Citigroup will send the hares racing for their brokers with research from its analysts claiming to justify a complex bid by Seven Network to buy Fairfax Media.

Citigroup’s authorship of the research will add to the interest as its broking side has acted for Seven in its acquisition of shares in West Australian newspapers (WAN). According to Citi, WAN would be a central part of the mooted bid for Fairfax by Seven.

But as entertaining as the speculation is, there are a few things that would stop it happening.

In a note to clients over the weekend, Citi said:

We believe SEV may consider spending some of its cash on FXJ. In this note, we analyse the risks/returns on two hypothetical funding structures, which ultimately result in SEV controlling FXJ.

Why would SEV acquire FXJ? — i) FXJ stock at an all-time low; ii) Fairfax family blocking stake now diluted to ~10%; iii) ultimately the combination of SMG, WAN and FXJ would create ANZ’s largest cross-media platform; iv) at least an estimated $65m in immediate cost savings; v) SEV’s investment in WAN indicates belief in long-term newspaper value; and vi) because its affordable.

We believe the FXJ share price being at an all-time low and the dilution of the Fairfax family’s stake to ~10% post the rights issue have created a “once in a life time” opportunity for Stokes, a long-term believer in newspaper value.

It is affordable — We have run two acquisition scenarios in which SEV pays $1.50 per FXJ share. The key difference in the scenarios is if SEV takes immediate control or is content to wait for private equity exit (i.e. ~6yrs) to assume full control. Assuming the latter, we estimate SEV could end up with control of FXJ with ~ $350m firepower to spare.

How much can SEV pay? — Without debt funding and partnering private equity but assuming SEV/WAN want immediate control, we estimate $1.50 per FXJ share. However, assuming private equity control and SEV not retaining any cash, we estimate $1.85 per

WAN may need shareholder approval to make such a significant acquisition. Any delay here may see a significant premium built into the FXJ share price.

Related party issues — We note the WAN Chairman recommending a transaction of significant benefit to SEV may be considered a conflict of interest.

Regulatory constraints — We note perceived control of both SMG and FXJ/ WAN would require the divestment of FXJ’s Radio assets, given the 2/3 cross-media ownership rule (i.e. ACMA would likely consider SEV to have control of TV, Radio and Newspapers in metro licence areas). However, we would view MMG or Supernetwork Radio as potential buyers of FXJ Radio assets.

Competition concerns — Despite any Radio divestment, the ACCC may have concerns over the impact to competition in key markets.

Is $1.85 per FXJ share too low? — We note the average entry price (even post the rights issue) of existing long-term FXJ holders is likely above $1.85. A SEV bid above this level may rely on additional debt funding, which we believe may be difficult to secure given the current state of credit markets.

The first point of interest is whether Seven would be interested. At the moment, no because there is no upside, the media market, especially TV advertising, is contracting and the network, along with Nine and Ten, is more interested in surviving rather than expanding.

Seven has around $1.5 billion in cash left over from the sale of 50% in Seven Media Group (Seven TV Network and Pacific Magazines) and that is far more valuable on the balance sheet than in Fairfax. Why any company with that cash would want to spend it and take on debt is beyond most people right now.

It’s a one way ticket to a very low share price, and Kerry Stokes is not in the business of making himself poorer if he can avoid it. That’s the way James Packer and John B Fairfax have made themselves poorer in the slump, but ill-timed deals.

Secondly, News Ltd would not let it happen.

Remember in late 2006 when Seven and Kerry Stokes were said to have taken a position in Fairfax? News swopped through Goldman Sachs JBWere and snapped up around 7.5% of Fairfax to prevent any move on it? (That sent Fairfax into the arms of Rural Press and the rest is, unfortunately for John B Fairfax, history).

There are no big cost savings between Seven, WAN and Fairfax and those that remain would be diluted or even wiped out by a move to take the Sunday Times seven days a week. This would attack the newly merged company at its weakest point. Also, the forced sale of the radio stations owned by Fairfax would result in more losses because values for radio stations have fallen and Seven would be a forced seller.

Finally, why would Seven want to buy into Fairfax while its current business model is being undermined daily by the internet and by the recession? Seven shares would be sold down heavily in any deal because shareholders (apart from Kerry Stokes) would judge it to be a value-destroying transaction.

There’s more logic to Seven revisiting its previous interest in Austar, the regional Pay TV operator. And it still has that undeclared 4.8% stake in Consolidated Media Holdings, the James Packer-controlled company with 25% of Foxtel, 50% of Premier Media Group (Fox Sports) and 27% of Seek.

And there’s still the C7 judgement appeal, which, if Seven wins, could trigger a realignment of media interests to make the whole thing go away.

Peter Fray

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