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Posted on 27 Jun 2008 by Forager

Babcock binges on easy credit – day four

Today’s post is all about Babcock’s financial history. The business listed in late 2004 and, like most floats, the prospectus was full of rosy growth projections. In this case, though, it was a case of under-promise, over-deliver.

The 2005 profit of $180m was $27m in excess of the prospectus forecast. And the trend didn’t end there, with profits growing 71% in 2006 and 70% in 2007. Management is still sticking by its forecast that this year will top $750m. If it turns out that way, we’ll have had average annual growth in earnings per share of 43% a year since 2005.

Profits have been growing because return on equity has been high – 27% in 2005, 24% in 2006 and 29% in 2007 – and most of the profits have been reinvested. The dividend payout ratio has been low (32% last year) and, with a large portion of the profits generated overseas, the franking rate has only been 50%.

Balance sheet set alight

It’s not only the profits that have been growing, though. Babcock’s balance sheet has been expanding faster than Twiggy Forrest’s bank account. In 2004 the company had $2.4bn in total liabilities supported by $1.6bn in shareholders’ equity. That was enough leverage for us but, with $16bn of assets and $13bn of liabilities sitting on the balance sheet at 31 December 2007, things look even scarier now.

But things aren’t quite as bad as they might seem, because much of the debt is tied to specific assets. When Babcock buys a wind farm, it might put up 20% of the capital itself and borrow the rest. If something goes wrong, the lenders only have recourse to the particular asset in question. As long as Babcock owns a diversified portfolio of assets, no one problem can bring the empire tumbling down.

It does, however, own a collection of seriously leveraged investments, and has $2.8bn of its own debt over and above that borrowed at the asset level. Even stripping out the limited recourse debt, this is not a balance sheet for the faint of heart.

Cash in but not so much out

The cash flow statement also tells a tale. Cash flow from operating activities has been negative every year since the float – reaching a deficit of $507m in the 2007 year. Profits not converted into cash is normally a huge red flag. In this case it’s mainly because the cash profit from selling assets, and the return on those assets, is included in the ‘cash flow from investing activities’ section. But it does show how dependent the business is on asset recycling.

And there’s been plenty of that. Babcock has invested a net $16bn of cash over the past four years – $25.5bn of purchases and $9.5bn of sales. No wonder the advisory team has been rolling in fees.

So that about sums up Babcock’s financial history as a listed business – rapid expansion fuelled by exceedingly generous credit. The returns to shareholders have been excellent – but how much was due to skill and how much due to excess risk remains to be seen.

Download the Babcock & Brown financials

Posted on 25 Jun 2008 by Forager

Babcock bosses let themselves down – day 3

Assessing the management team is one of the most important exercises to undertake when assessing business value. It’s also notoriously difficult.

Warren Buffett once said ‘In looking for someone to hire, you look for three qualities: integrity, intelligence, and energy. But the most important is integrity because if they don’t have that, the other two qualities, intelligence and energy, are going to kill you.’

The problem I’ve experienced is that most people show integrity when the news is all good. It’s when the share price starts heading south that you need to look closely (witness the number of profit upgrades since Flight Centre’s attempted management buyout last year).

So what does that say about Babcock & Brown? It’s easy to hurl abuse from the sidelines while the share price is getting hammered, but I’d like to hear from anyone that knows them better than me. That’s pretty much anyone that’s ever had anything to do with them – I’ve never had dealings with Babcock and I’ve never owned a share in the mother ship or any of the satellite funds.

From a distance, the two things in their favour are longevity and a lot of skin in the game. Run through the important executives and they’ve all been there a long time. On the board there’s executive chairman and founder James Babcock (31 years), executive director James Fantaci (26 years) and managing director Phillip Green (24 years). The rest of the 11-person senior executive team contains three with more than 20 years experience and another three with more than 15. They’re not fly-by-nighters.

And, while their pay packages look ludicrous, up to half is typically taken as shares in the business. In total, staff members own 40% of Babcock’s shares and they didn’t take any money off the table when the company floated in 2004 (it was all used for expansion purposes). These guys and girls care about the share price.

So why have they made such a mess of it? I normally go straight past the corporate governance section of an annual report, but the following commentary caught my attention as I flicked though Babcock’s 07 Report.

‘The establishment and successful operation of its specialised listed and unlisted focused investment vehicles (“Funds”) is fundamental to Babcock & Brown’s business model.’ Then it goes on to list the potential risks to this model:

  • failure of the Manager to act in the best interests of the investors of the Fund;
  • lack of independence of the Fund Boards;
  • restrictions imposed on the operations and decision making ability of the Fund Boards;
  • failure of the Manager to properly manage related party issues and conflicts of interests, where the Manager undertakes major related party transactions with Babcock & Brown Group entities, which are ultimately paid for by the Fund with a range of fees potentially being paid to the Manager;
  • the Manager may pursue growth with accompanying higher fees at the expense of the nature and risk profile of returns to fund investors;
  • lack of proper oversight of the performance of the Manager; and
  • lack of appropriate controls to manage these governance risks.

