Subscribe to our blog: 

Posted on 19 Aug 2008 by Forager

Babcock Implosion Gathers Pace

The bad news at Babcock & Brown is mounting. Since my last post on Babcock and Brown less than three weeks ago, the anticipated writedowns have finally begun, CEO Phil Green is about to resign and the share price has almost halved. The company is now, ominously, in a trading halt, with the interim results due on Thursday.

So far, it’s the managed funds causing all the trouble, although the funds and the mothership are inextricably linked. The fire sale of B&B Power’s assets continued this week with the sale of its Tamar Valley Power Station for less than half the $223m construction costs to date.

The proceeds of $100m won’t put much of a dent in the $3.7bn of outstanding debt and neither will the expected $330m in earnings before interest, tax, depreciation, amortisation, set up costs, transition costs, impairment expenses and ‘other non cash charges’ (that’s really what it says in the announcement – it really means ‘earnings before expenses’). Things are looking shaky.

Not only has Babcock been sacked as advisor to the fund – the board has appointed UBS to undertake a belated ‘strategic review’ – but it had $173m invested in B&B Power securities as at 31 December 07, and $380m of the fund’s debt is a loan from Babcock, the majority of which probably ranks behind the rest of B&B Power’s towering burden.

This is only one asset, but it’s a substantial one and if things are this bad with one of the few investments with a public profile, what does it mean for the rest of Babcock’s assets? As I said in the last part of my 10-part Babcock and Brown review, Babcock’s equity investors don’t need much to go wrong before they’re wiped out. And things are certainly going wrong.

Posted on by Forager

Why Short Toll Roads Fail

Why Short Toll Roads Fail
Sydney's M7

Investing in yet-to-be-opened toll roads is a risky business but, relative to the successes, the failures do seem to have something in common. They’re short slabs of tarmac.

Before a toll road is built specialist traffic forecasters attempt to estimate how much traffic will use the road. Their models are built around the time value of money – they assume that people attach a value to their time and will pay to save some of it.

Once you adjust for the inherent optimism required to win a bid, these models seem to work reasonably well for roads that cover long distances. Melbourne’s CityLink (22km), Sydney’s M2 (21km), M4 (40km) and M5 (32km) motorways and The Western Sydney Orbital (40km) have all been successful investments because the traffic projections have been close enough to accurate.

Toll roads don’t seem to work so well where the distances are short. Sydney’s Cross City Tunnel (2.1km) and the Lane Cove Tunnel (3.6km) are built on the same time value of money models but both have been abject failures – traffic has been less than half of what was forecast and equity investors won’t get a cent of their investment back.

It looks like people don’t value time after all. They value distance. Or perhaps they use distance as a proxy for time.

That would make some sense. The Cross City Tunnel might save 20 minutes of travel time but when you can see the other side of the city from the entrance, it doesn’t feel like it’s saving you much. Saving 20 minutes by careering along a 30km motorway at 110km an hour, on the other hand, feels well worth the money.

Distance is also much easier for us humans to quantify than time. The Cross City Tunnel might save 25 minutes one day and 15 the next but, in the absence of a daily stopwatch, it’s hard to know how much time you’re really saving. You know for sure, on the other hand, that it is only 2.1km long.

The theory that time-value-of-money models don’t work for short distances is reinforced by the first-week data provided by listed company ConnectEast. It owns a 39-year concession on EastLink, a 39km pay-per-section road between Mitcham and Frankston in Melbourne’s south east. The road has just opened and the company reported an average of 134,000 cars per day in the first week of tolling – ‘only’ 30% less than the forecast average for the first month.

What’s interesting, however, is that the average toll and average trip length was 9% higher than forecast. People are using it as expected for the long trips but they’re not prepared to fork out for short distances, despite the same cost per minute of time saving.

With only one week of traffic data, it remains unclear whether enough cars will use ConnectEast’s 39km of road to justify the current security price, but it looks like there’ll at least be enough cash to cover the interest bill, which isn’t a bad start.

