Seek makes an attractive offer

PORTFOLIO POINT: Seek Ltd’s capital raising does not threaten to dilute profitability or equity.

If the stockmarket crash of 2008 and the “recession-we-deserved” weren’t enough, capital raisings, debt repayments and ownership dilution have heaped burning coals on investors’ heads. Most raisings have been at substantial discounts to the share price and even equity per share, and those that were completed to pay down debt, diluted not only shareholders ownership stakes but also profitability per share.

The result has been a reduction in the value of the companies involved and ultimately a delay in any sustained recovery in the share price for those companies. (To read more on unwanted rights issues at big stocks, see James Kirby’s feature Rights to avoid.)

Occasionally – very occasionally – a raising comes along that doesn’t contain the corrosive dual dilution to profitability and equity, and Seek’s rights issue offer seems to be OK.

Seek has announced that it is buying the outstanding 50% interest in private vocational education service provider Think Group Limited for $42.5 million. It will also pay $14.5 million in Think Group debt, and it will also offer to buy an additional 10% stake in IDP education – a company that markets Australian universities in Australia – from the 38 university shareholders, making it a subsidiary.

As was the case with another education business, ABC Learning, most of the commentary and analysis has focused on the profit growth and the diversification of earnings, with scant regard for the impact on the value of the business.

Prior to this announcement, Seek was expected to earn about $56 million in 2008-09 and pay $42 million in fully franked dividends, to produce an owner’s return on the 54.3¢ of equity per share of approximately 52%, and producing a value of $2.65 for every 54¢ of equity per share. In 2009-10 the company was expected to earn $60 million and, assuming the same payout ratio, would result in a return to owners of 50.7¢ on equity and the value of the company rising to $2.74.

The transaction as announced is expected to double revenues and increase reported EBITDA by 45%. The company, however, is raising $100 million by issuing 38 million shares at $2.60.

In 2009-10 the company is now expected to earn $79.1 million, however it will also have raised an additional $100 million of equity by issuing those 38 million additional shares.

Logic suggests that the $100 million raised has increased profits initially by the difference between $60 million (the original forecast) and $79.1 million (the new forecast). In other words, the capital raised is generating a 19% return in the first full year. This is a good sign and is also a far superior way of assessing the merits of the acquisition and associated capital raising than simple “earnings accretiveness”.

Assuming the payout ratio remains the same in 2009-10 as the “original” forecast, the company will produce a return on equity (ROE) of 40%. This is a lower ROE figure because the new equity raised is generating a return of just 19% in the first year. The capital raising, well above the original equity per share, raises the equity per share for all shareholders and at the end of 2009-10, this will be approximately 84¢ and offsets the decline in the return on equity.

I like those little “before & after” shots you see in renovation magazines. We can do the same for Seek Ltd. Before the transaction was announced, the value of Seek Ltd would have been $2.74 in 2010. The “after” valuation for 2010 is now $2.92. The transaction, assuming its forecast contribution to 2010 performance is correct or conservative, will lift the value of Seek by 6%.

The capital raising at $2.60 does indeed offer investors a more attractive entry price than the market price prior of $3.21 prior to the announcement. Seek is trading today (May 1) at $3.41

Of course, in this report we have not discussed the merits of the business model or the prospects for education businesses and online search engines. (The Seek rights issue remains open; a closing date has yet to be declared.)

Roger Montgomery is a research analyst for Clime Investment Management Limited's (ASX:CIW) company valuation service StockVal. Exclusively for Eureka Report subscribers, StockVal is offering a free two-week test drive. Click here.