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Morningstar | Fair Value Estimate for No-Moat Seven Group Helped Along by Beach Energy Upgrade. See Updated Analyst Note from 10 Jul 2019

We increase our fair value for no-moat Seven Group by 5.5% to AUD 16.25 from AUD 15.40. Chief among drivers is a 15% increase in our Beach Energy fair value to AUD 2.25 per share, discussed in our July 8, 2019 Beach Energy note “We Increase our FVE for No-Moat Beach to AUD 2.25 with Potential for Further Gains Remaining.” Seven Group has a 25.6% stake in Beach and its equity share of the fair value uplift is worth around AUD 0.50. Other contributors include time value of money, as well as the favourable impact of positive market momentum on Seven Group’s listed share portfolio. The share portfolio was worth AUD 325 million or nearly AUD 1.00 per share at Dec. 31, 2018, and the S&P/ASX 200 has appreciated by nearly 20%.

Seven Group increased its fiscal 2019 group EBIT guidance by 12% to AUD 695 million in late April. The underpinner was unexpected WesTrac customer resilience into the fiscal second half. At the time we increased our EBIT forecast to a marginally below-guidance AUD 653 million. We now increase our forecast to AUD 700 million, slightly above guidance, increased Beach earnings featuring. Our fiscal 2019 EPS forecast strengthens marginally to AUD 1.33, though our fiscal 2020 EPS forecast softens to AUD 1.08 from AUD 1.06 given a reduced near-term Brent price outlook in line with the futures curve.

At AUD 18.55, Seven Group shares are now marginally overvalued. Our fair value estimate equates to a fiscal 2023 EV/EBITDA of 8.0 after stripping out AUD 440 million or AUD 1.30 per share lump sum for Seven Group’s ASX 200 share portfolio and property assets. It also equates to an adjusted fiscal 2023 price/earnings of 13.5 and dividend yield of 3.7%. At today’s fair value, these translate more favourably at 9.2 and 5.4%, respectively. We assume 5-year group EBITDA CAGR of 7.5% to AUD 915 million by fiscal 2023 at a midcycle EBITDA margin of 20%. Seven Group has a strong track record of delivering excellent returns for shareholders over the long run.

Seven Group is now essentially a large industrial equipment and investment company. The main operating business is WesTrac, the sole authorised Caterpillar heavy equipment dealer for New South Wales, Australian Capital Territory, and Western Australia. This business, excluding wholly owned Coates Hire, comprises AUD 5.80 or 36% of our fair value estimate. We assume healthy 7.8% 5-year EBITDA CAGR for WesTrac to AUD 337 million by fiscal 2023, reflecting strong growth in new machine sales from a low base, and rising maintenance business as the pool of heavy machinery continues to both grow and age. New equipment sales collapsed from fiscal 2013’s AUD 2.7 billion China-boom highs and have not yet meaningfully recovered from unsustainable AUD 600 million lows.

Coates Hire comprises AUD 4.65 or 29% of our fair value estimate. We anticipate more modest growth from the equipment rental business as we view current conditions, boosted by high profile public infrastructure expenditure as near to perfection. Coates stocks a broad range of equipment including power tools, lighting, ladders, scaffolding, earthmoving equipment, trucks and trailers, and more. We assume 3.5% normalised 5-year EBITDA CAGR for Coates to AUD 416 million by fiscal 2023. We anticipate we are near the peak of infrastructure expenditure in terms of timing, and that the peak could plateau given financial and physical capacity constraints in the economy. Combined, WesTrac and Coates Hire comprise just over two thirds of our group fair value estimate highlighting Seven Group’s leverage to local government, civil construction, and mining sectors. As consolidated entities they provide the bulk of solid group cash flows with other businesses/investments equity accounted.

Of the remainder of Seven Group’s business, Energy comprises the largest AUD 2.60 or 16% part, and Beach Energy represents the lion’s 90% share. The Beach shareholding in isolation is in fact worth more, AUD 3.90 per Seven Group share, but we have apportioned group net debt and corporate costs across all the segment fair value break-downs. Group net debt currently stands at approximately AUD 2.0 billion or AUD 5.85 per share. We have theorised Energy could be grown into another major plank for Seven Group, which could mark Beach as a takeover target. However, this could be achieved via creep, not necessarily an outright bid, which would be the lower risk strategy. But ultimately Beach cash flows must look a more attractive target versus its modest though reliable yield. That is unless Cooper Basin and Moomba Hub partner Santos has grander designs.

The 18% balance of our fair value estimate for Seven Group includes AUD 1.80 or 11% for media investments and 8% or AUD 1.30 for listed share and property portfolios. Of the media investments, a 40.9% stake in ASX-listed Seven West Media Limited (SWM) is the majority two thirds.

Group net debt of around AUD 2.0 billion translates to comparatively high net debt to capital of 47% and net debt/EBITDA of 2.6, or 3.1 including operating leases. However, this is distorted by equity accounted investments, and listed share and property portfolios. It looks better than before the Coates Hire’s consolidation, when net debt/EBITDA peaked at 4.5 in fiscal 2017, but remains somewhat high. Stripping out the share and property portfolio alone would reduce net debt/EBITDA to nearer 2.0, and doing the same for equity accounted units Beach Energy and Seven West Media would reduce it to nearer 1.0, which is a fairer reflection and considered reasonable. Even on the basis of the published accounts, we project net debt/EBITDA to fall to nearer 1.0 from 2.6 by as soon as fiscal 2023, despite continuing its 50% dividend payout ratio.

Consequently, we think Seven Group could comfortably acquire more Beach equity, or even a new business line. It would likely be accompanied by further sell-down of listed shares and property, which were worth over AUD 1.0 billion at their peak, and possibly media assets as well.

We still attribute no moat to Seven Group. We determine WesTrac and Coates Hire as moaty businesses, but don’t think Beach Energy or Seven West Media have economic moats. Beach Energy is not a low-cost energy producer and the intangible power of Seven West’s free-to-air licence has declined to the extent it no longer acts as a barrier to competition. We project group ROICs improving to a midcycle 11%, ahead of its 8% WACC though not sufficiently so to earn a moat. No-moat businesses Beach and Seven West Media stay our hand. Our five-year ROIC forecast credits improving earnings from the high-returning WesTrac business, in addition to consolidation of Coates Hire’s also high-returning earnings.

We are forecasting a 20% increase in fiscal 2019 dividend to AUD 50 cents from AUD 42 cents, anticipating recovery in the second-half payout ratio to 50%, and a 37% increase in underlying EPS to AUD 1.33 from AUD 0.97. At the current AUD 18.55 share price, our fiscal 2019 dividend forecast translates to a reassuring but modest 2.7% fully franked yield. We say reassuring given dividends are a yardstick for keeping companies honest. And Seven Group has grown or at worst held ground on DPS in every year since payment began in fiscal 1994. The 25-year DPS CAGR is 4.1% and this was achieved without ballooning issued capital or debt. Seven Group has undertaken share buybacks in the past but the modest franking balance of just AUD 88 million at end fiscal 2018 makes tax-effective buybacks less likely and dividends the more probable avenue for returns to shareholders. We project a 5-year DPS CAGR of 9.9% to AUD 67 cents by fiscal 2023 for a nominal 3.6% fully franked yield at the current price.