It almost reads as if they foresaw their own downfall. Maybe the lure of the dollar was simply too much to resist. Or maybe they really did think the banks were going to keep on lending ludicrous amounts of money forever and that you couldn’t possibly go wrong with infrastructure. Either way, the behaviour of the past few years is a black mark against what was a fairly impressive record.

Add your experiences to my limited knowledge by commenting below.

Posted on 24 Jun 2008 by Forager

Bristlemouth takes on Babcock and Brown – day two

While the sky high debt levels and frantic deal-making make analysing its funds a nightmare, the Babcock business itself is not difficult to understand. The company buys assets and then sells those assets to a managed fund. It collects fees on the way in, on the way out and for ever and a day.

Understandable but unsustainable

After a couple of days research, I’d describe it as understandable but unsustainable. My brother, an engineer, likes to argue the point with me, but infrastructure funds have their place. They should, however, be safe, conservative, income-producing investments. That would make them the opposite of the Babcock deal-making machines.

Take a look at the table below, which summarises Babcock’s revenue for the year to 31 December 2007.

Revenue by type Year ended
31 Dec 07($m)
Year ended
31 Dec 06($m)
Change
(%)
Base fees from assets under mgmt (AUM) 217 118 84.7
Co-investment income 156 110 41.4
Advisory fees from AUM 340 326 4.1
Performance fees from AUM 51 64 (19.9)
Other operating income 99 97 1.2
Operating Leasing trading profits 186 65 186.1
Development activity 410 189 117.0
Principal investment 461 278 65.7
Third-party advisory fees 25 45 (44.7)
Net Revenue 1,945 1,293 50.4

There are two striking aspects. The first is that Babcock hardly generates a cent from external clients. The $25m in advisory fees collected from unrelated parties is barely enough to cover managing director Phil Green’s $22m pay package. Almost 99% of its revenue comes from its own balance sheet or funds managed by Babcock.

Revenues at risk

The other striking aspect is how much of the revenue is potentially unsustainable. I saw the odd fee in my time at Macquarie, but the level of advisory fees collected from Babcock’s own funds is truly out of this world. The funds paid $340m for ‘advice’ on top of the $217m in base fees and $51m in performance fees. The funds also bought assets off Babcock for $410m more than Babcock paid for them (development activity) and, as far as I can tell, the $186m ‘Operating Leasing trading profits’ also relates to the sale of assets to a Babcock managed fund. If the supposedly independent directors of the funds became truly independent, up to half Babcock’s revenue could be at risk.

The rest of Babcock’s revenue relates to base fees, performance fees and income generated from its own investments – it owns stakes in the listed funds it manages (co-investment income) and assets it holds on its own balance sheet (principal investment). They can presumably kiss the performance fees goodbye but, assuming they keep hold of the management contract, the base fees should be worth something.

And, assuming Babcock has paid sensible prices, the assets it owns should generate a return, meaning overall this business should be able to generate a profit (before paying interest on its debt at least). But is there some sort of significant competitive advantage?

Easiest game in the world

While the sharemarket was enjoying its meteoric rise from 2003 until 2007, Babcock’s business was the easiest game in the world. But, now that the tide has turned, the $750m record profit forecast for this year – presumably on the back of asset sales – should be the last hurrah.

At less than 3 times those earnings and a discount to book value, you don’t need a future anything like the past to make some money. You can, however, give up on the idea that there’s a nice wide moat around this business

Posted on 23 Jun 2008 by Forager

Bristlemouth takes on Babcock and Brown – day one

It’s times like this you wish you’d done more. Babcock and Brown’s share price is in freefall and Mr Market is in a panic. Some of the panic seems justified and some of it not. Either way, the share price has been smashed, falling from an all-time high of $34.78 one year ago to today’s $6.21. I don’t know enough to make a call about this somewhat-complicated business at the moment, but it’s time to do a lot more work.

Every day for the next 10 days I’ll research one aspect of our 10-point test (see below). I’ll publish a blog entry (on The Intelligent Investor and Bristlemouth) by lunch and then it’s your turn to add your comments and thoughts. On Friday 4 July we’ll have covered the final point and I’ll need to make a decision: cheap, expensive or one for the ‘too hard basket’.

The non-banking investment banking industry

So let’s get cracking by taking a look at the industry. While Babcock is often called an investment bank, it’s not a bank. It’s not regulated by APRA, can’t accept retail deposits and doesn’t have access to the Reserve Bank of Australia (or any other reserve bank for that matter). It’s business is corporate advisory, fund development and fund management, none of which requires a banking licence.

And it’s not really an industry per se. Typically when researching this question we’re looking at, for example, the grocery business or the banking business, and trying to get a feel for the general economics of the industry. Is it capital intensive? Is it competitive? Is it cyclical?

