EUR 850.00 For Business Accounts Only

Morningstar | Seven Group Potentially a New Wesfarmers in the Making. FVE Upgraded to AUD 15.00.

Earnings visibility is improving for no-moat Seven Group, with asset purchases increasing the proportion of earnings consolidated on book increasing investment appeal. We view this as sufficiently important to soften our fair value uncertainty to high from very high, with a contemporaneous 7.0% lift in fair value estimate to AUD 15.00 per share from AUD 14.00. Key fair value influencers include a reduced 9.0% cost of equity assumption from 11.0% prior, and downgrade in credit risk to moderate from above-average. Examples of recent clarity-improving changes include purchase of the balance of equipment rental business Coates Hire and buyback of the TELYS4 preference shares.

At AUD 15.50, Seven Group shares screen as somewhat overvalued, though 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. It is somewhat of a pity it is overvalued--on tangible elements--because there are reasons to see in it another Wesfarmers in its infancy, that is, an Australian conglomerate whose diversified and changing portfolio delivered nearly 20-fold share price appreciation excluding dividends over three decades and a market capitalisation of AUD 52.9 billion. But we cannot clutch at such straws. Any fair value estimate for Seven Group must be based on solid fundamentals, not blue sky. Trying to buy what is unquantifiable requires a steady and disciplined hand. And the right price, offering a margin of safety, helps too.

We forecast a sharp 29% increase in fiscal 2019 dividend to AUD 54 cents from AUD 42 cents, anticipating recovery in the payout ratio to 50% from 36%, and a 12% increase in underlying EPS to AUD 1.09 from AUD 0.97. At the current AUD 15.50 share price, our fiscal 2019 dividend forecast translates to a 3.3% fully franked yield.

Seven Group has delivered excellent returns for shareholders over the long run. While the past is not necessarily a great predictor of future returns, positive behaviours within a reliably persistent management culture can be. Seven Group's consistent payment of dividends, for example, is a good sign. 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. Average returns on invested capital of 14.5% comfortably exceeded the weighted average cost of capital.

While we currently see the stock as somewhat overvalued, there is, as always, an alternative view. Our base-case fair value estimate makes growth projections based largely on known factors. But conglomerates like Seven Group evolve in unpredictable ways, and there is patent mileage in backing the right man. The longest-running constant in Seven Group is veteran chairman and majority shareholder Kerry Stokes. There have been wild ups and downs, but for the quarter century to fiscal 2018, ordinary shareholders enjoyed strong combined dividend and share price appreciation under his stewardship.

Kerry Stokes recently turned 78 and isn't going to be calling the shots at Seven Group forever. However, there is now little doubt his son and successor Ryan Stokes is putting his stamp on the group. He is well qualified with nearly 15 years of Seven board experience before taking on the MD/CEO role in fiscal 2015. The Beach Energy buy-in, the sale of WesTrac China, and the purchase of the balance of Coates Hire were done under his watch. We expect Ryan Stokes will at worst be a successful steward of shareholder capital, and at best a personality with the vision and drive to create Australia's next successful conglomerate.

We 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 such an extent it no longer acts as a barrier to competition.