Domain The Main Game For Fairfax

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Two indicative proposals from private equity have not resulted in a formal bid for Fairfax and the company is pursuing its agenda of de-merging Domain. Brokers explore the path forward.

-Main issue for bidders likely to be rapidly declining earnings profile
-Has uncertainty created a buying opportunity?
-Citi calculates negligible cash flow ex Domain
 

By Eva Brocklehurst

Fairfax Media ((FXJ)) has confirmed the two indicative proposals from private equity have not resulted in a formal bid, although did not provide a definitive reason as to why TPG decamped. Management suggests TPG did not want to proceed with buying the entire company. With respect to Hellman & Friedman, it was not able to form a bid by last Friday's deadline and Fairfax terminated discussions.

Citi believes the main issues for the bidders were a rapidly declining earnings profile and potential restructuring and redundancy charges needed to keep newspaper earnings in positive territory.

Morgan Stanley is disappointed, having expected at least one bid would prevail, but remains positive about the fundamentals of the business and the strategy that is in place to realise value. Fairfax is debt free and the Domain spin-off is on track for completion by the end 2017.

While expecting the shares may ease on the back of the failure to procure a definitive bid, the broker believes there is nothing to change the fundamental view and retains an Overweight rating.

Meanwhile, media ownership reforms are back in the Senate in the first week of August. The broker envisages no change to the rules but, if ownership rules are removed, this will provide Fairfax with more options.

In the past, the company has received informal offers for other assets, such as radio, and Morgan Stanley would like the company to promote this path. The broker believes exiting non-strategic assets for cash and reinvesting the proceeds through a buy-back would be a sensible way of creating additional value.

UBS believes the keys to hurdling price/earnings return targets involve aggressive gearing in an unlisted environment and organic earnings growth.

The company is expecting FY17 operating earnings (EBITDA) of $262-266m and will provide an update on Domain at the FY17 results. Listings have returned to positive growth in the June quarter and Morgan Stanley observes comparables will get considerably easier in the September quarter.

Domain Valuation

Morgan Stanley calls for an investor briefing on Domain to discuss the growth strategy, particularly around expanding into the broader digital/e-commerce opportunity.

UBS would also like further detail on what amounts will be paid away by the agent equity model in the de-merging of Domain, particularly as agent equity interests are apportioned over time and "Premium Plus" contributions grow.

The broker also has queries regarding the revenue and cost structure of the de-merged Domain. Without these items, UBS is hesitant to apply a similar operating earnings multiple to the Domain digital business to that which it applies to REA Group ((REA)).

Citi retains a positive view on Domain, as it is consistently growing faster than its rival and has high exposure to Sydney and Melbourne. Nevertheless, current earnings are likely to below normal because of low listing volumes in those cities. When assessing a fair multiple for Domain, Citi uses REA as a starting point and believes there are two reasons for the Domain to trade at a premium and one reason to trade at a discount.

Reasons for a premium are growth and exposure to Sydney and Melbourne. The reason to trade at a discount is, size. Fundamentally, Citi envisages the smaller portal is deserving of a discount, as its development and marketing costs are likely to be similar to its larger peer but there will be lower revenues to support those functions.

Credit Suisse reinstates coverage of Fairfax with an Outperform rating and $1.10 target and considers the uncertainty created by the private equity negotiations has created a buying opportunity ahead of the de-merger of Domain. The broker envisages potential for Domain to grow value over time and narrow the gap to REA Group.

Credit Suisse's valuation implies a multiple of 17.8 times FY18 adjusted operating earnings, similar to REA Group on 17.5. The broker suspects investors will pay a premium for the strong growth opportunity in Domain, post the de-merger.

Fairfax Without Domain

The bulk of the company's value is comprised of Domain while the remainder faces structural pressures. The company has noted Domain revenue is up 10% in the second half, and there is been a pick up in digital revenue growth over the last few weeks. This is been offset by greater revenue decline in print.

On this basis Citi shifts its view back to a fundamental valuation, reducing its target by -12% to $1.06 and retaining a Neutral rating. The broker forecasts operating earnings of $31m for metro media in FY17, off revenue of $517m. Cost savings in FY18 of $30m should keep the division in positive territory despite double-digit revenue declines.

Nevertheless, after restructuring charges, net cash flow is negligible and Citi calculates Fairfax will need to repeat the same cost savings every year and is unlikely to stabilise revenue in the next few years.

There are two Buy ratings and three Hold on FNArena's database. The consensus target is $1.14, suggesting 19.6% upside to the last share price. Targets range from $1.00 (UBS) to $1.50 (Morgan Stanley).
 

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