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.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.