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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.

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