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.

For years cap rates have been tumbling (see chart below) 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.

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.

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.

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.

The structure of Babcock’s capital – day nine

Babcock & Brown’s capital comes from a combination of bank debt, subordinated equity and ordinary shares. I’ll run through each in turn.

The senior debt is comprised of a $2.35bn revolving line of credit, of which $1.92bn had been used at 31 December, and a US$200m facility, which was fully drawn at 31 December.

The annual report puts the margin on both facilities at 1.3%, but a recent announcement from Babcock regarding its lenders’ waiver of a right to review the facilities said the margin had increased 50 basis points to 200 basis points (2%). I’m not sure where the extra 20 came from but we’ll take them at their latest word.

It’s impossible to know what other conditions are attached to these facilities but they most likely include debt-to-equity and interest cover provisions.

Babcock’s capital structure

Facility	Amount as at 31 December	Interest margin
Line of credit	$1.92bn	2.00%
US facility	US$200m ($205m)	2.00%
Aussie subordinated notes	$414m	2.20%
Kiwi subordinated notes	NZ$225m ($199m)	2.20%
Total/Average	$2.74bn	2.04%

The subordinated debt comprises two subordinated notes listed on the Australian and New Zealand stock exchanges. There are 4.14m Australian securities on issue with a face value of $100 each and 225m New Zealand securities with a face value of NZ$1 each. Both facilities accrue interest at a margin of 2.2% over the relevant bank bill rate and are fully subordinated to the corporate facilities (if it all falls apart, the corporate facility providers get their money first).

They also both convert into shares at maturity. For the Aussie notes that’s in 2015 and for the Kiwi notes it’s 2016. Despite reset dates five years before maturity, the subordinated nature and conversion into equity makes this sort of financing relatively safe for shareholders. As a potential investment in their own right, both are trading at huge discounts to face value and we’ll include them in our valuation analysis.

Taking the non out of non-recourse

Before moving on to shares and options, it’s worth noting some of the other details regarding interest-bearing liabilities – some of the non-recourse debt is a little more recourse than management would have you believe. This is debt that relates to specific projects and the lenders can’t come after the rest of Babcock’s assets if disaster strikes. But the fine print shows that it doesn’t quite end there. Babcock has ‘given undertakings to inject equity into the project-specific entities in certain circumstances’ and it has also ‘given performance undertakings’. In other words, Babcock is going to share in the pain if something goes wrong.

Finally, at 31 December there were 294m ordinary shares on issue and 34m options. Of the latter, almost 23m are exercisable at $5 per share and the remainder at prices between $13.31 and $25.54 – so there’s the potential for some dilution.

It’s not a particularly complicated structure, but there is a substantial amount of debt in front of shareholders and a significant number of options on issue.

And that brings to a close nine days of preparation. Next up it’s time for the big one – trying to estimate what it’s worth. Given the uncertainty to date, I’m not feeling confident. But it will be an interesting exercise nonetheless.

Restoring confidence in Babcock & Brown – day eight

Making the bull case for Babcock doesn’t require the creative mind of a science fiction writer. If the future is remotely like the past and the business continues earning returns on shareholders’ equity in excess of 25%, those that buy at the current price will do very well.

Given the current ‘crisis of confidence’, that proposition might sound ludicrous. But Babcock os not the first investment bank to dust investors’ capital in pursuit of a quick buck. And most of the others are not only alive and kicking, but making obscene profits.

Sure, it goes wrong from time to time. But, on average, the returns generated in the investment banking game are exceptional (for staff and shareholders).

Macquarie Group, for example, has churned out its fair share of mediocre products over the years and been through several of its own confidence crises. Yet its return on equity has averaged almost 25% during the past 16 years.

The reason is that investors have incredibly short memories: for all the talk of reputations lost, it seems punters are only too willing to forgive and forget when the latest prospectus arrives in the post. With years of experience in wind and solar energy, Babcock remains extremely well placed to cash in on the current investor enthusiasm for renewable energy.

Given a couple of years and some price recovery in its managed funds, Babcock’s current crisis could be long forgotten.

Any buyers out there?

Shareholders could also see a huge upside if Babcock is able to sell assets on its own balance sheet at attractive prices. Selling on investments for a profit has been the major factor in Babcock’s profit growth to date. As I’ve mentioned in previous posts, until they got involved in the infrastructure bubble (is anyone calling it that yet?), they were very good at identifying opportunities in advance of the masses.

It seems unlikely given current market sentiment and the lack of available credit, but if Babcock was able to sell assets at a profit during the next 12 months, it would hush the naysayers (like me) who think they paid too much. It would also give them a war chest with which to pursue further acquisitions – something I’d be a lot more comfortable about in the current distressed environment (now is presumably a great time to be taking cheap assets off the likes of Centro and GPT).

So far, nothing has actually gone disastrously wrong. And it’s not impossible to envisage a scenario, three or four years down the track, where the company is firing on all cylinders, money is pouring into the renewable energy sector, and Babcock is standing at the gate collecting its fees and making a motza on investments made in today’s distressed environment. There is, however, a lot that needs to go right between now and then.

