis was carried out recently in this post by NilDesperandum.

Dixons is on target to turn over sales in excess of £3.5b for this year, up from £2.4b just three years ago. But its progress on the profits front has been less than spectacular. Profit margins in 1997 were 8.2%. In 1999 they were 7.3% and a further fall looks likely this year after Dixons reported a fall in margins in its half-year results back in January.

What would Dixons do with its cash windfall? It may have to use some of it to fund a tax bill, but the amount of tax it would have to pay if Freeserve was sold is unclear. Most of the money would probably be returned to shareholders via a special dividend. Dixons doesn't have the opportunity to invest the funds in its own operations as its expansion potential is limited. An acquisition spree looks unlikely as well. They are few UK targets in its chosen area of any notable size. Dixons appears to suffer from the same domestic-focus problem as Freeserve. Only 2% of its sales are from outside the UK. Once the added sparkle of Freeserve has gone who will want to invest in yet another retailer which is struggling to maintain its margins?

Related Links
• Unbundling NTL
• Freeserve discussion board
• Dixons website | discussion board