The curious case of Seven Group Holdings

At the beginning of this month, Seven West Media (ASX: SWM) announced its full year financial results which fell short of market expectations. In addition, earnings guidance for the next financial year were also below expectations. The challenges facing the traditional media industries have been well documented: at a time when eyeballs are increasingly hard to come by (unless you are Facebook or Google) – and advertising revenues waning, content costs are increasing.

In a brutal two-day period following the announcement of its results, Seven West Media’s share price declined by 28%. In dollar terms, more than $400 million was wiped off the value of the company. And since the stock’s most recent 52-week high achieved in June, $700 million in value had been wiped off the company’s value following its result.

So what does this have to do with Kerry Stokes’ Seven Group Holdings (ASX: SVW)? Well, Seven Group Holdings owns approximately 41% of Seven West Media. So the approximate math is as follows: for every $700 million that Seven West Media declines in value, Seven Group Holdings should decline by approximately $290 million – all else being equal.

Now, over the period during which Seven West Media declined in value by $700 million, Seven Group Holdings actually increased in value by approximately $500 million! So to be clear, this implies that the non-media assets in the Seven Group Holdings portfolio increased in value to the tune of nearly $800 million (or by around 30%) over just a two-month period. This is a fantastic outcome for Stokes’ non-media assets.

The next question is: what are these non-media assets – and why are they doing so well? Seven Group Holdings’ primary non-media assets include 100% ownership in WesTrac – a dealer of Caterpillar equipment in Australia and China; 46.5% ownership of Coates Hire – a leading construction equipment hire business; and 100% ownership in Allight Sykes – a manufacturer of industrial lighting, pumps and generators. In addition, Stokes’ conglomerate also owns interests in energy assets, property and other listed investments.

Now, it’s fair to suggest that Stoke’s energy, property and listed assets probably are not responsible for the 30% two-month gain observed in his non-media portfolio. So that leaves his equipment businesses. But according to Macquarie, WesTrac is not expecting any sales growth at all over the next twelve months – and if Caterpillar’s global outlook is anything to go by, demand for mining and construction equipment is unlikely to improve any time soon. All in all, Macquarie expects these non-media assets to deliver earnings that are down around 5% over the coming year versus the year just gone.

Is a 5% annual earnings decline worthy of a 30% re-rating in value? It could well be – depending on how low the market’s expectations were leading into the result. For example, if the market were expecting, say, a 10% decline, then 5% is a great outcome.

Whichever way you cut it, investors in Seven Group Holdings need to pay a lot more for a business that is barely growing today, than they have for some time. Upon considering the ratio of the company’s enterprise value to its expected full-year earnings (before interest, tax, depreciation and amortisation): just three years ago it was below 6 times; at the beginning of 2016 it was a little over 10 times; and today, it is more than 13 times. It may well be justified. But as the price goes up, so too do the required future earnings that the business needs to deliver for investors to make money.

This article was first published in the Herald Sun.

Montaka is short the shares of Seven West Media and Seven Group Holdings.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.