What, then, are the prospects for Brisbane’s 6km long RiverCity Motorway and the 6.7km BrisConnections Airport Link? If the ‘long trips only’ theory of toll road usage bears out, investors have plenty of reasons to be concerned.

Posted on 08 Aug 2008 by Forager

Property Trust Losses Should Top $30bn

Someone needs to tell the bean counters at Australia’s property trusts that there’s a credit crisis on. While the writedowns have been coming thick and fast (Lend Lease this week joined Australand, Mirvac and GPT in the dog box), the extent of the asset revaluations is a joke.

Property trusts value their assets based on a capitalisation rate or ‘cap rate’. The concept is simply to value the asset such that the rent received provides a return equal to the cap rate. If you’re receiving $100 rent a year and your cap rate is 10%, you value the asset at $1,000.

Property Trust Losses Should Top $30bn

For years cap rates have been tumbling (see chart above) in line with falling interest rates and, supposedly, lower risk. As a result, property trusts across the board have been booking massive profits and increasing net ‘tangible’ assets.

Welcome to 2008. Interest rates are up, inflation is out of the bag and, thanks to the credit crisis, risk premiums are through the roof. That being the case cap rates should go back up by a lot more than the pathetic 25 basis point (0.25%) rises by Australand and Mirvac (Lend Lease didn’t fess up about their assumptions but the extent of the writedown wasn’t significant).

Bunnings Warehouse Trust at least went with 50 basis points, but that only takes their cap rate up to a meagre 7.08%. Whatever planet they’re on, it’s not the same one as the rest of the financial markets – who does anything for a 7% yield these days? The cap rates should be 2% higher, at least.

So why aren’t they? The problem is that if they were, truly massive writedowns would be required. Every 1% increase in cap rates translates to a writedown of about 12% in asset value. Across the 16 property entities covered by The Intelligent Investor, a 200 basis point rise in cap rates – which would only take them up to about 9% on average – would result in $30bn of losses, a figure that the managements of these trusts have chosen not to face.

But they may as well get on with it. The sector is trading at a massive discount to reported NTA, which is the stockmarket’s way of saying you’re not fooling anyone.

Posted on 04 Aug 2008 by Forager

Lessons From The Bear Market

From a research perspective, the past 12 months have been the most difficult in The Intelligent Investor’s 10-year history. The Growth Portfolio fell 37% in the year to 30 June, the Income Portfolio fell 26%, and the last Buy recommendation to show a positive return was ARB Corporation in August 2006. There have been 15 since, of which three – Timbercorp, RHG and Platinum Asset Management – have more than halved.

That would be concerning in itself, but it’s been all the more frustrating because this bear market was supposed to be fun. We spent an exasperating few years standing on the sidelines refusing to get dragged into the bull market euphoria. We first lamented the lack of bargains way back in September 2003 when Making the case for cash. We made The case for more cash in July 2004 and then sounded a series of increasingly dire warnings: Profits won’t defy gravity forever in May 2005; Easy money signals tough times ahead in April 2006; Rise and fall on RBA’s call in June 2006; Dear Glenn, you have a problem in January 2007; Hangover will follow global binge in June 2007; Expensive lessons from cheap credit in August 2007; Scylla, Charybdis and Bernanke in September 2007; and Strong arms ready to crush weak hands in January 2008.

And on top of the worrying global picture, we warned about particular sectors with articles such as Is your bank going broke? in April 2007, Danger lurks in the banking sector in January 2008, and countless warnings on the listed property sector, such as Property trusts don’t add up from June 2006 and last year’s special report Are your property investments safe as houses?. We rang the warning bell on MFS and ABC Learning and, at 30 June last year, the ratio of sells to buys was five to one. People were leaving The Intelligent Investor because they were sick of the pessimism.

