Firstly, some readers took my previous post as a ringing endorsement of the QR National float. I want to reiterate that I do not have a strong view either way. If you are going to invest in it, though, you need to understand the differences between this and a normal industrial business. Jochi posted this comment about Roger Montgomery’s view of the float:
“I listened to Roger Montgomery’s Analysis of the Queensland Rail float, in 2012, the intrinsic value (using his model) of QRN will be about half the lower end of the listing price. So why would you pay for a company that will only be worth about half the listing price in 2 years’ time?
Also the return on equity was something like 5%, you can get 6% risk free in the bank, why bother with the hassle of investing in QRN?”
Before I explain why it doesn’t work for QR National, Roger’s dividend discount model needs a brief explanation. The model extrapolates out the current year’s dividend based on the amount of equity reinvested (profits less dividends) and the historical return on that equity.
So, if you start with a business that has $100 equity and it makes a $10 profit (assuming a 10% return on equity) but only pays out $5 as dividends, you have $5 reinvested in the business the following year. Now, with the $100 of original equity and $5 of new equity, you have $105 working for you the following year. This $105 earns $10.50 in profit, assuming the same 10% return, and you get $5.25 in dividends and reinvest $5.25 in the business. Do this process over and over again, discount all of the dividends back to today’s dollars and you have your value for the business (see table below).
This valuation model works well when:
a) The most recent year is an accurate estimate of the ongoing earnings power of the business as it stands.
b) The historical return on equity (ROE) is an accurate estimate of what the ROE will be on new capital invested in the business
Some businesses meet these two criteria, many don’t. QR National belongs in the latter category.
When they first opened the refurbished Westfield near our Sydney office, I’d estimate 95% of the capital had been spent but only one third of the shops were open. Even those that were open wouldn’t have produced a normal profit in the first year, because the centre wasn’t attracting much traffic and the place was still a construction zone.
No one in their right mind would look at that shopping centre and say ‘Frank Lowy, this business is crap. You’re only earning a 3% return on capital’. Of course the first year returns would have looked crap, most of the capital invested wasn’t yet earning a return.
Yet that’s exactly what people are doing when they take QR National’s 2012 profit and use it to evaluate the business. Between now and 2012, QR National will spend $3bn on new assets. That’s on top of the $2.4bn already spent on growth-related capital expenditure over the past three years. Relative to the $6.3bn or so of assets they started with, it’s a massive expansion plan, almost doubling the company’s assets, and much of the additional capital won’t be contributing a full return by 2012.
Not only is the 2012 profit number misrepresenting the underlying earnings power of the business but, by taking that year’s ROE and using it to assess all future capital investment decisions, Montgomery is doing the business a double disservice.
What matters for QR National investors is what the business will be making in 2015, once all of the new capital invested is making a full contribution to earnings. That’s a difficult question to answer but it’s also the fun part of analysis.
It’s quite clear that there is significant demand for more rail infrastructure, particularly in Queensland. Dalrymple Bay Coal Terminal, owned by Prime Infrastructure, is currently operating well short of its 76mtpa capacity. There are ships queued up as far as you can see.
There’s nothing wrong with the port and there is plenty of coal being mined. The problem is that there isn’t adequate rail infrastructure to get it from the mine to the ports.
Of course, demand doesn’t equate to profit. We would need to analyse the whole supply chain, from miner through to steelmaker, and work out whether it’s going to be the miner, rail owner, rolling stock owner, port owner, shipping company or steel manufacturer that is going to end up with the lion’s share of the profit.
Solve that problem and you’ll know whether QR National will be earning a healthy return on capital in 2015 or not. And this, not 2012, is the key to whether an investment today makes sense.