Why proposed Domain spin-off has been good news for Fairfax
Key statistics: ASX: FXJ
Closing share price 18.04.17: $1.025 52-week high: $1.145 52-week low: $0.720 Most recent dividend: 2c Annual dividend yield: 3.88% Franking: 70%
Has the horse already bolted?
As evidenced by Fairfax Media's share price performance on both an absolute and relative basis over the past month or so, management's intent to spin off Domain Group has attracted a lot more "interest" than we had initially expected.
In essence, while we viewed the proposed separation of Domain from Fairfax's other assets as a positive development for shareholders, the resulting takeover interest was a surprise.
Although limited at this stage to press coverage and related speculation, what we do know is that private equity firm TPG Capital has recently "run the numbers" on Fairfax in an effort to get control of the company before it proceeds with its proposed spin-off of Domain.
The rationale for doing so is based on the view that TPG's primary interest is likely to be Domain given the private equity firm's current and previous investments in the global sector.
By taking control of Fairfax before it hives off a circa 35% interest in Domain through a separate listing, TPG hopes to limit the complexity and potential cost of the transaction.
This makes some sense, with the key motive behind Fairfax's decision to separate Domain from its other businesses being to enable the market to more accurately ascribe value (that is, price) to its distinct business units.
The fact that Fairfax's share price had responded positively to the proposed spin-off of Domain is evidence of this.
While Fairfax's price has rallied further on news (ironically from a Fairfax publication) that TPG is considering a tilt at the company ahead of the proposed demerger, this appears to have now given the private equity firm pause for thought.
While it remains to be seen whether the horse has already bolted for TPG in light of the recent share price jump (and the fact that the private equity firm would need to factor a control premium of 20%-30% into its equation), there could be merit in waiting it out.
This is based on the view that by doing so, TPG may be able to acquire, albeit at a higher price, Domain without having to assume the divestment risks attached to Fairfax's remaining assets.
Although we surmise that the inherent value of Fairfax's remaining assets (that is, excluding Domain Group) exceeds what the company's current market capitalisation implies, it could be difficult for TPG to realise this value when divesting these non-core assets.
The fact that, as with any leveraged buyout, TPG will look to divest these non-core assets as soon as possible given the high proportion of debt it will use to fund the acquisition is also likely to be a factor.
Regardless of whether a takeover offer for Fairfax does materialise before or after the Domain spin-off, it does in our view reflect positively on the company's asset base and growth strategy.
While it is difficult to provide any insights on the future prospects of Fairfax's traditional media assets, we believe TPG's purported interest in Domain highlights to us that the asset is far from mature or ex-growth. A similar case in our view could be made for the company's entertainment-on-demand offering, Stan.
Thus, while Fairfax is by no means a one-trick pony, we expect Domain to remain the key driver, at least for the next several years.
Press speculation regarding TPG Capital's interest in Fairfax proves this, with the private equity firm's ability to generate a sufficient internal rate of return likely to be predicated on its ability increase Domain's free cash flows to reduce its financial leverage and maximise the equity it realises on exit (the earnings multiple relative to peers).
While it remains to be seen whether recent press speculation regarding TPG's interest in acquiring Fairfax in its entirety will be confirmed by either party, it is worth remembering that current media ownership laws prohibit a foreign buyer from owning more than 5% of an Australian media company without Foreign Investment Review Board consent.
This, of course, coincides with the level at which an investor must lodge a substantial shareholding notice with the ASX.
Given TPG Capital's previous and current investments in the other online property portals such as RentPath in the US and PropertyGuru in Asia, it seems reasonable in our view to assume that where there is smoke there is also fire.
With Fairfax's proposed spin-off likely to go some way to ensuring that the inherent value of its asset base is more accurately reflected by the market, it follows that now is as good time for a prospective buyer to run the ruler over the company.
Fairfax's shares are currently trading at 16.5 times 2016-17 earnings and 2.48 times book value with a prospective dividend yield of 3.9%.
While by no means cheap, the combination of management's strategic initiatives and takeover interest are likely to support these metrics.
From a technical point of view, resistance is located between $1.11 and $1.15, with the 61.8% Fibonacci retracement at $1.30.
While noting that some of the recent increase in Fairfax's current share price can be attributed to speculation regarding a takeover, we remain confident that the company's shares can sustain these levels ($1.10-$1.20 a share) in the longer term.
Key in this regard will be management's ability to extract value from its asset base through its strategic initiatives, which includes the spin-off of Domain and further restructuring its publishing business.
Disclosure: Fairfax is held within the Fat Prophets Concentrated Australian and Small/Midcap Portfolios.