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Posted on 18 Jul 2008 by Forager

The Structure of Babcock's Capital – Day Nine

Babcock & Brown’s capital comes from a combination of bank debt, subordinated equity and ordinary shares. I’ll run through each in turn.

The senior debt is comprised of a $2.35bn revolving line of credit, of which $1.92bn had been used at 31 December, and a US$200m facility, which was fully drawn at 31 December.

The annual report puts the margin on both facilities at 1.3%, but a recent announcement from Babcock regarding its lenders’ waiver of a right to review the facilities said the margin had increased 50 basis points to 200 basis points (2%). I’m not sure where the extra 20 came from but we’ll take them at their latest word.

It’s impossible to know what other conditions are attached to these facilities but they most likely include debt-to-equity and interest cover provisions.

Babcock’s capital structure
Facility Amount as at
31 December
Interest margin
Line of credit $1.92bn 2.00%
US facility US$200m ($205m) 2.00%
Aussie subordinated notes $414m 2.20%
Kiwi subordinated notes NZ$225m ($199m) 2.20%
Total/Average $2.74bn 2.04%

The subordinated debt comprises two subordinated notes listed on the Australian and New Zealand stock exchanges. There are 4.14m Australian securities on issue with a face value of $100 each and 225m New Zealand securities with a face value of NZ$1 each. Both facilities accrue interest at a margin of 2.2% over the relevant bank bill rate and are fully subordinated to the corporate facilities (if it all falls apart, the corporate facility providers get their money first).

They also both convert into shares at maturity. For the Aussie notes that’s in 2015 and for the Kiwi notes it’s 2016. Despite reset dates five years before maturity, the subordinated nature and conversion into equity makes this sort of financing relatively safe for shareholders. As a potential investment in their own right, both are trading at huge discounts to face value and we’ll include them in our valuation analysis.

Taking the non out of non-recourse

Before moving on to shares and options, it’s worth noting some of the other details regarding interest-bearing liabilities – some of the non-recourse debt is a little more recourse than management would have you believe. This is debt that relates to specific projects and the lenders can’t come after the rest of Babcock’s assets if disaster strikes. But the fine print shows that it doesn’t quite end there. Babcock has ‘given undertakings to inject equity into the project-specific entities in certain circumstances’ and it has also ‘given performance undertakings’. In other words, Babcock is going to share in the pain if something goes wrong.

Finally, at 31 December there were 294m ordinary shares on issue and 34m options. Of the latter, almost 23m are exercisable at $5 per share and the remainder at prices between $13.31 and $25.54 – so there’s the potential for some dilution.

It’s not a particularly complicated structure, but there is a substantial amount of debt in front of shareholders and a significant number of options on issue.

And that brings to a close nine days of preparation. Next up it’s time for the big one – trying to estimate what it’s worth. Given the uncertainty to date, I’m not feeling confident. But it will be an interesting exercise nonetheless.

Posted on 15 Jul 2008 by Forager

Restoring Confidence In Babcock & Brown – Day Eight

Restoring Confidence In Babcock & Brown – Day Eight

Making the bull case for Babcock doesn’t require the creative mind of a science fiction writer. If the future is remotely like the past and the business continues earning returns on shareholders’ equity in excess of 25%, those that buy at the current price will do very well.

Given the current ‘crisis of confidence’, that proposition might sound ludicrous. But Babcock os not the first investment bank to dust investors’ capital in pursuit of a quick buck. And most of the others are not only alive and kicking, but making obscene profits.

Sure, it goes wrong from time to time. But, on average, the returns generated in the investment banking game are exceptional (for staff and shareholders).

Macquarie Group, for example, has churned out its fair share of mediocre products over the years and been through several of its own confidence crises. Yet its return on equity has averaged almost 25% during the past 16 years.

The reason is that investors have incredibly short memories: for all the talk of reputations lost, it seems punters are only too willing to forgive and forget when the latest prospectus arrives in the post. With years of experience in wind and solar energy, Babcock remains extremely well placed to cash in on the current investor enthusiasm for renewable energy.

Given a couple of years and some price recovery in its managed funds, Babcock’s current crisis could be long forgotten.

Any buyers out there?

Shareholders could also see a huge upside if Babcock is able to sell assets on its own balance sheet at attractive prices. Selling on investments for a profit has been the major factor in Babcock’s profit growth to date. As I’ve mentioned in previous posts, until they got involved in the infrastructure bubble (is anyone calling it that yet?), they were very good at identifying opportunities in advance of the masses.

It seems unlikely given current market sentiment and the lack of available credit, but if Babcock was able to sell assets at a profit during the next 12 months, it would hush the naysayers (like me) who think they paid too much. It would also give them a war chest with which to pursue further acquisitions – something I’d be a lot more comfortable about in the current distressed environment (now is presumably a great time to be taking cheap assets off the likes of Centro and GPT).

