Over the long-term the secret to successful investing may simply require identifying and buying great businesses.

A moat is a structural feature allowing a firm to sustain excess profits over a long period. Moats can take many forms, and you can read more about spotting them here

Seven Group Holdings (ASX:SVW) awarded narrow moat rating

Morningstar Australia analyst Mark Taylor recently upgraded Seven Group Holdings to a narrow moat rating. Today I’ll reveal why and see how the shares trade today versus Taylor’s estimate of fair value.

You can find more information about how analysts arrive at their moat, fair value, uncertainty and capital allocation ratings at the foot of this article.

What does Seven Group Holdings do?

Seven owns several assets across industrial and mining equipment, construction materials, energy and media.

Seven’s fully owned WesTrac Australia and Coates Hire businesses provide solid revenue and cash flow via exposure to the local government, civil construction, and mining sectors. WesTrac is the sole authorized Caterpillar dealer in Western Australia, New South Wales, and the Australian Capital Territory. Meanwhile, Coates Hire is the biggest domestic equipment rental firm. A more recently acquired 73% stake in building products and construction materials business Boral (ASX:BLD) adds to the infrastructure thematic.

Elsewhere, a 30% stake in Beach Energy (ASX:BPT) provides a growing energy exposure with leverage to oil and gas prices. The company's media investments are in large listed domestic television, newspaper, and magazine companies. The major media investment is a 40% shareholding in Seven West Media (ASX:SWM). Other investments include a portfolio of Australian dividend-paying shares.

Kerry Stokes owns more than half of the company and has a dominant role in Seven Group’s strategy and management.

Why the moat upgrade?

Mark Taylor has upgraded Seven Group Holdings to a narrow moat rating in anticipation that it will earn economic profits for longer than previously credited.

A narrow moat rating means that our analysts think a company is likely to sustain excess returns for at least a decade. Seven Group's upgrade to this rating stems from the fact that a progressively higher portion of their revenue is coming from WesTrac and Coates Hire – two businesses that Taylor thinks have a moat.

WesTrac has a monopoly on some of the world’s best Caterpillar sales and maintenance territories. While its Caterpillar dealerships can be terminated with 90 days' notice from either party, Taylor sees no reason for this to happen any time soon. Meanwhile, Coates’ merger with National Hire in fiscal 2012 gave it unmatched scale in a fragmented industry. It has the largest national footprint, is close to customers, and attracts tier-one customers including government entities.

Taylor doesn’t think Boral, Beach Energy, or Seven West Media have economic moats. He sees Boral’s network of quarries linked to the New South Wales train system as impossible to replicate, yet they only contribute a small minority of earnings. Beach Energy is not a low-cost energy producer, and the intangible power of Seven West's free-to-air license has declined to such an extent that it no longer acts as a barrier to competition. However, these no-moat businesses comprise only a third of Seven Group earnings.

When a company has a moat, it will often show returns on capital that are comfortably above its cost of capital. Since Seven Group’s merger with WesTrac in 2010, group returns on capital had improved to an estimated 10.5% by fiscal 2023. Taylor forecasts them to reach 12.0% midcycle, which is notably higher than Seven's estimated cost of capital of 8.0%. He sees the competitive strengths of WesTrac and Coates Hire playing a key role in this improvement.

Are Seven Group Holdings shares good value?

Taylor’s upgrade to Seven Group Holdings’ moat rating also came with a 5% bump in his fair value estimate to $32 per share. He assigns a medium uncertainty rating to his forecasts and valuation due to the cyclical nature of some of the firm's markets, especially in mining and construction equipment.

Taylor expects Seven Group’s earnings before interest, taxes, depreciation and amortisation ("EBITDA") to grow at 5% per year to 2028 with a midcycle EBITDA margin of 19%. He anticipates strong earnings growth from the higher margin energy segment, including from Beach Energy thanks to its Waitsia gas project development. His valuation implies an adjusted fiscal 2028 EV/EBITDA of 7.3, P/E of 14 and dividend yield of 2.3%, assuming a 30% payout ratio.

At a current market price of around $40 per share, Seven Group Holdings looks overvalued — and it isn't the only ASX share that looks expensive at the moment. Here are 3 other ASX shares trading well above Morningstar's estimate of fair value.

Seven Group Holdings (ASX:SVW) ★★

Moat Rating: Narrow
Share Price on 10/05/2024: $40.09
Fair Value: $32.00
Price To Fair Value: 1.25 (overvalued)
Uncertainty Rating: Medium

What these terms mean

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.