When a Donkey Meets a Thoroughbred

After a quick holiday across the pond in NZ (luckily not near Christchurch), your blogger returned to Australia to the news that West Australia Newspaper Holdings (WAN) is going to buy the Seven Media Group from Seven Group Holdings (SVM).   So a WA media monopoly is marrying the TV sideshow of a Caterpillar servicing business.   I can’t wait to see their kids.

Rather than ploughing into the financial media for summaries and the usual warring opinion pieces, I thought I’d look at the merger based purely on the numbers.  No bias from the usual financial commentators – just the shiny prospectus and the raw numbers giving me the answers to:

  1. Is Seven Group worth buying?
  2. If so, how much should WAN pay for it?

Would I want to own Seven Group?

My standard test of any business is to look at how good it is at generating income from its capital.  In other words, what is its return on equity (ROE)?   The Seven Group forms part of SVM, which consists of the Seven Group and Westrac (a heavy machinery servicing group).  Aside from the free-to-air channels 7, 7two and 7mate, the Seven Group also owns Yahoo!7 and Pacific magazines, which accounts for 29% of all Australian magazine sales.

It’s difficult to differentiate the after-tax profit of the Seven Group from the whole of SVM, but the buyout prospectus does provide a forecast EBIT for FY11 of $388M.

Now, WAN is planning to purchase Seven for just over $4 billion in enterprise value.  This represents a measly 9.5% EBIT return on that enterprise value.  However, WAN is financing some of this purchase debt, so the actual increase in their equity levels will be $2.4B.  This equates to an EBIT return of about 16% on the increase in equity.  This is an improvement, but remember we haven’t deducted interest (did I mention debt?) and tax.

So, it looks like the Seven Group isn’t very good at turning shareholder capital into decent returns.  I know I certainly wouldn’t buy it, even at big discounts to its intrinsic value. Which pretty much answers the first question – WAN shouldn’t buy Seven.  It’s a donkey.

Unless of course the Seven Group is a better burro than WAN – which leads us to…

Would I want to own WAN?

A glance at WAN’s pre-buyout ROE makes for some impressive reading – it averages well over 100% for the last 5 years.

Their debt levels are very modest (about twice after-tax earnings and 10% net debt to equity) and their intangible assets are very low.  This may explain the very high ROE – no inflation of equity with goodwill and branding value.  WANs market dominance in the Western Australian print and radio media landscape is also a plus.  The big flaw is the same flaw held by all traditional media companies – eroding advertising revenues due to the internet.  None the less, WAN was a company‘d like to own given it traded at the right price.  It’s a thoroughbred.

So, I believe WAN investors will be worse off for this buyout.  They have a very high ROE company with a dominant market position.  Once the buyout is completed, they will have bought a larger, poorer-performing media company that has assets in very competitive market spaces.   Taking the analogy to extremes, the new company will be an Ass.

The deal would only make sense if WAN was paying a lower price for Seven.  Which leads us to…

What should WAN pay for Seven Group?

The easy answer is to take the expected after-tax earnings of the Seven Group and divide them by a required rate of return (RR).   Assuming an optimistic after tax profit of $300M for FY11 and an RR of 15%, the purchase price should be about $2.7B total.  That’s a bit different from the $4.0B they are intending to pay, including debt.

So it looks like WAN is paying way too much for its donkey sire.

Are we missing something?

So the numbers tell us it’s a bad deal, but are we missing something that the boring old figures don’t tell us?  The synergies are estimated at $15M in the prospectus, which is nothing in the scheme of a $4b sale.  Diversifying WANs revenue base is a good idea, but not at the cost of overpaying for Seven.  The only non-tangible benefit I could think was acquiring an asset that provides good revenue growth for WAN, which would justify the high purchase price.  So is there something inside Seven worth getting a hold of?

The forecast EBIT (by segment) of the combined WAN/Seven Group is shown in the graph below, taken from pg 11 of the WAN buyout prospectus.

So, the vast majority of the EDITDA for the newly merged company will come from Free To Air television and WAN’s assets.  Both of these segments fall under the “traditional” media tag mentioned earlier.  They havehigh production costs (cameras, actors, printing presses), are very competitive (channels 7, 9, SBS and ABC) and are being assailed by the cheap and ubiquitous internet.  Only 2% of EBITDA comes from online sources.

To take a macro view, the table below (WAN buyout prospectus, pg 60) shows the size of each segment of the entire Australian advertising market.