Not our finest hour

Yet here we are somewhere between the start and the end of the bear market we had to have – what was supposed to be our finest hour – and our Growth Portfolio is suffering more than the overall market. How did we get here?

It’s not that we’ve bought a bunch of dud stocks. Despite share price retractions that might make you think otherwise, many of the businesses we’ve recommended are progressing as expected. Albeit hindered by the high Aussie dollar, ARB and Cochlear are working out nicely, Flight Centre has well and truly exceeded expectations and Infomedia is still churning out dividends in the face of a gale force currency headwind.

Even where we think we’ve initially overestimated the value on offer – as with Timbercorp, RHG, Platinum Asset Management, Sigma Pharmaceuticals and Mortgage Choice – the extent of the error is a fraction of the share price fall. No, the problem is that because of our investments in stocks such as these, we’re now passive participants in a market that offers extraordinary value.

Given the excesses and problems we accurately foresaw, it would have been reasonable to expect more patience. Instead, we shot our bolt too early, despite expecting better value to emerge. We thought we’d be able to switch from our original selections into that better value as it emerged – but that clever trick doesn’t work if the value continues to emerge in the stocks you’ve already picked. It has been a salutary experience for everyone and we owe it to ourselves – and to you – to try to take something from it.

Psychological shortcomings

As humans we’re all psychologically wired to be poor investors. We’re wired to follow the crowd, to extrapolate the recent past, and to cling to our prior decisions in spite of confuting evidence. These psychological shortcomings are exacerbated for us by the fact that we provide our research to some 9,000 subscribers and face constant pressure to provide buy recommendations.

Over the years we’ve handled these pressures reasonably well, but the main lesson from the past year is that we aren’t immune. The experience itself has taught us a lot (C.S. Lewis called experience ‘that most brutal of teachers’, but ‘you learn’ he said, ‘my God do you learn’) but we’ve also decided to add some extra rigour to the way we reach our stock recommendations.

Senior analyst Gareth Brown recently handed me an article published in The New Yorker in December last year. Centre stage in the story is Peter Provonost, a critical-care specialist at Johns Hopkins Hospital in the US. In 2001, in an attempt to counter line infections at the hospital, he introduced a simple five-step checklist for doctors to follow. As the article explains:

Doctors are supposed to (1) wash their hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. Check, check, check, check, check. These steps are no-brainers; they have been known and taught for years. So it seemed silly to make a checklist just for them. Still, Provonost asked the nurses in his [intensive care unit] to observe the doctors for a month as they put lines into patients, and record how often they completed each step. In more than a third of patients, they skipped at least one.

During the next two years, they calculated that this simple checklist ‘prevented forty-three infections and eight deaths, and saved two million dollars in costs.’ The article goes on to ask, if something so simple can transform intensive care, what else can it do? Well, for one, it can improve the analytical process at The Intelligent Investor.

Redressing the balance

I feel we need to define the process we use for selecting stocks more clearly. So for starters we’ll be instituting a simple, written checklist that forces us to address certain issues that our psychology might otherwise encourage us to gloss over. We’re also going to redress the balance between the time we spend running the business and the time we spend researching stocks – we all feel there’s too much of the former and not enough of the latter – and we need to apportion our time better between genuine searching for opportunities and simply regurgitating news. So you can expect to see more in-depth stock research – especially from Greg and myself.

Finally, I’d like to reiterate the sentiments in Greg’s Confessions from the research desk. I’m proud of the service The Intelligent Investor has provided over the past decade and, while we’ll have our ups and downs, now is certainly not the time to panic and make wholesale changes. The Growth Portfolio has risen 3% in July while the index fell 6%. Given the portfolio of extraordinarily cheap stocks it contains, that’s a trend we expect to continue. So amid all the pessimism, we see reasons for optimism.

It would be wonderful to relive the past 12 months knowing what we know now, but unfortunately life isn’t like that. It is at the times we are most challenged that we learn our most valuable lessons. For the analysts at The Intelligent Investor, now is such a time.

