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Huntley's Recommendation: Babcock & Brown Limited

Recommendation: Hold

BNB buys and develops infrastructure and real estate assets then sells them to investors, while also running an operating leasing business. The competitive advantage behind the pipeline of assets is management and staff. BNB benefited from the pre-2007 era of cheap equity and debt but now faces the hangover from the boom. It bought quality assets, though in some cases overpaid. The complexity of BNBs accounts, the dependence on debt in a credit crisis, recent reputation damage and questions about the sustainability of revenues from the specialist funds make this a high-risk investment which could yet go to zero. It is not for conservative or income-oriented investors.
Event
22-Aug-2008

BNB announced 1H08 NPAT attributable to ordinary shareholders of $150.9m, down 24%. EPS plunged 43.3%. There was no interim dividend.

Business Impact: While our feeling is the company will survive by the skin of its teeth, there can be no guarantees BNB will avoid liquidation. The margin for error is small and despite the fall in the share price this investment remains very high-risk. Given we think the company will scrape through, the main problem we have with the stock is the impossibility of accurately valuing an entity which is going to shrink when we don’t know how much. The value probably lies somewhere between $5 and $10 per share but this is only a tentative guess. As a complex and intricate black box BNB has been impossible to analyse accurately in the credit crisis, and this isn’t about to change. We don’t know how to value a company whose earnings and assets just six months from now are so uncertain, so we are going to continue with no published valuation until there is more certainty. We can’t construct recommendation price ranges without a valuation to anchor the range. The omission of the dividend reflects the liquidity and capital pressures. There will be no further dividends until after sufficient progress on corporate debt reduction. A new Chairman and CEO have launched a radical Board overhaul and change of culture and strategy.

Forecast Impact: --

Recommendation Impact: Our instinct is to hold on for a rally which would accompany deleveraging and derisking, but any investors who can’t tolerate the risk of losing what remains of their investment should sell.
Event Analysis
BNB announces interim profit down 24%, major Board and management changes, and foreshadows cultural and strategic change

BNB announced 1H08 NPAT attributable to ordinary shareholders of $150.9m, down 24%. EPS plunged 43.3%. There was no interim dividend. There were non-cash impairment charges of $386m and realised trading losses of $55m across the four divisions. Net operating cashflows increased 62% to $299.6m, reflecting the non-cash nature of the charges. Assets under management increased 41% to $74.4m. CEO Phil Green has stepped down voluntarily to become an executive director. He has been replaced by CFO Michael Larkin. Executive Chairman Jim Babcock has also stepped down to become a non-executive director. Elizabeth Nosworthy is the new Chairman. The Chair of the Board’s audit and risk-management committee will be replaced by former Westpac CFO Pat Handley. The other two executive directors will leave the Board to increase the proportion of non-executive and independent directors, more of whom will be hired in time. The only executive director now is the Managing Director, Michael Larkin.
Our comments

