Was Nine’s pre-emptive strike on Southern Cross Media really a good idea?

It may turn out to be wishful thinking, but beleaguered free-to-air TV operator Nine Entertainment (ASX: NEC) clearly expects the Turnbull-led coalition government to abolish the population reach rule and two-out-of-three cross-media ownership law, otherwise it wouldn’t have bothered to acquire a 9.9% stake in regional free-to-air TV and radio network operator Southern Cross Media Group (ASX: SXL) from the Macquarie Group (ASX: MQG).

Given the sorry state of Australia’s metropolitan and regional free-to-air television industry, the government is expected to acquiesce to media pressure and throw it some sort of life-line by abolishing reach rules, which prevents mergers between metro and regional free-to-air networks.

To put the state of the free-to-air television industry sector in context, Seven West Media Ltd (ASX: SWM), Nine and Ten Network Holdings Ltd (ASX: TEN) reported combined losses of $2.8 billion in the 2015 financial year – after all three were forced to write down the value of their television licences and other intangibles – which compares to combined revenues of $4 billion.

By taking a foothold in Southern Cross Media ahead of these reforms, Nine expects to be the most likely of the free-to-air players to take the company out. 

The market clearly gave Nine ‘props’ for trying to do something positive, with the share price rallying from $1.31 on February 10 to $1.62 on the strength of its 9.9% stake in Southern Cross Media.

Admittedly, the federal government party-room had already approved a number of media reforms, including abolishing the reach rule and the two-out-of-three cross-media ownership law.

By abolishing the reach rule, metropolitan free-to-air broadcasters Ten, Nine Entertainment and Seven will be allowed to merge with regional broadcasters, including WIN, Southern Cross Media and Prime Media Group Limited (ASX: PRT).

But any pre-emptive strike on Southern Cross Media by Nine or anyone else clearly remains high risk, especially with the country likely to go to a federal election well ahead of these reforms being approved by parliament.

Similarly, there’s no guarantee Nine’s interest in taking Southern Cross Media out would go unopposed.

Due in part to the need for scale to compete, other free-to-air operators will hardly take Nine’s acquisition of Southern Cross Media lying down, and Bruce Gordon’s WIN Corporation has been interested in launching a share raid on Southern Cross for some time.

With the regional free-to-air advertising market down by 11.3% in February, any future suitors of Southern Cross Media may not wish to pay too much for its regional TV assets, although it’s regional and metropolitan radio assets should be of interest.

But should the government’s proposed changes to media ownership eventually pass through parliament, Gordon’s WIN Corporation could conceivable end up with up to a 19.94% share in Nine – up from the legal limit of 14.96% it currently owns – and this could help block any proposed merger with the Southern Cross Media Group.

Since its share price rally earlier this year, Nine is now trading at a premium to its intrinsic value (17.48%) and an 8% premium to 12 month target price of $1.50, which makes an entry point at current levels more difficult to justify.

Indeed, there are some positive catalysts for the stock – including potential licence fee cuts, affiliate fee renegotiations, renegotiation of the Warner Bros contract, further capital management, and the launch of OzTAM’s cross-platform measurement system – which should aid digital monetisation.

However, concerns around long-term market growth, and the state and speed of regulatory reform remain an overhang for both Nine and the sector at large.

While the stock does have a long-term funding surplus of $784 million, both earnings per share (EPS) and return on equity (ROE) are expected to show some improvement.

There seems little to be gained by paying too much for this stock, especially ahead of a clearer window on regulatory reforms.

For those willing to take a longer -term view on the stock’s fortunes without a post-reform environment, any price around $1.20 makes for a more justifiable entry point.