west at it again, page-14

you might be interested in the result of 10 days of BNB analysis by the Intelligent Investor. Not good...

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.

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.