I trust that the lessons we learn now will have a greatly beneficial impact on the performance of our recommendations in coming years, and that we will restore the excellent performance our portfolios have shown in the past.

Posted on 29 Jul 2008 by Forager

Is Babcock Cheap? – The Final Day

A few years ago I read a book called No Two Alike by Judith Rich Harris, which Charlie Munger had recommended at the Berkshire Hathaway AGM. In it, Harris marvels at how different children can be, even those born to the same parents and raised under the same roof. Her argument is that there is no ‘right way’ to bring up a child; you need to adapt your child-rearing approach to suit a child’s strengths and weaknesses.

I know nothing about raising children, but valuing businesses is no different. The aim is always to work out how much cash is going to end up in shareholders’ pockets and when. But there is no ‘right’ way to work that out – you need a different approach for each different type of business. For a business with consistent and reliable earnings, a simple price-earnings ratio is a useful and accurate tool. For a business that goes through regular ups and downs you might use a PER but adjust the earnings to the average you expect over the cycle.

In some cases it might be more relevant to focus on a company’s asset backing, or book value, and its return on those assets. Sometimes you know the cash flows aren’t going to be consistent but are reasonably predictable, in which case a simple discounted cash flow analysis might be useful (see my research on RHG Group for a specific example). And you may find that one method suits one part of a company, while another suits a different part.

Which is the conclusion I’ve reached with Babcock. If I had to describe it in a sentence, I’d call it a combined funds management/private equity business. There aren’t really any comparable listed companies in Australia but Babcock has a lot in common with the US private equity group Blackstone (listed on the NYSE).

Although the funds management and private equity businesses are intertwined, I want to pull the two apart and value them separately. The funds management side is relatively straightforward and we’ll start there.

Locked in and risk free

Babcock had $72bn in funds under management (FUM) at 31 December and it earned $217m in base fees in the prior year. The GPT joint venture will probably be unwound and depressed stock markets will put a dent in FUM this year, but the reduction won’t be as significant as you might expect: 44% of the FUM at 31 December was unlisted and most of the listed funds pay fees based on enterprise value, which includes the debt component.

And the average funds under management last year would have been about $58bn, given the balance at the start of the year was only $44bn. So even if the FUM fell to less than $72bn this year, the average balance should still be higher than last year and so should the fees – I’d hazard a guess at something like $250m.

These management contracts are worth a lot more than the base fees though. Babcock is also the preferred advisor to all its funds, so every time they do a deal Babcock collects another pile of fees. Again, these fees might be at risk, especially if the funds were forced to appoint genuinely independent boards, but if things continue as they are I’d reckon on at least $140m a year in fees (they banked $340m in advisory fees last year but that should be considered abnormal given the amount of new funds raised). I’m basing the $140m off 20% turnover in the funds, or $14bn of deals a year, and a typical 1% fee paid to Babcock.

So, if Babcock were to offer me this funds management and advisory business, I’d estimate a total of $390m a year as a sustainable level of revenue. Assuming the overall cost-to-income ratio of 60% applies to this income (that’s the average across the Babcock business), it would translate into $150m-odd in pre-tax earnings.

Is Babcock Cheap? - The Final Day

Given the current market ructions and questions being asked about Babcock’s business model, there’s obviously a risk that some of this revenue will disappear. But it’s a very attractive revenue stream, which doesn’t really require any capital, and seven times pre-tax earnings, or $1bn, seems a reasonable price tag (assuming no growth and targeting a post-tax return of 10% after a standard 30% company tax charge). That number also translates nicely to about 1.4% of funds under management, a fairly typical valuation for a business such as this (see James Greenhalgh’s Platinum against the world series).

That’s the most attractive part of the business. There is no capital at risk and most of the contracts last at least another 20 years. Unfortunately, it’s nowhere near enough to justify the current share price. In fact, it’s not even half the value of the $2.7bn debt, so there needs to be significant value in the private equity side of the business – and that’s a lot more difficult to get a handle on.