Babcock & Brown: how bad can it get?

Downside analysis is one of the most important parts of any security analysis; what’s the worst that can happen here? For Babcock & Brown, the answer is simple. With $2.15bn of senior debt and another $614m of unsecured noteholders queued up in front of shareholders, there is definite potential for a wipe-out.

That turns the situation into one of risk versus reward. What are the chances of it happening and what’s my reward if it doesn’t? The reward we’ll come to in a few days’ time. For now, we’ll focus on the chances of a wipe-out.

We often talk chance and probability at The Intelligent Investor, but this is a lot more subjective than calculating the odds of flipping three heads in a row. Like trying to calculate the odds of global warming, this experiment won’t be repeated. There’s no refining your probabilities once reality unfolds and, even if you’re right, you might be wrong (see Right decision, wrong result from 2003).

But that doesn’t make the exercise any less important. And to make an attempt, we need to get stuck into some numbers. The balance sheet is where most things go wrong and I’ve reproduced the table below from the Babcock’s management review in the 2007 annual report.

Babcock’s 2007 balance sheet

	Assets ($m)	Liabilities ($m)	Net ($m)
Real Estate	5,447	3,667	1,780
Infrastructure	5,919	3,669	2,250
Operating Leasing	1,926	1,567	358
Corporate and Structure Finance	976	386	590
Segment Assets and Liabilities	14,268	9,290	4,978
Corporate Debt	-	2,760	(2,760)
Net Cash	363	-	363
Total	14,631	12,050	2,581

These numbers are not audited, so they need to be taken with a grain of salt. But they are much more useful than the audited numbers at the other end of the report. They show how much of the debt is ‘full recourse’ and which has recourse only to specific assets. If one of these assets goes bankrupt, the creditors won’t have recourse to any of Babcock’s other assets. Think of it as a fund manager where each investment’s debt sits on the fund manager’s balance sheet – you can see how leveraged the investments are but one disaster won’t bring the empire crashing down.

That doesn’t make it any less

Still, the $14.6bn worth of assets on Babcock’s balance sheet is offset by $12.1bn of debt. If the assets were sold for 17% less than their balance sheet value – hardly a substantial markdown in the current environment – shareholders would be left grasping at thin air.

For the time being at least, though, that looks unlikely. The consortium of banks providing the $2.15bn corporate facility have waived their market-based review clause that had allowed them to put Babcock under the blowtorch if its share price fell below $7.50. They obviously think it’s worth more as a fee-gouging going concern – and I wouldn’t disagree.

But Babcock isn’t out of the woods yet. There are, no doubt, plenty more clauses relating to interest cover and debt-to-equity ratios. If the business takes a turn for the worse, the banks will be back at the table.

It’s impossible to know what most of the assets are worth or what Babcock paid for them. But, as an example, the company had listed investments sitting on its 31 December balance sheet valued at $1bn. An admittedly-stressed Mr Market is currently pricing them, in total, at around $600m. These assets won’t be revalued to their current market price (believe it or not, they are valued at the board-calculated underlying net tangible asset value of the various funds), but it’s a safe bet the banks are keeping a close eye on their security.

Debt waiver or not, the balance sheet leverage remains a worry. The other issue that could bring Babcock unstuck is a severe deterioration in its earnings. I’d guess the banks are comfortable with their exposure thanks to the $70bn of assets under management on which Babcock collects its fees. Even if its highly profitable asset flipping came to a screaming halt, Babcock still has some very generous management contracts locked in place.

Locked-in fees on a huge pile of debt

It’s another case of ‘believe it or not’, but most of the contracts stipulate that the fund has to pay Babcock a percentage of enterprise value (market capitalisation plus net debt). And while the market capitalisations of its funds have been plummeting, the debt isn’t going anywhere. So the fees should hold up reasonably well. I’ve read a number of the fund prospectuses and, while GPT Group seems to think it has a way out of its joint venture with Babcock, the rest of the funds seem to be pretty effectively tied in. Most of the management agreements are 25-year contracts and can only be terminated if there’s a material breach of the contract.

So Babcock has a nice reliable stream of fees with which to service its debt. But it’s unlikely to be enough. Babcock’s interest bill will be something like $280m for the year and I’d guess the banks require coverage of something like three times. It might collect $400m a year in base fees, but by the time you subtract staff costs, rent and the like, it’s not going to be anywhere near enough.

There’s some comfort in the locked-in income (especially for the banks) but the short of it all is that we’re back to where we were – as a shareholder, you need this balance sheet to be worth something and producing income. Otherwise, you’ll end up with nought.

The assets are all they’re cracked up to be – safe, reliable, cash-producing assets – but the amount of leverage makes it very hard to reach a confident conclusion. Unless you’re buying it for a song (we’re getting there, I promise), Babcock’s balance sheet is one to be wary of.

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.

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.

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

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.