So far, nothing has actually gone disastrously wrong. And it’s not impossible to envisage a scenario, three or four years down the track, where the company is firing on all cylinders, money is pouring into the renewable energy sector, and Babcock is standing at the gate collecting its fees and making a motza on investments made in today’s distressed environment. There is, however, a lot that needs to go right between now and then.

Posted on 08 Jul 2008 by Forager

Babcock & Brown: How Bad Can It Get?

Downside analysis is one of the most important parts of any security analysis; what’s the worst that can happen here? For Babcock & Brown, the answer is simple. With $2.15bn of senior debt and another $614m of unsecured noteholders queued up in front of shareholders, there is definite potential for a wipe-out.

That turns the situation into one of risk versus reward. What are the chances of it happening and what’s my reward if it doesn’t? The reward we’ll come to in a few days’ time. For now, we’ll focus on the chances of a wipe-out.

We often talk chance and probability at The Intelligent Investor, but this is a lot more subjective than calculating the odds of flipping three heads in a row. Like trying to calculate the odds of global warming, this experiment won’t be repeated. There’s no refining your probabilities once reality unfolds and, even if you’re right, you might be wrong (see Right decision, wrong result from 2003).

But that doesn’t make the exercise any less important. And to make an attempt, we need to get stuck into some numbers. The balance sheet is where most things go wrong and I’ve reproduced the table below from the Babcock’s management review in the 2007 annual report.

Babcock’s 2007 balance sheet
Assets ($m) Liabilities ($m) Net ($m)
Real Estate 5,447 3,667 1,780
Infrastructure 5,919 3,669 2,250
Operating Leasing 1,926 1,567 358
Corporate and Structure Finance 976 386 590
Segment Assets and Liabilities 14,268 9,290 4,978
Corporate Debt 2,760 (2,760)
Net Cash 363 363
Total 14,631 12,050 2,581

These numbers are not audited, so they need to be taken with a grain of salt. But they are much more useful than the audited numbers at the other end of the report. They show how much of the debt is ‘full recourse’ and which has recourse only to specific assets. If one of these assets goes bankrupt, the creditors won’t have recourse to any of Babcock’s other assets. Think of it as a fund manager where each investment’s debt sits on the fund manager’s balance sheet – you can see how leveraged the investments are but one disaster won’t bring the empire crashing down.

That doesn’t make it any less

Still, the $14.6bn worth of assets on Babcock’s balance sheet is offset by $12.1bn of debt. If the assets were sold for 17% less than their balance sheet value – hardly a substantial markdown in the current environment – shareholders would be left grasping at thin air.

For the time being at least, though, that looks unlikely. The consortium of banks providing the $2.15bn corporate facility have waived their market-based review clause that had allowed them to put Babcock under the blowtorch if its share price fell below $7.50. They obviously think it’s worth more as a fee-gouging going concern – and I wouldn’t disagree.

But Babcock isn’t out of the woods yet. There are, no doubt, plenty more clauses relating to interest cover and debt-to-equity ratios. If the business takes a turn for the worse, the banks will be back at the table.

It’s impossible to know what most of the assets are worth or what Babcock paid for them. But, as an example, the company had listed investments sitting on its 31 December balance sheet valued at $1bn. An admittedly-stressed Mr Market is currently pricing them, in total, at around $600m. These assets won’t be revalued to their current market price (believe it or not, they are valued at the board-calculated underlying net tangible asset value of the various funds), but it’s a safe bet the banks are keeping a close eye on their security.

Debt waiver or not, the balance sheet leverage remains a worry. The other issue that could bring Babcock unstuck is a severe deterioration in its earnings. I’d guess the banks are comfortable with their exposure thanks to the $70bn of assets under management on which Babcock collects its fees. Even if its highly profitable asset flipping came to a screaming halt, Babcock still has some very generous management contracts locked in place.

Locked-in fees on a huge pile of debt

It’s another case of ‘believe it or not’, but most of the contracts stipulate that the fund has to pay Babcock a percentage of enterprise value (market capitalisation plus net debt). And while the market capitalisations of its funds have been plummeting, the debt isn’t going anywhere. So the fees should hold up reasonably well. I’ve read a number of the fund prospectuses and, while GPT Group seems to think it has a way out of its joint venture with Babcock, the rest of the funds seem to be pretty effectively tied in. Most of the management agreements are 25-year contracts and can only be terminated if there’s a material breach of the contract.

So Babcock has a nice reliable stream of fees with which to service its debt. But it’s unlikely to be enough. Babcock’s interest bill will be something like $280m for the year and I’d guess the banks require coverage of something like three times. It might collect $400m a year in base fees, but by the time you subtract staff costs, rent and the like, it’s not going to be anywhere near enough.

There’s some comfort in the locked-in income (especially for the banks) but the short of it all is that we’re back to where we were – as a shareholder, you need this balance sheet to be worth something and producing income. Otherwise, you’ll end up with nought.

