With a fortnight to go before Seven Network shareholders vote on the contentious merger with Kerry Stokes’ WesTrac group, the fate of the proposal appears to be very finely balanced.
It hasn’t helped Stokes’ cause that the two most prominent institutional advisory firms, RiskMetrics and CGI Glass Lewis, have advised their clients to vote against the deal.
That adds to the pressure on Seven’s two biggest institutional shareholders, Ausbil Dexia and Perennial Investment Partners, who between them hold about 12% of Seven and have the ability to torpedo the scheme of arrangement. They have been playing their cards close to their chests.
The RiskMetrics analysis of the proposal is a very balanced document that, while it does raise some concerns about the related party and business risks associated with the proposal, fundamentally recommends against it on valuation grounds.
In concept, if the starting point is that Stokes, Seven’s executive chairman and owner of 48.7 per cent of its capital, has unchallengeable control of Seven, the deal makes a considerable amount of sense.
Seven is essentially a very heavily cashed up investment holding company that has traded at a very significant discount to net assets. It has struggled to find worthwhile places to invest its remaining $1 billion of cash. It also has a $600 million deferred tax liability ticking away within its accounts.
WesTrac, wholly owned by Stokes, operates Caterpillar franchises in Australia and China and is very exposed to the boom in mining and resource infrastructure occurring here and there. It also has $1 billion of debt, but its main bank facility – which would be repaid with Seven’s cash if the merger were to be approved – doesn’t mature until December 2012 and the rest of its debt is in the form of US notes that mature in relatively small tranches over the next decade.
The merger is the one transaction, given Stokes’ presence on both sides of the deal, that can be implemented as a pure merger, with Stokes receiving almost entirely scrip in exchange for WesTrac. (RiskMetrics identified pre-merger related party transactions that would release $150 million of cash to Stokes, along with ongoing rental payments).
There are several reasons why the structure makes sense for Stokes and Seven.
For Stokes it completely removes any refinancing risk within WesTrac in 2012. In addition, it ought to see Seven shares re-rated because the group would then have WesTrac’s operating cash flows. And finally, it protects WesTrac’s Caterpillar franchises, as much as possible, because Stokes would own 69% of the merged group.
For Seven, it promises that re-rating by the market. It also uses the group’s cash to buy a business that is generally regarded as very attractive. Finally, because it is a scrip-based deal, it would enable a re-basing of the carrying value of Seven’s assets for tax purposes that would reduce its deferred tax liability by $200 million. Indeed, RiskMetrics says Stokes’ representative told it the reduction in cash terms would be closer to $300 million.
More broadly, by putting all his major interests into one listed vehicle in which he would have a 69 per cent interest, Stokes would have the bulk of his fortune exposed to the continuing performance of Seven.
So, given that Stokes already controls Seven, the concept makes sense. It would be difficult to find another transaction that he would agree to that dealt as well with the issues latent within Seven.
The problem is with the valuation. The independent expert, Deloitte Corporate Finance, did declare the terms fair and reasonable.
It came up with such broad valuation ranges for both Seven and WesTrac, however – because of the difficulty in valuing both Seven’s stake in the Seven Media Group leveraged joint venture with Kohlberg Kravis Roberts & Co and WesTrac’s China businesses – that there was only a 50 per cent over-lap between valuation of the consideration and the assets to be acquired. In other words, there was a 50 per cent chance that Seven shareholders would be paying too much.
RiskMetrics notes that Deloitte used a future maintainable earnings base for Seven’s businesses that was lower than the earnings forecast for 2011 but a higher maintainable earnings number for WesTrac than its forecast earnings.
It concluded that the terms weren’t compelling from a valuation perspective, although it also said that some shareholders might consider the opportunity to have an exposure to WesTrac provided sufficient benefits to balance the concerns RiskMetrics expresses.
The sharemarket provides an interesting commentary on the proposal. Seven shares leapt from $6.98 before the proposal was announced to a high of $8.07 a couple of weeks later before falling back to around $7.50 as doubts about the proposal being approved began emerging. That would suggest the Stokes camp’s basic premise – that the shares would be re-rated if the deal (which would see Seven shares issued to Stokes at an above-market $8.70 a share) goes ahead – is correct.
It doesn’t however, help conclude the argument over whether the terms of the proposal are too generous to Stokes given the risks and related party entanglements involved.
Stokes has said the proposal is a one-time deal – Seven won’t be offered WesTrac again. If it is defeated, however, he would still have to find a solution to Seven’s market rating, its tax liability and his own funding of WesTrac’s funding and refinancing needs in future.
Ausbil Dexia and Perennial have a lot of leverage in the circumstances and, given the conga line of critics of the terms, rather than the concept, a lot of pressure on them to try to use it. Stokes, with his vast history of deal-making, of course, isn’t necessarily the easiest of adversaries to negotiate with.
This article first appeared on Business Spectator.
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