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Morningstar | As Investor Exuberance Turns to Despair, We Turn Positive on Nine-Fairfax Combo. See Updated Analyst Note from 18 Nov 2018

We lift our fair value estimate for Nine Entertainment by 18% to AUD 2.00 per share. This follows Fairfax Media shareholders' approval on Nov. 19, 2018 of the proposed scheme to merge with Nine--an event that has prompted the formal publication of our forecasts and intrinsic assessment for the combined entity.

The increase in the still no-moat-rated Nine's fair value estimate primarily stems from our AUD 62 million synergy expectation from combining with Fairfax, with the most obvious sources being corporate expenses and non-content-related areas, such as back office, promotional/advertising, communication, information technology, and professional fees. Even this may prove conservative, given the potential upside from collaboration and savings on newsroom/journalistic resources over time--a fertile area that could reduce the combined entity's newsroom/news-gathering cost base by a further AUD 50 million.

All this was detailed in our report "Nine and Fairfax Muscle Up to Enter the House of Pain: Urge to merge has strategic merits, but structural headwinds are here to stay." However, since the publication of this report on Sept. 17, 2018, sentiment on Nine and its merger with Fairfax has turned abruptly, with Nine's stock price slumping almost 30% since then, falling below even our prior market-low AUD 1.70 fair value estimate for Nine as a stand-alone entity.

The ferocity of the market's about-face is such that we now see the risk/reward profile as skewed to the upside at the current Nine stock price. We have been vocal in trying to taper market exuberance over the benefits of the Nine-Fairfax merger, and have fervently argued size and scale do not furnish the combined group with an economic moat or spare it from the structural headwinds wreaking havoc on traditional media. However, we believe the risks are more than reflected in the 19% discount Nine shares are trading at relative to our AUD 2.00 fair value estimate.

We are fully cognisant of the fact that, since the proposed Nine-Fairfax merger was first announced on July 26, 2018, there have been some lukewarm trading updates from both companies. These updates showed signs of slowdown in both the free-to-air TV advertising market (impacting Nine) and the real estate market, with an associated drop in new listings (impacting Fairfax's 59.4%-owned crown jewel in Domain). But the inherent cyclicality of these businesses is hardly news, a point that we have long argued when the stock prices of Nine and Fairfax were trading at eye-watering premium to our fair values estimates.

At the current Nine stock price, what investors should now focus on is the strategic rationale for combining Nine and no-moat-rated Fairfax, following the recent relaxation of media ownership laws. Combining the country's top-ranked TV network and the second-largest newspaper group, topped with a collection of quality digital assets in Nine Digital, subscription video on demand, or SVOD, operator Stan, and Fairfax's 59%-owned Domain, ensures the merged entity remains relevant in the eyes of audiences and advertisers.

Amid intensifying competition from digital insurgents such as Google, Facebook, YouTube, and Netflix, this cross-media behemoth will be better-positioned to compete. Nine-Fairfax will be an all-encompassing multimedia platform that will reach more than half of Australians each day through television, online, print, and radio. This should provide advertisers with a broader platform to reach audiences across the spectrum. Furthermore, the vast personnel and editorial resources of the combined Nine-Fairfax, backed by a strong balance sheet (pro forma net debt/EBITDA of just 0.6), will facilitate greater investments in marquee content and digital capability--both crucial to ensuring the merged group's long-term future.

Lastly, all the key assets that excited investors when the merger was first announced are still there. The potential for Domain to close the gap to REA Group in the digital real estate classified space, the cross-promotional opportunity for Nine's national TV properties in raising Domain's awareness beyond New South Wales and Victoria, the structural hedge that SVOD operator, Stan, provides against the longer-term challenges facing free-to-air TV. These elements all remain and we believe have not been fundamentally impaired by anything that has occurred in the last month or so while Nine's stock price has been falling.