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Morningstar | Tuning Into Seven News?. See Updated Analyst Note from 02 Oct 2018

Shares in no-moat Seven West Media are trading 40% above our AUD 0.70 fair value estimate, the steepest premium to intrinsic assessment in our domestic media sector coverage. This is despite six consecutive years' of earnings decline (EBIT CAGR of minus 11%, EPS CAGR of minus 16%), and DPS falling from AUD 0.25 in fiscal 2012 to zero in fiscal 2018.

The abrupt turn in investor sentiment appears to be driven by: (1) the prospect of earnings recovery in fiscal 2019; and (2) potential corporate activity along the lines of the proposed Nine-Fairfax merger, following the recent media ownership reform.

On the first point, our current estimates already factor in a 10% increase in fiscal 2019 EBIT, in line with management guidance of 5 to 10% growth. Our concern is the sustainability of such an earnings recovery longer term, in the face of structural pressures which have a put lid on free-to-air advertising market growth (minus 1% CAGR over last six years) and decimated industry EBITDA margins (down to an estimated 15.6% in fiscal 2018 from 20.8% in fiscal 2012). These structural challenges are reasons why we continue to forecast Seven's five-year EBIT CAGR at minus 2%.

On the second point, the only obvious acquirer of Seven is News Corporation. However, we believe the chances of such a deal are low. News effectively doubled down its bet on the subscription TV industry, via Foxtel's recent restructure (News now owns 65% of the pay TV entity). It has committed to investing in the vehicle to transform it into a hybrid operator offering traditional satellite-delivered pay TV and broadband-delivered streaming services. It would be curious, and detrimental to sentiment for its own stock, if News suddenly spent AUD 1.5 billion-plus on Seven, a free-to-air operator whose fortunes are inversely correlated with the success of a subscription TV company.

As such, we believe Seven's current stock price offers a good opportunity for shareholders to crystallise the recent gains.

We reiterate our intrinsic assessment is based on Seven as a stand-alone entity, and is predicated on our view of Seven's sustainable, midcycle TV revenue share and margins. We project that midcycle metropolitan TV advertising revenue share for Seven to be 37.5% longer term, with sustainable EBIT margin pegged at 16.0%. This is below the 22.7% average EBIT margin achieved over the past eight years, reflecting the continuing impact of structural pressures on the industry from digital and mobile insurgents, as well as the likely re-emergence of cost pressures to slow audience losses to these disruptors.

As for our estimated 10% or AUD 23 million lift in Seven's fiscal 2019 EBIT to AUD 259 million, its composition is worth noting. To begin with, we forecast around AUD 10 million of this increase is attributable to the new affiliation agreement with Prime Television, one that begins from July 2018 and we believe sees the affiliation rate (as a percentage of Prime's advertising revenue payable to Seven) step up from low 40% to around the 50% mark. The rest of the forecast lift in fiscal 2019 EBIT is from AUD 13 million in cost-cuts, broadly in line with management's AUD 10 to 20 million guidance. These drivers underscore our concerns regarding sustainability of earnings growth beyond fiscal 2019, as the affiliation increase is largely a one-off step up while cost-cutting is hardly a sustainable way to grow earnings longer term.

There is another earnings composition factor we feel is worth highlighting. The TV division accounts for 92% of Seven's group EBIT. However, the studio production business accounts for 26% of TV EBIT, or 24% of group EBIT. This is up from 10% of TV EBIT or 6% of group EBIT six years ago. The increasing dependence on the production business is a double-edged sword. On the upside, it reduces reliance on structurally-challenged TV advertising market. On the downside, such "hit-driven" production earnings can be volatile and lumpy, albeit they have enjoyed CAGR of 11% over the past six years. Critically, it is a well-kept secret how much of the production unit's current AUD 56 million EBIT base is attributable to the ageless Home and Away franchise (we estimate it could represent more than 50% of Seven's production earnings). Any slippage in the popularity of this program in overseas markets could have a material impact on production earnings.