EUR 850.00 For Business Accounts Only

Morningstar | Increased to AUD 14 Following TELYS4 Conversion and Rethink on New Equipment Sales

We are increasing our fair value estimate on no-moat Seven Group Holdings by 12% to AUD 14.00. Half of the upgrade reflects Seven Group sensibly using its rampaging share price to value-accretively convert TELYS4 shares into ordinary shares at a ratio of 4.6 ordinary shares for every TELYS4. But we have also favourably reassessed prospects for Seven Group’s WesTrac Caterpillar heavy machinery and Coates Hire equipment-rental businesses, and added extra for the time value of money since our last upgrade in May.

The nearly 5 million TELYS4 on issue have not enjoyed the price appreciation of the ordinary shares and prior to this transaction traded at a 20% discount to face value. Holders have consequently voted the conversion proposal through, which will result in ordinary shares on issue increasing by just 4.4%, but will increase our fair value estimate by AUD 0.75 per share due to the wide gap between the AUD 22.25 ordinary share price and our prior AUD 12.50 fair value estimate. In addition, we have substantially increased our revenue forecast for WesTrac, which comprises an upgraded 40% of our fair value estimate (previously 33%), only partially muted by slightly lower assumed revenue growth for Coates Hire, which now accounts for 30% of fair value.

Our fair value estimate equates to a fiscal 2023 EV/EBITDA of 8.6 after stripping out AUD 383 million lump sum for Seven Group’s ASX 200 share portfolio and property assets. It also equates to an adjusted fiscal 2023 price/earnings of 13.4 and dividend yield of 4.7%. We now assume five-year group revenue CAGR of 8.0% to AUD 5.1 billion at a midcycle EBITDA margin of 18.6%. That contrasts to our prior fiscal 2023 revenue and EBITDA margin forecasts of AUD 3.9 billion and 21% respectively, and fiscal 2018 revenue of AUD 3.5 billion at 18.4% EBITDA margin. The reduction in margin reflects the increase in WesTrac sales which are lower-margin than for the group overall.

We still think a plus AUD 22 share price implies a too aggressive five-year revenue CAGR of 8.5% and EBITDA margin of 23.3%. We still struggle to entertain such a high margin or revenue combination given our more subdued outlook for mining and infrastructure spending.

We assume Australian minerals expenditure increases at a five-year CAGR of 8% to a sustainable midcycle AUD 22.5 billion by 2023, from a low base; but Australian public infrastructure expenditure remains comparatively flat at AUD 38.5 billion from a high base. Forecast minerals expenditure of around AUD 16 billion for 2018 is 60% below AUD 38 billion mining boom highs of 2013, and there has been considerable underinvestment in the subsequent downturn that we expect to resolve to sustainable long-term levels, though not as high as the China boom.

Public infrastructure investment over the same period however increased by 20%, boosted by major road and rail projects that are approaching peak spend. We view material increase in spending from these heady levels unlikely. Mining and public infrastructure spending are major drivers of heavy equipment sales and hire, and Coates Hire in particular has been a beneficiary of East coast infrastructure spending.

The substantial increase our midcycle revenue forecasts for WesTrac is a change in tack which follows a closer look at how improving market fundamentals, including rising Australian minerals expenditure, are likely to impact the business. Seven Group recently said Westrac continued to benefit from growth in mining production and an aging Cat heavy equipment fleet driving product support business. We now think the investment deferral driving that higher product support work, in combination with improving fundamentals, is likely to result in faster than previously credited growth in new equipment sales from the current low base. That’s despite Morningstar’s unchanged forecast for commodity prices to deteriorate. Stronger new equipment sales will in turn underpin Support revenue. Our midcycle EBITDA margin for WesTrac is unchanged at 10.0%, anticipating growth in Support margins to offset the higher proportion of lower margin new equipment sales revenue.
With respect to Coates Hire, we leave our midcycle EBITDA margin assumption unchanged at 40%, but reduce the five-year revenue CAGR assumption to just 1.1%, which takes revenue to AUD 1.0 billion by fiscal 2023, down 10% on our prior AUD 1.1 billion estimate. Coates’ fiscal 2018 revenue was AUD 978 million. While of only limited fair-value impact, we don’t agree with the market’s more enthusiastic outlook for public infrastructure spending to support higher revenue expectations.