FTA television has grown at an average annual rate of 4% – barely above inflation.  It’s plain to see that the online section is the standout, growing from 5% to 17% of expenditure in the last 5 years.

The rate of growth of the online market is highlighted further the following graph (WAN prospectus, pg 65).

However, the new company will only have a 2% EBITDA exposure online.  So obviously it isn’t looking to tap into the rapidly growing online market.  With the purchase of Seven, they’ll have a very big exposure in TV and an increased exposure to print, but a miniscule exposure to the medium of the future – the internet.

Summary

So, in summary the buyout is a bad deal.  It takes a high-ROE print monopoly and adds a poor-performing media asset that has little exposure to the growth segment of the market.  I guess you can chalk this up to another boomer-controlled media company struggling with the challenges of the internet.  Or maybe it’s just a run of the mill, over-priced M&A.

Over at Empire Investing, we’ve taken a look at the composition of WAN post-buyout and calculated the new intrinsic value.  With the increase in equity and forecast earnings for FY11, we wouldn’t buy it for anything more than $4.20.

If someone can shed some light on the drivers behind the deal, please do.  I just can’t see what the point is.

In any event, I bet Kerry Stokes is stoked.

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Comments

  1. “If someone can shed some light on the drivers behind the deal, please do. I just can’t see what the point is”.

    the answer is very simple:
    The main point with nearly all debt financed M&A is to create permanent tax-free interest revenue flow to…the financing banks.
    (consulting fee is also nice bonus).

    And nobody cares what ROE is left after that.
    Servicing the debt is what makes you modern human beeing:)

    • WA Spewspapers

      “If someone can shed some light on the drivers behind the deal, please do. I just can’t see what the point is”.

      You answered that question in your last sentence – Kerry Stokes is the driver of the deal, with the PE cowboys riding shotgun.

      For the same reason as ( KS’ media company) Seven merged with (KS’ mining services company) Caterpillar, this deal is structured to shift debt that was on one balance sheet onto another…

      The PE guys who bought Seven need an exit and weren’t going to get it at a good price via trade sale; Stokes needed to roll Caterpillar’s debt into a vehicle that could bear it, despite Seven having absolutely no logical synergy or alignment of interests (other than shareholders) with the mining services company; Seven is struggling under its debtload and now seeks to roll it from a private balance sheet onto a public balance sheet.

      At the end of the day, WA Newspapers shareholders aren’t investing in a local newspaper any more… They are investing in Kerry Stokes and his deal making ability.

      • As part of the deal WAN is paying off $650 million in Seven Group debt, but increasing its borrowings by over a billion in the process. The debt reshuffle continues.

        Just a pity there’s no revenue vehicle inside Seven Group that grows at a faster rate than interest.

  2. The real question here is if there is any value in the WesTrac stub-stock after the split.

    I haven’t looked at the numbers yet, but there could be a natural excess of sellers here…

  3. Dear Bog what a mess! The thing is a pseudo private equity vehicle with a capital goods business strapped on the side. If I ever get through a valuation I’ll deduct a 30% premium for pissing me off. Even then I’d want a 40-50% margin of safety.

    The whole thing looks like a massive shell game to be honest.

    pass.

    • Amen to that Lighter. Even if WAN traded at our valuation we’d be wary of purchasing.

      When smaller good companies meet poor larger ones, the poor one always wins. The ROE of WAN will start tracking back towards the historical avergae of Sevens ROE in the next few years: 5-10% I’d imagine.

  4. Could it be that Yahoo!7 is of any future value? If we look to the ABC’s investment in online content delivery and consider that Seven have a long way to go even to match, I’d have to conclude that Seven is an old dog trying to learn new tricks. And we all know how well old dogs adapt to the times.

    Personally I wouldn’t bother investing in any of the following dying markets;
    Free to Air Television
    Paid Television
    News Papers and
    Online News

    Think about it from a service provider’s prospective. In this industry, adding value for the consumer means fewer paid advertisements and better content. Its hard to achieve both, and the revenue growth figures make that very clear.

  5. WAN offer fails to please lukewarm investors

    LUKEWARM investors have taken up just 14 per cent of the retail component of West Australian Newspapers’ $653 million capital raising as part of the financing for the $4.1 billion takeover of Seven Media Group.

    About 4300 of about 13,000 retail shareholders applied for $47m of the $328m offer at $5.20 a share.

    http://www.theaustralian.com.au/business/wan-offer-fails-to-please-lukewarm-investors/story-e6frg8zx-1226027011796