The Anglo File: Energis May Not Be the Best Destiny for Racal

LONDON -- The U.K. telco Energis(ENGSY Quote) is in talks to buy Racal Telecom, a division of Racal Electronics (RCALY Quote). Racal Telecom, however, is certainly no Vodafone (VOD Quote), another business Racal Electronics spun off, and it is questionable whether this is an appropriate acquisition for Energis.

Following a series of reports in weekend newspapers, Racal confirmed on Monday it is in advanced discussions to sell its telecom division to Energis for between 700 million and 800 million pounds ($1.1 billion and $1.3 billion). Both stocks reacted positively to the news, with Racal closing on Monday up 6.8% and Energis up 2.3%. By Wednesday, both had given back some of those gains with Racal down 0.4% to 409 pence and Energis slipping 1.4% to 1,540 pence.

Energised Shares Stock price of Energis (ENGSY) year-to-date

Source: Baseline

Racal and Energis have similar histories but differing fortunes. Racal's telecom business was born out of British Rail placing telecom wires along its tracks while National Grid, the electricity distributor, did essentially the same alongside its network. National Grid spun off Energis two years ago and the telco is now valued at 1.2 billion pounds, compared with approximately 750 million pounds for Racal.

Why does Energis want Racal? Three main factors are at work here.

The Company Racal Keeps

Racal has a number of clients deemed attractive by Energis. As well as railway operators and public-sector bodies, Racal also has high-value customers such as the national lottery operator Camelot, NatWest Bank (NW Quote) and Barclays Bank (BCS Quote).

The coverage of Racal's network is also impressive. Telecom networks associated with electricity grids tend to be more reliable than those strung along railway lines, but railways provide greater depth, giving better access to business customers. This depth is important for Energis if it is to take advantage of the opportunities presented by the British telecom regulator's plan to force British Telecom (BTY Quote) to unbundle the local loop.

Probably the most compelling reason for Energis to buy Racal is for defensive purposes. Excluding Racal, there are currently four telecom transmission providers operating in the U.K.: BT, Cable & Wireless (CWP Quote), Energis and NTL (NTLI Quote). By snapping up Racal, Energis will effectively retain this structure and prevent the likes of Deutsche Telekom (DT Quote) from wiggling its way in.

Yet there is still a risk that rivals with deeper pockets, such as Deutsche, may decide to step in and start a bidding war for Racal.

The Price Is Right

Racal's price tag of about 750 million pounds, which is 3.8 times forward sales compared with Energis' 10.8 times, looks fair. However, should the price start to increase, analysts such as Jane Bidmead of Dresdner Kleinwort Benson are hoping Energis will see sense and walk away.

"Racal does present an opportunity at this sort of price; they aren't overpaying," Bidmead says. "But I hope Energis would shy away if the price did start increasing significantly." Bidmead has a buy recommendation on Energis and Dresdner has had an investment banking relationship with the telco in the past three years.

The possibility of rivals entering into talks with Racal is not out of the question. The similarity of the newspaper reports suggests that Racal deliberately leaked the story, perhaps in the hope of alerting other bidders who might be willing to pay more.

While Racal's network would be an attractive asset in some telcos' hands, it is less so in the hands of Energis. This is because the network is largely similar to Energis' network, which would limit any potential cost-savings. It is perhaps notable that Energis has yet to make any statement to shareholders about the potential synergies it envisions from the acquisition.

The biggest fear among investors is that any acquisition would distract Energis from pursuing its European expansion plans, the value of which far outweighs beefing up its presence in its domestic market.

Last month, Energis bought the Swiss Internet services group Unisource Carrier Services for 60 million pounds. In the process, Energis transformed itself from being a British long-distance carrier into a pan-European operator with a network presence in 11 countries. The acquisition of Racal, as well as being by far the most expensive Energis has made, would hardly offer the same long-term strategic opportunities.

Energis has a lot of work to do if it is to convince investors that buying Racal is really in everyone's best interests. If it can't, it would do as well to hang up the phone with Racal and concentrate on dialing those international numbers.