Lots of assets and almost as much debt

The value in the private equity side lies in the assets currently sitting on the balance sheet and Babcock’s ability to buy more and sell them at a profit in future. It has been very good at this for the past four years, but four years of boom-time profits hardly constitutes a track record.

And it’s the value of the assets currently sitting on the balance sheet I’m most concerned about. Babcock’s balance sheet grew by more than 60% last year – adding about $6bn of highly geared assets in the space of 12 months. Working out what those assets are worth is next to impossible, but what I do know is that there isn’t much margin for error. If the $15.6bn of assets turned out to be worth 10% less than their current balance sheet value, Babcock’s $5bn equity share (the rest is limited recourse debt) would be knocked down to $3.4bn. Make that 20% less and you’d be down to less than $2bn which, by the time you subtract the $2.7bn of corporate debt, would mean negative shareholders’ equity. In a world where credit is hard to come by and expensive, 10 or 20% is hardly inconceivable.

Babcock’s leveraged assets
Division Assets Liabilities Net assets Potential impairment Conservative net assets
Real estate $5.4bn $3.7bn $1.8bn 20% $691m
Infrastructure $5.9bn $3.7bn $2.2bn 20% $1.1bn
Operating leasing $1.9bn $1.6bn $358m 10% $165m
Corporate and structure finance $967m $386m $581m 0% $581m
Total $14.3bn $9.3bn $5.0bn $2.5bn

Of course, it’s possible some of the assets are worth more than their balance sheet value – the sale of its wind assets in the next three months is expected to generate a significant profit. And, if my experience in this area is anything to go by, the structured finance assets should be very safe.

But Babcock also has more than $1bn invested in its own funds with a current market value of about $600m. It is, put simply, impossible to estimate with any degree of confidence what these assets are going to be worth to shareholders.

Too murky for me

Picking up stocks on the cheap often requires special insight or a better understanding of a business than others. But it doesn’t require any special mathematics. When you find something cheap, it should be blatantly obvious that it’s cheap. Whichever way I look at it, there’s nothing blatantly obvious about the value on offer here.

It might not always be like that. Were it to sell some assets at attractive prices and pay down debt, the situation might become much clearer. If I could buy it for less than the value of the fund management contracts, for example, I’d get pretty excited. As it is, it remains one for the too hard basket. I’ll continue to cover it in The Intelligent Investor but I’m keeping the recommendation as AVOID.

The preference shares (ASX code BNBG), on the other hand, look tempting. There’s a real risk of a wipe-out, but they’re yielding north of 50%** a year to the first reset date on 15 November 2010 (including dividends and capital gains). I’d suggest it’s going to be very hard for the ordinary shares to beat that over the next couple of years. And while I’m not convinced the shares are worth their current market price, there’s enough value in the locked-in management contracts and the assets on the balance sheet to give those holding the preference shares some comfort that the company can meet its obligations.

We’re seeing a lot of value in listed income securities at the moment and this looks like one to add to the list. I’ll publish a proper review on The Intelligent Investor soon, but it looks like much better value and a lot less risk than the ordinary shares.

So that brings an end to this 10-day series that ended up taking a month. It’s an interesting business, Babcock, and I wouldn’t be at all surprised to see it confound the sceptics and prosper. But it seems impossible, for now at least, to determine whether it has a competitive advantage or has simply ridden the infrastructure boom of the past five years.

** Correction: The yield to maturity is actually 34% at a price of $69, not north of 50% as suggested. You can read our review of BNBG here.

Disclosure: The author, Steve Johnson, owns shares in RHG Group. Other staff members own shares in RHG and Platinum Asset Management.

Warning: The advice given by The Intelligent Investor and provided on this website is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether the advice is appropriate to your investment objectives, financial situation and needs before acting upon it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.