How moguls make money

PORTFOLIO POINT: As Kerry Stokes builds his fortune, minority shareholders have not enjoyed the same benefits.

Two weeks ago Kerry Stokes announced a deal that would see a top-rating television network merged with a successful newspaper. At face value this seems a sensible deal, but there are reasons investors should be wary.

The deal will see the company that is 68%-owned by Kerry Stokes, Seven Group Holdings (SVW), sell the Seven Media Group to WA Newspapers (WAN), in which Stokes owns 24.3%. The announcement sent WAN’s share price down 14% to a 19-month low.

Some of the selldown can be attributed to the scheme that saddles one of the most successful newspaper operations in the country with $2.1 billion worth of debt; however much of it has to do with the manner in which previous deals orchestrated by Stokes have seen the media mogul increase his wealth at a time when shareholders have not seen a corresponding benefit.

If we go back 10 months, Stokes was in the midst of yet another related party transaction. He was effectively buying Seven Media as he swapped his 100% holding in the earthmoving equipment dealership WesTrac for more shares in his minority-owned Seven.

At the time Stokes was effectively buying Seven Group Holdings, the independent expert valued Seven Media at $2.9–3.3 billion. But now when Stokes is effectively selling Seven Media – less than a year later – the value of the same assets is 55% higher at $4.6–5.1 billion.

Talk about buying low and selling high!

The independent expert justified the increased valuation saying it resulted from a “substantial increase in forecast earnings”. At the time of the WesTrac deal the expert forecast EBITDA of $290 million for 2010. Yet just 10 weeks after the shareholder vote, Seven ruled off its year with EBITDA of more than $361 million – an improvement of about 25%.

Nothing was revealed to the market about this variance until final results in late August. So back in April, when the deal was being voted on and receiving court approval, the financial year 81% complete, strong Christmas trading already banked and with a typical 2–3 month forward view on TV bookings and ads, it appears no one at Seven perceived the 25% profit bonanza that awaited them.

Extending this line of enquiry, where did the additional earnings came from?

By trawling through nearly 1000 pages of material released by Seven and WA Newspapers since that time it’s possible to see than in the nine weeks between Justice Jacobson’s approval of the WesTrac scheme and year end, Seven found an additional $43.6 million in TV revenue and managed to cut operating costs by $23.5 million. Similar trends can be seen in the 2011 EBITDA forecasts made last year.

As far as I can determine, the new independent expert devotes just one sentence to this sudden good fortune: a better advertising market and the continuation of licence rebates.

Seven’s good fortune doesn’t seem to have been shared by other Australian media companies. Since the WesTrac deal was announced, the share prices of other Australian media companies have mostly declined; some significantly.

-Seven's outstanding performance
Company	March 16, 2010	March 8, 2011	/-
Seven Group	$8.00	$8.80	10%
News Corp	$18.16	$18.02	flat
Network Ten	$1.78	$1.28	-28%
Fairfax	$1.76	$1.26	-28.40%
Prime Media	$0.74	$0.72	-2.70%
Consolidated Media	$3.20	$3.05	-4.70%

Over the same period the ASX 200 has risen a fraction of 1%. Yet “underlying” TV earnings at Seven have risen 44% and the valuation has increased 55%. All these various valuations have had real-world consequences – with specific benefits to Kerry Stokes.

All things being equal, if this year’s Seven valuation was used in April 2010, Stokes would have received 42.3 million fewer Seven shares in the WesTrac deal. Those additional shares allowed him to increase his ownership of the shares by a further 5.1% to his current 68% holding but, just as importantly, those shares have a value of almost $375 million.

It’s a surprising turnaround in less than a year – at a time when the rest of Australian media was clearly struggling – that a TV and magazine valuation could rise 55%.

Anyway, the WesTrac deal worked so well that we now have another related-party transfer on our hands and this time the shareholders of WA Newspapers are in the frame.

My role in the saga

I have a confession to make. In another life, I produced some research highlighting how Stokes could use buybacks to increase his shareholding in Seven, from his then 26% to 32%. He announced his first buyback eight weeks later. That was so successful Seven completed a series of them over the following five years, which lifted his stake from 26% to 43% without him needing to buy a single share.

I now regret my insight. Off-market buybacks are generally used to return surplus cash to shareholders. BHP is doing one right now. Throughout the period from 1999 to 2003, when Seven conducted its buybacks, the dividend was static. It can be argued that cashflow that should have boosted the dividend was instead diverted to buying back stock: a move that delivered greater control to Stokes.

The WesTrac deal last year was the culmination of all these buybacks and enabled Stokes to push his shareholding in Seven from about 25% in 1998 to 68% in 2011 and the overwhelming majority of that increase came without any share purchases on his part!

WA Newspapers

For 15 years WA Newspapers was a market darling, a blue-chip company that outperformed the market by a massive 7% per annum. That equates to a return almost 200% higher than the market. It did so because it had strong cash flow and astute managers such as Denis Thompson and Tom Garvan. A strong shareholder focus gave rise to a high dividend payout and minimal debt.

Those days are now a distant memory. With Stokes as chairman WA Newspapers has underperformed the market by 5%. This echoes Seven’s own 1% pa underperformance since Stokes took control 15 years ago. And if WA Newspapers shareholders approve the proposed scheme they will saddle the company with an additional $2.1 billion of debt – roughly triple its current debt load relative to earnings. What comes next? Fairfax? Consolidated Media? APN?

Seven’s actions are within the letter of the law. A battalion of accountants, lawyers and investment bankers will certify their claims. But based on what I know, I could not be certain that under this deal some shareholders will ultimately be better off than others.

It’s been said that Stokes is one of the country’s most active philanthropists. He has, for example, donated many a Victoria Cross, which he had personally bought, to the Australian War Memorial. The fact that he can generate incredible wealth is not in dispute either. He has achieved control of more than one media outlet starting with only a modest shareholding. What a pity the minority shareholders of these companies have not benefited in a manner they would expect.

Mike Mangan is a fund manager at 2MG Asset Management. From 1992-2005 he was one of Australia’s leading media analysts. He has no financial interest in WA Newspapers