Putting Babcock to the 10-point test
1. The industry 23 June
2. Babcock’s business 24 June
3. Management 25 June
4. Financial performance 26 June
5. Track record 27 June
6. Regulation 30 June
7. Downside risks 1 July
8. Upside potential 2 July
9. Capital structure 3 July
10 Debt levels 4 July

It’s impossible to pigeon-hole Babcock into any particular category. But without getting into the specifics of Babcock’s business – we’ll get onto that tomorrow – we can attempt to answer the same general questions about its business model and competition.

Corporate advisory is a competitive but potentially highly lucrative business. Most ‘wanna be’ corporate advisors struggle, but the few that rise to the top can generate hundreds of millions of dollars in fees without bearing any risk.

Most of the successful players, including the likes of Macquarie Group and UBS, bring balance sheet and underwriting capabilities to the table, which gives them an edge when it comes to the big deals. They also bring their conflicts of interest, which has allowed the likes of Carnegie Wiley and Gresham Partners (part owned by Wesfarmers) to carve out successful businesses on the back of independence.

Most of Babcock’s advisory fees are generated from its own managed funds – a locked-in client is as good as any – but it does have specific industry knowledge that is sometimes used by external clients.

Fund development – the lynch pin

The most important cog in the Babcock wheel seems to be its ability to generate new funds by taking assets onto its own balance sheet for a period of time, before creating a listed fund and selling it the assets at a profit. It’s been obscenely profitable over the past few years thanks to booming equity markets – it didn’t seem to matter what asset you bought, you could flog it off at a profit – and every investment bank around the world has been getting in on the act.

While a lot of participants think they are geniuses when the wind is at their back, my guess is that if there is any sort of competitive advantage in this business, it would come from an ability to identify assets that are cheap. As of, well, now, the pass the parcel game is over, and anyone caught with overvalued assets on their balance sheet has a problem. But if you’ve identified assets that are cheap, or even reasonably priced, it shouldn’t matter if you have to hang on to them for a few years.

Again, we’ll come to the specifics of Babcock tomorrow but it seems they’ve done some intelligent and somewhat contrarian things over the years, especially before they listed (think Japanese property, German property and wind farms before they became the latest craze).

While distinguishing skill from luck is nigh on impossible, it is conceivable that some participants could have a competitive advantage.

The managed fund gravy train

Not only have Babcock been selling their assets at huge profits, they’ve been selling them to listed funds under lucrative long-term management contracts with, you guessed it, Babcock. While generating new business was only possible while the stockmarket was dishing out cash like the late Kerry Packer in a casino, the funds already created will remain lucrative as long as the contracts stay in place.

As far as economic returns go, there aren’t many better businesses than funds management. Especially ones where the funds are locked in (while Babcock will get lower fees if the value of its funds falls, you can’t redeem your investment, you can only sell it to someone else). Once you cover your fixed costs – how hard can it be to buy a wind farm and hold it for the next 25 years? – everything flows through to the bottom line.

So, after all that, I’d sum up the Babcock business model as follows:

a) potentially lucrative for the bigger players;

b) capital intensive but with the potential to earn excellent returns on capital;

c) highly dependent on financial markets and therefore highly cyclical; and

d) a people business – long-term returns are driven by quality of staff and risk management.

Tomorrow I’ll publish my thoughts on the Babcock business itself. But in the meantime, why not post your own thoughts on Babcock’s industry – and my assessment of it – in the comments area below.

Posted on 11 Jun 2008 by Forager

A load of uBS

The review was nothing out of the ordinary. Another float, another avoid recommendation from The Intelligent Investor. Admittedly, James Greenhalgh’s review of the Burrup float was a particularly scathing one but when The West Australian called me for a comment, I simply pointed out what I point out every time a company floats on the stock exchange; typically, it’s a good time for the seller – who knows the business inside out – to be selling. That makes it a bad time for you – knowing a whole lot less than the seller – to be buying.

The article that followed the next day gave us some great publicity, but I had to read the section from the underwriter twice:

A UBS spokesman dismissed the investment note as “a promotional ploy by a stock tipsheet, rather than a serious attempt at analysis”.

Now, Mr Spokesman, I understand you’ve got a float to sell. But having an investment bank question my motives is like having Ben Cousins lecture me on drugs. Sure, publicity is good for our business. But it pales in comparison to the quality of our recommendations. If we get them wrong, people won’t pay us subscription fees.

Your company, Mr Spokesman, has a whole different set of incentives. Assuming the float goes ahead, you’ll get paid based on the float price. You’ll get $10m if too many investors listen to us and the price comes in at the bottom of the $1.75–$2.25 range, and $15m if you convince everyone it’s the greatest float ever. Not only are you incentivised to sell it to us at the highest price possible, but you don’t wear any of the risk if it all goes wrong.

Not bad for a few months’ work. Not as good as the $20m you collected for the RAMS float – the company’s current market capitalisation is only slightly more than your fee – but that’s a story for another day.