Did BT Group plc Actually Tell Me To Bet On Vodafone Group plc This Week?

BT (LSE: BT-A) (NYSE: BT.US) has entered exclusive talks to acquire EE for £12.5bn, it emerged earlier this week. Dear me…

I appreciate BT is churning out cash, but such an expensive deal heightens the risk associated to BT stock into 2015. 

I am not buying Vodafone (LSE: VOD) (NASDAQ: VOD.US) instead, however. I’ll explain why.

Mr Market 

BT stock has outperformed the FTSE 100 index by almost 10 percentage points since it confirmed, on 24 November, that it was considering a takeover of Telefonica‘s O2 mobile operations in the UK. A couple of days later, EE’s owners — Deutsche Telekom and Orangeannounced they were “in exploratory discussions” with BT. 

Short-term movements in stock prices do not dictate investment strategies, but they should not be overlooked, either.

Since 5 December, when BT stock rose to 420p, the shares have lost 5.4% of value. The FTSE 100, by comparison, has lost 5% of value over the period. It could be argued that BT shares should have fared much better than the index in the wake of M&A talks.

Furthermore, since BT announced earlier this week that it was in exclusive talks to buy EE, its stock has underperformed the market by about three percentage point.

Why so? 

An Expensive Call

The purchase price of £12.5bn for EE on a debt/cash free basis isn’t good news for shareholders.

In short, BT is valuing the target’s equity at 2x sales and 8x earnings before interest, taxes, depreciation and amortisation (Ebitda). That is premium of about 20% to BT’s own valuation. BT should have asked for a 20% discount against its own valuation, in my opinion, or should have opted to go for O2, which is smaller but has a decent network. 

The implied valuation of EE is demanding even assuming BT can achieve synergies of between 5% and 7% of the EE’s revenues (between $320m and £450m annually). While BT says that “in considering the financing of the cash element, BT has a range of options and is mindful of the importance of maintaining a conservative financial profile”, it looks like the British behemoth is paying too much for assets that may promise significant synergies, but whose Ebitda and revenue growth prospects are not particularly appealing. 

Vodafone Is Still Expensive

Does BT’s strategy suggest it may be time to bet on Vodafone? Well, maybe — although Vodafone stock is not exactly in bargain territory right now.

Vodafone shares, which trade at 223p, have been resilient in the wake of upbeat quarterly results, which showed an improvement in its operations. M&A talks also contributed to value creation in recent weeks.

I may add Vodafone to my diversified portfolio — but only if it drops to 170p/180p. And even then, I would not feel very comfortable retaining a meaningful exposure. I think Vodafone’s dividend, its main attraction, is jeopardised by its capital structure, which is stretched.

Just like BT, Vodafone may decide to become a fully fledged quad-play services provider, but it’ll have to engineer a multi-billion takeover of Liberty Global. An alternative would be to acquire Fastweb, which is another takeover target, according to the rumour mill. 

For now, I’d look elsewhere for value. 

Initially, I thought BT would maintain financial discipline in M&A, but it looks increasingly likely I will be proved wrong.

I am not bothered, though, because I think I may opt to invest in a company identified in this FREE wealth report -- its shares have risen by more than 200% since 2012 and its prospects look really good. Incidentally, it's not too big and could also be taken over

Our report tells you how to record a market-beating performance and find value across many sectors: you should click here now to get your free copy right now.

Our report is completely free and without further obligation for a limited amount of time!

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.