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Morningstar | Fairfax Media Not Cost-Cutting to Greatness but It Still Helps; FVE up 7% to AUD 0.75

We raise our fair value estimate for Fairfax Media by 7% to AUD 0.75 per share, predominantly driven by upgrades in two areas.

First, it reflects cost-driven lifts to our metropolitan publishing forecasts. While the division's 120 basis point rise in fiscal 2018 EBIT margin to 9.6% was broadly in line with expectations, we see the improvement continuing at a greater pace than previously anticipated, aided by cost-savings from the recently-struck print-sharing agreement with News Corporation. In fact, we have raised our long term, midcycle metropolitan publishing EBIT margin to 10.0% from 9.0%.

Second, we have cut our corporate overhead cost estimates by AUD 8 million a year on average over the forecast horizon, to around AUD 20 million per year. This is in recognition of the impressive halving of these expenses in fiscal 2018 to AUD 23 million versus our AUD 32 million forecast, with management confidently projecting sub-AUD 20 million level on a rate-run basis in fiscal 2019.

Despite these upgrades, shares in no-moat-rated Fairfax are still trading at a significant premium to our revised intrinsic assessment. This is not surprising given the fresh prism through which investors are now looking at the stock--one that has an implied worth of AUD 0.89 per share based on the current stock price of suitor Nine Entertainment (consideration being 0.3627 Nine shares plus AUD 0.025 cash for each Fairfax share).

As such, we believe the situation provides Fairfax shareholders with a good opportunity to crystallise the premium built into the stock price. This is especially as we assess Nine to be worth AUD 1.50 per share on a long-term, midcycle view (versus current stock price of AUD 2.40). The premium in the current Fairfax stock price is also generous, given its legacy publishing units are still undergoing a transition and whose combined core EBIT fell 28% in the second half of fiscal 2018, with fiscal 2019 total group revenue down a further 5% to-date.

Fiscal 2018 normalised group net profit after tax, or NPAT, fell 12% to AUD 125 million, albeit in line with forecast. Final DPS was down 10% to AUD 0.018, fully franked, bringing the total for the year to AUD 0.029, 69% franked. At the operating level, EBITDA (including associates) dropped 6% to AUD 217 million and 2% shy of our estimate. The slight miss was mainly driven by disappointing results in regional newspapers and New Zealand operations, with cost rationalisation not quick enough to respond to deteriorating revenue declines especially in the second half (not helped by the drought in Australia).

The metropolitan media division saw revenue decline 6% year on year, in line with our expectations. However, aggressive cost cuts led to a 7% rise in core EBIT to AUD 47 million. High-single-digit growth in digital subscriptions was encouraging. We forecast digital growth to offset the losses in Fairfax's traditional publishing business by fiscal 2021 and see revenue growth resuming at 1% per year from thereafter.

Drought-impacted regional media revenue fell 7% year on year. Continued cost-saving initiatives, including the closure of seven titles this year, were not enough to meet our expectations, and the division's EBIT margin slipped to 12.7% from 15.4%. Despite the drought, revenue continues to fall at a slower pace each year and we expect revenue to bottom out in fiscal 2022, from which point, we forecast sustainable EBIT margin to be around 11%, from 12.7% in fiscal 2018.

Domain's result was broadly in line with our Morningstar technology analyst's forecasts (see report published on Aug. 13, 2018 titled "Domain Remains Overvalued as Fiscal 2018 Result Meets Expectations.")

The balance sheet remains in good health, with net debt of AUD 136 million as of June 30, 2018. This equates to a healthy 0.5 times net debt/EBITDA ratio. The net debt is made up of 60%-owned Domain's AUD 127 million net debt, 54.5%-owned Macquarie Media's AUD 18.2 million net debt, with net cash of AUD 9.5 million held by Fairfax entities. The interest coverage ratio, EBITDA/interest expense, increased to 40 times from 27 times, indicating Fairfax is in a strong financial position.