The assets are all they’re cracked up to be – safe, reliable, cash-producing assets – but the amount of leverage makes it very hard to reach a confident conclusion. Unless you’re buying it for a song (we’re getting there, I promise), Babcock’s balance sheet is one to be wary of.

Posted on 02 Jul 2008 by Forager

Babcock plays the regulatory game – day six

Babcock plays the regulatory game - day six  As I mentioned in the first post in this series, Babcock & Brown is not a bank. That means it’s not regulated by APRA and doesn’t need to worry about capital adequacy and the like. But regulation plays a large part in its business, because many of the assets it owns and manages – power stations, ports, wind farms and the like – are either natural monopolies or former government businesses, and the government therefore likes to moderate how much money they can make.

Regulation comes in as many different forms as there are assets. Airports in Australia are subject to ‘light-handed regulation’ – don’t abuse your power and you’ll be left to your own devices. But at the other end of the scale are monopolies where the government (or its representative) has complete control over the price you can charge.

For example, the price the Dalrymple Bay Coal Terminal can charge users is set by the Queensland Competition Authority with reference to the amount of capital invested. It’s know as a WACC (weighted average cost of capital) model, where the regulator sets a price that’s supposed to provide a particular return on the owner’s investment.

At Dalrymple Bay, the regulator’s most recent determination was that – based on assets of $850m, a WACC of 9.02%, annual capital expenditure of $30m and corporate overheads of $6m – the owner of the terminal (B&B Infrastructure) should collect $86.8m a year in revenue.

You might think this type of arrangement would make for a boring and straightforward business, but for the MBAs working at places like Babcock it simply represents a challenge. Convince the regulator that Dalrymple Bay’s overheads are $10m not $6m, and you’ll collect an extra $4m a year in revenue. Convince it that your cost of capital is 10% and not 9%, and another $8m a year will land in your pot.

For Babcock, regulation is not so much a risk as an opportunity to put its skills to the test. With increasing private investment in public infrastructure and new frameworks on the slate for carbon trading and renewable energy, it’s a set of skills that might well come in handy.

Posted on 30 Jun 2008 by Forager

Babcock stains a promising record – day five

Last spring I had the pleasure of watching a magpie raise her chicks five metres from my living room window. Apart from the rather amusing flying lessons, the expectant look the youngsters gave mum when she returned to the nest always made me chuckle. No thanks or appreciation, simply ‘what’s for dinner?’.

As the Babcock & Brown share price plummeted on 12 June, our research director Greg Hoffman would call out a new low every 10 minutes and look at me like a magpie chick waiting for a worm. After I told him I didn’t know it well enough too many times, he went off in search of alternatives.

All of the Babcock-related securities were down significantly. How about the unsecured notes (BNBG), he asked? Same problem. B&B Wind? Yeah, it’ a possibility but it needs to be cheaper. B&B Power? Alinta assets, no thanks. B&B Infrastructure? Hang on, doesn’t that own Dalrymple Bay Coal Terminal? I worked on a bid for that at Macquarie – it’s a sensational asset. I’ll take a look.

Something simpler please

So, in the search for a simpler alternative unfairly tainted by the Babcock brush, I downloaded the latest annual report for Babcock and Brown Infrastructure (BBI). I was in for a shock.

This fund listed in 2002 with Dalrymple Bay as its only asset. In 2003, it bought interests in two power stations and a wind farm. In 2004, it added a New Zealand energy and gas business, a submarine cable linking power grids in the US and a gas transporter operating in the Isle of Man, Channel Islands, Portugal and the UK. In 2006 it gobbled up PD Ports, WestNet Rail, NorthWestern Energy in the US, a Belgian water container business and failed in a bid for GasNet. In 2007 it teamed up with Singapore Power, B&B Power and B&B Wind in the highly competitive auction for Alinta and bought separate ports businesses in Spain, Belgium and Italy.

Phew. That was enough for me, I didn’t need to turn past page seven. Whatever happened to cheap German or Japanese property that no-one else wants?

When I read the prospectus in 2004, I grudgingly gave these overpaid bankers the benefit of the doubt. The case studies of investments they’d made included a bunch of German apartments where the rent more than covered the debt repayments and all maintenance costs, and Japanese property that was generating enough cash flow to do the same. Both asset classes looked unloved and cheap. They were also gaining valuable expertise in renewable energy – particularly wind – long before it became trendy and, at that point, I’d have been prepared to call it a somewhat impressive track record.

Not so good with others’ money

It was established with their own money, though. Since the float, Babcock has become the steward of more than $70bn of other people’s money and, as you’ve read above, its approach has been quite different.

That’s a shame (to say the least for the people whose money it is). Someone inside Babcock obviously has the skills to identify assets that are cheap. It wouldn’t have generated 70% profit growth a year but, with discipline and patience, they could have generated excellent long-term returns (imagine what they could be doing with a nice large pile of cash right now). If there’s to be a recovery it will require a return to the strategy that was once extremely successful.

Note: Babcock made an important announcement today regarding its debt facilities. We’ll discuss it on day 7 – downside risks.