Seven's potential unearthed

Kerry Stokes' plan to sell his privately-held Caterpillar franchises into Seven Network for $2 billion is certain to generate controversy. It is, at face value, not just a very big related-party deal but one which brings together the unlikely mix of earth moving equipment and media investments and in the process lifts Stokes' holding in Seven from 47 per cent to 68 per cent.

For a market that has always been cynical about the way Stokes has crept his way to control of Seven and used the $2.5 billion of net cash released by the brilliantly-timed sale of a 53 per cent interest in the underlying media businesses to Kohlberg Kravis & Roberts in 2006, an insider deal with no operational logic or synergies would immediately arouse suspicion.

However, the problem for Seven and its shareholders is that despite an exhaustive search for alternatives for deploying the group's remaining $1 billion of cash the board couldn't find an acquisition within the media sector (and, apparently, some that fell completely outside that space) that made sense.

At the moment Seven has an inefficient balance sheet. It is effectively an investment company with its interest in Seven Media Group alongside KKR, 23 per cent of West Australian Newspapers, 22 per cent of Consolidated Media and some other investments including, reportedly, a sizeable holding of Telstra shares.

The $1 billion of net cash remaining from the KKR deal is trapped. An attempt to return it to shareholders would crystallise a $600 million-plus deferred tax liability. The obvious option for using that cash efficiently and in a fashion that creates the capacity to pay franked dividends is to use it to acquire an operating business.

Stokes may have hoped that last year's raid on Consolidated Media might have used up Seven's financial capacity but James' Packer's emphatic response has created a stalemate for Seven that only a change of heart by Packer towards ConsMedia and its collection of pay TV interests could break.

Stokes' WesTrac Holdings is well known to most of the Seven board.

Stokes acquired his initial Caterpillar franchise in 1988 when he bought Wigmores – the original $40 million vehicle which launched the first of Robert Holmes a Court's audacious series of bids for BHP – from the imploding Bell Group after it was effectively destroyed by the 1987 sharemarket crash.

For Stokes, the unlikely combination of cash flows from mining equipment and media investments has worked for him personally for more than two decades.

There is little doubt that if WesTrac were offered separately to the market in an initial public offering it would be swamped by investors.

Its West Australian, Chinese and NSW heavy equipment management businesses are high-quality growth businesses with exposure to the booming Pilbara and Chinese resource economies. The massive expansions BHP Billiton, Rio Tinto and others are committed to it Western Australia underwrite its long-term growth.

The questions for the Seven minorities are not whether WesTrac is a good business but whether it belongs within their portfolio and whether the terms are attractive.

Their independent directors have conducted a protracted due diligence process, including visits to China (where it owns one of only four Caterpillar franchise) and Caterpillar's head office in North America, and commissioned an independent expert's report that concluded that the deal was fair and reasonable.

The minorities will be able to veto the deal if they choose – Stokes will be unable to vote his shares at the scheme meeting that will vote on the proposed deal.

At an enterprise value of about $2 billion (half debt, half equity) WesTrac is valued on forward multiples of earnings that are close to the multiples on which the two closest comparable companies – Finning International and Toromont Industries of Canada – trade.

The consideration is entirely scrip, priced at the equivalent of $8.70 per Seven share, or a significant premium to its recent share prices.

In other words, Seven (the merged group would be called Seven Group Holdings) would acquire WesTrac without paying a control premium but issue stock at a premium to reflect the increase in Stokes' interest to 68 per cent.

At first glance, whatever the merits of the particular combination of assets, the terms appear reasonable and the financial logic of trading the trapped cash for high quality operating earnings with good growth prospects defensible.

The proposal would bring all Stokes' major interests together in a single listed entity. While he would dominate the register, he's controlled Seven for a very long time. The percentages might change but the reality Seven shareholders have lived with since he gained control of the boardroom is unaltered.

Apparently Caterpillar insists that he retain at least a 60 per cent interest in the holder of its franchises, so there is a floor under his eventual holding, while Seven itself wants to have a free float of at least 30 per cent of the new entity's shares to protect its position in the ASX indices.

Seven Group would, if the deal is consummated, have strong cash flows about $300 million a year if WesTrac meets its 2011 earnings before interest, tax, depreciation and amortisation forecast of $231 million as well as no net debt of consequence and some residual cash once it pays down about $700 million of WesTrac's $1 billion of borrowings.

If Stokes were positioning Seven for another tilt at ConsMedia, or to buy back the KKR interest in the Seven media businesses, or for some other large play – whether in media or an unrelated sector – it would make sense to bulk up Seven Group, add solid cash flows and increase his own shareholding to create flexibility to issue equity and debt in future without jeopardising his own control.

The scheme meeting to approve the deal, or not, is scheduled for mid-April so the market and Seven shareholders will have plenty of time to analyse and debate the appeal, or otherwise of the proposed transaction.

Their problem is that while they can stop the acquisition of WesTrac if they choose, Stokes could use the cash in Seven's balance sheet to pursue other non-media deals.

In that sense, the fact that the proposal is a related-party transaction is a positive because they get to have the decisive say on whether or not the $1 billion of remaining cash is used for this particular acquisition on known and apparently favourable terms or whether Stokes just goes off and spends it on whatever takes his fancy without having to justify himself or the deal to the minorities.