Donkey, thoroughbred marry

On Monday, at an Extraordinary General Meeting, Western Australian Newspaper (WAN) shareholders will likely approve the purchase of Seven Media Group (SMG) for $4.1 billion. 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 (FTA) channels 7, 7two and 7mate, the Seven Group also owns Yahoo!7 and Pacific magazines, which accounts for 29% of all Australian magazine sales. The important numbers arising from a WAN-7 entity can be summarised as follows:

  • Purchase price of SMG – $4,100 million
  • Forecast increase in Net Profit after Tax (NPAT) for FY11 – $200 million
  • Total debt after deal – $2,000 million
  • Increase in WAN equity base – $2,600 billion

From this we can calculate the following:

  • Return on purchase price – 5.0%
  • Return on increased equity – 8.3%
  • Return on total equity on new WAN-7 entity – 11%
  • WAN’s current Return on Equity (ROE) – 94%
  • Proportional increase in WAN equity base – 16 fold
  • Proportional increase in NPAT – 3 fold

A 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)?  This applies equally to a share market investor and a potential buyer like WAN. A closer look behind the numbers and business reveals what’s behind the purchase.

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 earnings before interest and tax (EBIT) for FY11 of $388M.

WAN is planning to purchase Seven for just over $4 billion in enterprise value.  On the forecast figures, this represents a measly return of 9.7%.  However, WAN is financing some of this purchase with debt, so the actual increase in their equity will be $2.6 billion.  This equates to an return of about 16% on the total increase in equity – but this is before interest (notice the large debt required) and tax, reducing returns to well below the average for most listed industrial companies.

The vast majority of the forecast earnings for the newly merged company will come from Free To Air television and WAN’s newspaper assets.  Both of these segments fall under the “traditional” media tag.  They have high production costs (cameras, actors, printing presses), are very competitive and are being assailed by the cheap and ubiquitous growth in internet content and media delivery.  Channel Ten’s recent results have shown just what a competitive space the Free to Air Television (FTA) market has become.  Five years ago it was the most profitable FTA channel and now it’s the least profitable, much to Mr Murdoch’s chagrin.  Channel 9 used to be “The One”, now it’s the middle brother.

The forecast increase in online revenue from 0% to 2% for WAN represents an insignificant move in the sector that has the highest potential growth.  Over the last several years, online advertising revenue has grown 17% whilst traditional free-to-air and print ad revenues have stagnated.  Despite this, the WAN-7 merger is just ploughing ahead with the old media model, albeit on a much larger scale. 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.

Therefore, with the purchase of Seven, WAN will have a very big exposure in TV – with over 58% of revenue to come from Channel 7, 7Two and 7Mate – and an increased exposure to print, but a miniscule exposure to the medium of the future – the internet.

There will be some minor synergies, estimated at $15 million in the prospectus, which is nothing in the scheme of a $4 billion sale.  Diversifying WANs revenue base might be a good idea, but not at the cost of overpaying and moving into an already competitive space. 

In comparison to the proposed merger, WAN’s pre-buyout ROE makes for some impressive reading – it averages at well over 100% for the last 5 years. A very happy return for loyal shareholders and amongst the best of the large listed industrials – a thoroughbred.

Debt levels are very modest (about twice after-tax earnings and 10% net debt to equity) and intangible assets are very low.  WANs market dominance in the Western Australian print and radio media landscape is very strong and relatively stable.  Their long term problem is the same flaw held by all traditional media companies – eroding advertising revenues due to the internet. 

Given the lack of growth potential in its current market, a merger/buyout of a wider media company makes sense. But why would WAN consider doing so whilst diluting their shareholder’s returns (from approx. 94% to 11% ROE) even when Seven is acknowledged as the best performer of the bunch? What potential actually lies ahead for the new entity and is it this blue-sky dreaming that is being reflected in the asking price or something else? Given these unknown risks and opportunities ahead, and WAN’s current ROE and performance, what should they be paying?

The easy answer is to take the expected after-tax earnings and divide them by a required rate of return (RR).   Assuming an optimistic after tax profit of $300 million for FY11 and a heavily discounted RR of 15% (remember, current returns are near 100%) the purchase price should be about $2.7 billion total.  That’s a bit different from the $4 billion they are intending to pay, including debt, even if it is at a small discount to the original price.

The resulting WAN-7 entity will become a very large, relatively poor-performing company saddled with large amounts of low-returning debt, still exposed to the traditional media vagaries of print and TV. The current WAN shareholders seem to agree, with only 14% of them taking up their entitlement in the recent in-house capital raising. 

Prior to the merger, WAN was rightly valued as a “Good” company, with high Return on Equity and a solid, competitive business with a FY11 valuation at $5.00 or so share. The WAN-7 entity, whilst a blue-chip proposition for institutional investors, should be properly valued as non-investment grade or “Poor” and over-priced beyond $4.00 a share.

In any event, the owners of Seven will receive a pretty penny and I bet Kerry is stoked

Latest posts by __ADAM__ (see all)