While our feeling is the company will survive by the skin of its teeth, there can be no guarantees BNB will avoid liquidation, which would send the stock to zero. The timing and value of asset sales to reduce gearing is uncertain, gearing is still too high and there could well be more writedowns in the current environment of falling asset values and, for some assets, rising discount rates. Despite the fall in the share price this investment remains very high-risk. Our instinct is to hold on for a rally which would accompany deleveraging and derisking, but any investors who can’t sleep at night for worry about losing what remains of their investment should sell. Speculators prepared to back the enormous turnaround ahead can have a go – the upside from a successful recovery and turnaround is multiples of the current share price - but this isn’t our official recommendation. Speculating requires accepting you can lose all your money. The appointment of Pat Handley as an independent chair of the audit and risk management committee is a good sign. Handley is respected for his work to save Westpac with Bob Joss in the early 1990s. Presumably he is joining the Board with his eyes wide open and would not be doing so if he thought BNB was unsalvageable. We are encouraged by banks’ continuing support for highly geared organisations deleveraging under stress. Given we think the company will scrape through, the main problem we have with the stock is the impossibility of accurately valuing an entity which is going to shrink when we don’t know how much. Full-year earnings could be anywhere between $200m, an NPAT covenant, and $525.1m, last year’s profit attributable to ordinary shareholders. No one, not even management, can have much idea about the second-half result. Pulling some numbers out of the air, a five PER applied to the average of these two profits gives a $5.09 per share valuation. A nine PER gives $9.16. The value probably does lie somewhere between $5 and $10 per share but this is only a tentative comment. As a complex and intricate black box BNB has largely been impossible to analyse accurately in the credit crisis, and this isn’t about to change. We don’t know how to value a company whose earnings and assets just six months from now are so uncertain, so we are going to continue with no published valuation until there is more certainty. We can’t construct recommendation price ranges without a valuation to anchor the range. The omission of the dividend reflects the liquidity and capital pressures on BNB. There will be no further dividends until after sufficient progress on corporate debt reduction. This means selling about $2bn in assets to reduce gearing to 20-30% within 18 months. The company expects to resume paying dividends in FY09. There is no rational way to forecast these, so it’s safest to forecast no FY09 dividend in case the deleveraging takes longer than expected. There is no floor to the previous earnings guidance, confirmed with this result, for FY08 earnings to be less than FY07. Downside risks include lower fee revenue from managing listed funds where market cap is the fee driver, failure to sell the European windfarm assets, execution on the FY08 transaction pipeline, restructuring costs and the size of restructuring savings. Having a high proportion of independent directors is popular in Australia. The reforms to the Board are intended to meet this demand. A turnaround at BNB is possible if the company can survive by deleveraging. At the moment the margin for error is small. There is a full-year NPAT covenant of $200m. Assets of $14.2bn are supported by equity of just $2.6bn, although much of the project debt is non-recourse to BNB shareholders. The new CEO reassured the analyst presentation four times that the company was under no pressure to reduce gearing via asset firesales and would deleverage in an ‘orderly’ manner. If this can be done, the banks should stay on-side and let BNB survive. The stock is a defacto workout. Management reiterated BNB continues to operate within its key debt covenants. In particular BNB does not have to sell its European windfarm assets, which are slated for sale, to stay within the covenants. Only 30% of the non-recourse real estate debt (the writedowns were concentrated in real estate) has any covenants. We are wary of the appointment of the new CEO from within the existing management ranks which oversaw previous risk management mistakes, but at the analyst presentation Michael Larkin did impress with his commitment to the Board’s agenda for cultural change, his command of the company’s business and accounts, and his humility. The latter is nearly always present in CEOs which restore market confidence in companies which fell from grace. He and the new Chairman accept BNB has made mistakes (particularly at Babcock & Brown Power), needs to change and will be held to account for its promise to change. The new Chairman talked at length about the culture which led to the company’s current predicament. BNB began as a partnership of capable, creative individuals who retained substantial autonomy after the company went public. The senior staff was ‘an eclectic group of free spirits’. There were not sufficient centralised risk controls and disciplines; this led to the overpayment for Alinta. The company retained its highly entrepreneurial culture in which many staff saw themselves as ‘masters of the universe’ and aggressively pursued short-term trading profits (principal trading). This culture delivered strong earnings growth when capital markets were highly liquid but also left the group unfocused and with too many non-core/surplus assets. BNB was like ‘an army that outran its supply lines’. The new Chairman and CEO do not entirely blame the credit crisis for BNB’s plight. They accept this just exposed major mistakes made by the company. BNB now accepts the availability of equity and debt will be constrained in the future. Major cultural change is required. The former culture will be replaced by one more typical of large corporations: one companywide set of guidelines for investments, which must demonstrate sufficient long-term payoffs for shareholders, coupled with centralised risk controls. Capital will be allocated mainly to asset origination, asset development and co-investment. There will be no more short-term opportunistic trading. But there needs to be a balance between constraints and an appropriate degree of entrepreneurialism. The corporate and structured finance division will be wound down, with all the focus to be on the areas where BNB has international competitive advantages: infrastructure, real estate and operating leasing. Consistent with lower leverage the ROE target will fall from 25-30% to 15-20%. By the end of FY09 there will be operating cost savings of at least 20% of the annualised 1H08 cost base. 25% of staff will leave the business. Institutional investors retain their confidence in BNB’s unlisted funds but want more alignment between their interests and BNB staff; this will be delivered. Phil Green and Jim Babcock have given their word they will not interfere with the new CEO’s agenda. They remain major shareholders and understand what is at stake. They remain directors, we are told, because their longstanding relationships with key bankers and co-investment partners are critical to the business’s health, though our feeling is they might leave the Board after a year or so. Our feeling is the Chairman did not want two major, disgruntled and exiled shareholders potentially opposing the reform agenda. The Chairman herself may well leave once the turnaround is underway. There are many similarities between the turnaround of AMP and what BNB now has to do. Major cultural change and a refocus on core activities were required at AMP after its disastrous expansion into the UK, but as these were implemented the successful core business could shine and the stock became a successful investment again. Then-AMP CEO Andrew Mohl was appointed from the management culture which got AMP into trouble, though he eventually pulled off an outstanding turnaround. If BNB can deleverage and increase its chance of survival we see no reason why it cannot transition from a highly leveraged investment bank to a low-geared manager of assets. Such a business could be valued and recommended at a price.