Investment analysts at Merrill Lynch have taken the big stick to the Seven Network in a note to clients this morning, outlining a case for why “Seven is not a buy”.

The report is quite damning and confirms the unease that exists among investors and analysts at the way the company and its board has invested over $700 million in the market to maximise franking credits, but which have suffered big losses.

“While the operational assets of Seven Media continue to trade well, we believe Seven Ltd will continue to trade at a discount to its cash backing until it makes a significant acquisition with its $1.8bn of cash and short-term investments. Earnings are expected to decline in FY09, hit by a softer TV advertising market and costs associated with the coverage of the Beijing Olympics in 1Q FY09.”

Penned by analyst, Alice Bennett, it follows up from a ratings report written mid week which examined the first half ratings performances of Ten, Nine and Seven and what it meant for the various companies, Seven Network, Ten Network and Consolidated Media Holdings, which owns 25% of PBL Media, which owns the Nine Network East Coast stations and NBN.

Nine surprised Seven and the market with a much stronger first half performance. Seven lost share to Nine, Ten and the ABC, although Seven’s dominance of the important 6pm to 7 pm timeslot tightened as the year went on and continues into the second half of the ratings year.

Cons Media is one of the companies in which Seven has been investing some of the money: its investments were above $3.16 a share and this morning Cons Media was trading around $3.09, after dipping under $3 earlier in the week.

Seven shares were trading around $7.90 this morning, off around 10 cents. Its low for the past year is $7.05 and the high was an euphoric $16.08 during the heady, pre credit crunch days last November.

Seven’s major market investment is West Australian Newspapers where it built a 19% stake but failed to get board representation. Seven has been trying to negotiate a truce and at least one representative onto the board, but the WAN share price has fallen from the $11 mark when Seven revealed its hand earlier in the year, to around $8.02 this morning. That’s a big loss and its one of the reasons why the market is suspicious of Seven.

Ms Bennett wrote this morning:

Seven has underperformed the ASX300 Industrials by 8% YTD and is trading largely in line with its estimated cash-backing (incl. ST listed investments) of $7.68/sh. The stock is now -32% below our fundamental $11.86/sh valuation and -10% below our revised PO $8.90/sh, which assumes a 25% holding company/acquisition risk discount. However, we see significant downside risk to FY09 estimates, with our EPS estimate -18% below consensus. As a result, we believe it is prudent to retain our Neutral recommendation given the stock’s appealing valuation is offset by the significant earnings risks it faces.

In our view, the market is underestimating the negative impact of the Olympics and the full impact of consolidating Unwired (particularly the amortisation of licenses, which will negatively impact FY09 earnings by c.$40m). Recall that the value of Unwired’s licenses were written up at Seven’s 1H08 result (reflecting the acquisition price Seven paid), which resulted in a big lift to D&A.

Our base case assumes the TV ad market declines by -1% and Seven’s revenue share is 39% in FY09 (41.5% in 1H09), assisted by the Olympics. Our bear case assumes the TV ad market declines by -5% in FY09 and Seven’s revenue share is 1% lower at 38%. This would cut our FY09 EPS by -30% and FY10 by -20%, and our SOTP valuation would reduce from $11.86 to $10.18/sh. Our PO, which assumes a 25% discount to valuation, would decline from $8.90/sh to $7.65/sh.