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Morningstar | No-Moat Seven Group Impresses with Stronger-Than-Expected 1H. FVE Upgraded to AUD 15.40. See Updated Analyst Note from 19 Feb 2019

We increase our fair value estimate for no-moat Seven Group by 2.5% to AUD 15.40 per share. The company reported a better than expected 63% increase in underlying first-half fiscal 2019 NPAT to AUD 258 million, 32% ahead of our AUD 196 million forecast. But our long-term forecasts remain largely intact, unswayed by typically volatile half-to-half earnings moves. Seven Group has not changed guidance for a 25% improvement in underlying fiscal 2019 EBIT from continuing operations to AUD 621 million. We increase our fiscal 2019 EBIT forecast by 4% from a guidance-equalling to a guidance-beating AUD 653 million, believing the company is holding something up its sleeve. That would still represent a sharp 26% decline in second-half EBIT versus the first half.

Company rhetoric is more bullish than numerical guidance, anticipating increased new equipment sales for WesTrac driven by higher activity levels in both mining and construction markets and customers replacing fleet. And actions are underway to grow market share for Coates Hire in the second half. WesTrac comprises the largest 37% share of our fair value estimate, followed by Coates Hire at 30%.

Our fair value estimate equates to a fiscal 2023 EV/EBITDA of 7.6 after stripping out AUD 380 million lump sum for Seven Group’s ASX 200 share portfolio and property assets. It also equates to an adjusted fiscal 2023 P/E of 13.8 and dividend yield of 3.6%. At today’s fair value, these translate more favourably at 9.5 and 5.2%, respectively. We assume five-year group EBITDA CAGR of 8.1% to AUD 940 million at a midcycle EBITDA margin of 20.2%.

The market appreciated the strong first half, the shares up more than 10% on announcement. But at AUD 18.75, we think Seven Group shares screen as overvalued. Our quibble is with the price not the business. The company has a strong track record of management and is now easier for the average person to understand than in many years due to portfolio and ownership simplification.

We think an AUD 18.75 share price implies a too-aggressive five-year EBITDA CAGR of 10.7% and EBITDA margin of 22.5%. We still struggle to entertain such a high margin or revenue combination given our less bullish outlook for commodity prices and mining and infrastructure spending. We anticipate pull-back in iron ore prices to a midcycle USD 40 per tonne versus recent USD 90 per tonne spot pricing. And we think the public infrastructure spending boom is near peak. The growth we do see for Seven Group and other mining and construction-exposed companies is founded substantially on a forecast increase in sustaining capital works, particularly in the resources sector, following an unsustainable period of capital deferment post the end of the China resources boom.

The first-half 2019 profit beat was generated chiefly in the WesTrac heavy equipment segment where parts shipments increased by 27% on the previous corresponding period, with strong customer demand for autonomous technology to be retro-fitted to existing equipment. Maintenance revenue also grew strongly with customers looking to extend machine age. This was only partially offset by lower than expected Coates Hire margins with hire days affected by wet weather in a very competitive market. Group revenue grew by 31% to AUD 2.1 billion and EBITDA margin to 22.1% from 17.0%.

Net operating cash flow jumped 130% to AUD 309 million in line with our expectations including unfavourable working capital movement. Despite this, the net debt position was little changed at AUD 2.1 billion. Annualised net debt/EBITDA remains a somewhat elevated 2.3 excluding operating leases, and reflective of recent Beach Energy and Coates Hire acquisitions, and contributing to high fair value uncertainty. The risk is somewhat ameliorated by unconsolidated 40.9% and 25.6% stakes in listed entities Seven West Media and Beach Energy, respectively worth AUD 410 million and AUD 1,040 million based on our fair value estimates, and a further AUD 325 million of other ASX-listed holdings marked-to-market at December-end.

Seven Group has a solid track record of dividend payment and we expect this to continue. For the quarter century to fiscal 2018, an ordinary shareholder enjoyed combined dividend and share price appreciation of 10.3% CAGR, well ahead of the S&P/ASX 200 Accumulation's 7.5% CAGR. Holding to form, the company paid an unchanged interim of AUD 0.21, although considerably lower than we expected on a reduced 28% payout. We lift the expected second-half payout but regardless cut our fiscal 2019 DPS forecast to AUD 0.50 from AUD 0.55, representing just 2.7% yield at the current share price. Our fiscal 2019 EPS forecasts is increased by 11% AUD 1.22.