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Morningstar | Fairfax on Cloud Nine

We view Nine's merger proposal as a positive for shareholders of Fairfax. Based on the latest closing prices, the deal values no-moat-rated Fairfax at AUD 0.84 per share comprising 0.3627 Nine shares (at AUD 2.26) and AUD 0.025 cash. This is 20% above our AUD 0.70 fair value estimate for Fairfax, so little wonder the board will unanimously recommend the proposal to shareholders.

The consideration is generous, struck on a forward EBITDA multiple of 8.3, or 7.0 if AUD 50 million cost-savings are factored in on a pro forma basis. This is not bad for a group with a five-year EBIT CAGR outlook of minus 6% based on our estimates (excluding Domain which Fairfax holds 60% of). The deal has also banished any anxiety about Fairfax becoming a predator post the recent media ownership law relaxation.

Critically, the proposed merger affords Fairfax shareholders a chance to crystallise the stock price gain. This is because we see Nine shares as overvalued on a midcycle sustainable earnings basis, trading at a 50% premium to our AUD 1.50 per share fair value estimate.

There are also risks to consider for those who choose to remain as shareholders of the merged entity were it to complete. For instance, we calculate the EPS accretion on a fiscal 2018 pro forma basis to be marginal (2% versus management's neutral). Longer term, value accretion also remains hostage to how the merged entity competes against the relentless onslaught of digital disruptors such as Google, Facebook, and Netflix. Furthermore, there is the chance an interloper may crash the party and make a play for Nine, puncturing the corporate premium built into Fairfax's stock price. This is not as outlandish as it may sound, especially if a traditional media operator (say, News Corporation) decides to diversify away from print and pay TV in Australia. A free-to-air TV network with a 50% interest in a popular subscription video on demand service called Stan may just fit the bill.

Completion of the proposed merger has some way to go, with management projecting consummation by the end of calendar year 2018, assuming receipt of all necessary approvals. In the meantime, Fairfax's stock price will trade in tandem with Nine's, given the fixed ratio of the scrip consideration.

We do not see any procedural impediments to the deal. The October 2017 passing of the media reform package has removed the legislative hurdle to this proposed merger, while the competition regulator's views are likely to be enlightened by the current digital inquiry showing the challenges facing traditional media from proliferating digital onslaught.

In terms of the details of the proposed scheme of arrangement, Fairfax shareholders will receive 0.3627 Nine shares for each Fairfax share, along with AUD 0.025 in cash per share. Using Nine's last closing share price of AUD 2.26, this implies an offer price of AUD 0.84 for Fairfax shares, an 8% premium to Fairfax's predeal closing price.

Nine shareholders will hold a 51.1% majority interest in the new company, while Fairfax shareholders will make up the remaining 48.9%. Nine's current CEO Hugh Marks, will lead the new company and the six-person board will have equal representation from current Fairfax and Nine directors, although both the chairman and the managing director will be from Nine. The ACCC will conduct a review of the merger, with the public review scheduled to take 12 weeks (after receipt of all submissions and relevant information). This deal would have been unthinkable this time last year owing to the "2 out of 3" rule, which prevented one company from owning a TV station, radio station, and newspaper in the same area. This and the "75% audience reach" rule were abolished in October 2017, clearing the path for a deal like this.