Babcock & Brown Limited (BNB) Market cap review clause triggered...

Babcock & Brown Limited (BNB)

Market cap review clause triggered
Recommendation: Hold 13/06/2008


No recommendation trigger guide available. Analyst Note: No trigger prices given there are doubts BNB will continue as an ongoing business.

Investment Rating
BNB buys and develops infrastructure and real estate assets then sells them to investors. Earnings growth potential derives from the investment world's appetite for infrastructure assets, BNB’s global network which identifies real estate and infrastructure assets for sale, the improving quality of the revenue stream and the company's record at investing profitably for its own account. The competitive advantage behind the strong pipeline of deals and assets is management and staff.

BNB’s market capitalisation has fallen below the trigger for its banks to review the company’s corporate debt. This could lead to forced asset sales. There is some doubt BNB will continue as an ongoing business.


Result Description
Yesterday aggressive selling pushed BNB’s market capitalisation below the $2.5bn threshold which gives the providers of the $2.8bn corporate debt facility the option of a review. We understand the various banks will meet on Monday to discuss whether to exercise their option.


Impact
We did not predict this week’s spike in oil prices, the damage it would wreak on equity markets and the opportunity it would provide for sellers to smash BNB’s share price. At the time of our last review just three days ago BNB’s market cap was $3.5bn, a full $1bn above the $2.5bn trigger. We thought the credit crisis would gradually end and BNB would continue to be able to refinance. We also didn’t predict the B&B Power refinancing debacle, which was out of character from this group and is a central cause of this week’s selloff. BNB shot itself in the foot with this huge mistake.


A sustained recovery in equity markets and especially global financial stocks was already a precondition for a recovery in BNB shares. Now BNB itself has even more work to do to regain the confidence of the market. This will take a long time.


From the outset we’ve said BNB is a higher-risk stock and not for conservative investors, particularly those reliant on their investments for income. The triggering of the market cap review clause means this is more the case than ever. While we think the company will survive, conservative risk-averse investors should not own the stock.


There are no suggestions of irregularities, fraud or dishonesty within BNB, and no questions about management’s integrity. This is vital for retaining the banks’ confidence.


Recommendation Impact (Last Updated: 13/06/2008)
The trigger of the review clause has substantially increased the risks in owning BNB shares and we have no choice but to downgrade to Hold. Much depends on the size of the holding in an individual’s portfolio.
Price data based on previous close.
Previous Close Market Cap
$5.25 $1,750 (million)
52 Week High/Low
$34.78 - $4.70
Sector
Diversified Financials


Intrinsic Valuation
$6.10
Note
Valuation is based on NTA.


Moat Rating Narrow
Risk High
Company Beta 2.00
Sector Beta 1.28


Year 12/06A 12/07A 12/08E 12/09E
NPAT ($m) 308.60 525.10 632.00 731.80
EPS (c) 115.40 172.00 177.40 205.40
% Change 49.90 49.00 3.10 15.80
DPS (c) 36.00 54.40 64.00 75.00
Franking (%) 50.00 50.00 50.00 50.00
Dividend Yield (%) 1.80 2.00 12.20 14.30
PER 17.20 16.10 3.00 2.60

Source: Aspect Huntley analyst estimates

2 Year Price Chart






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Event Analysis



The facts about BNB’s situation

Yesterday aggressive selling by quant funds, retail investors and hedge funds pushed BNB’s market capitalisation below the $2.5bn threshold which gives the providers of BNB’s $2.8bn corporate debt facility the option of a review. We understand the various banks will meet on Monday to discuss whether to exercise their option.

Should the banks call for a review, there will be a consultations with the company over four months, during which BNB will continue to operate as normal with full access to the corporate debt facility.

There are no automatic prescriptive requirements such as acceleration of debt repayments. During the review period, the company would need to seek the lenders’ permission to pay dividends and subordinated note interest. The four-month review, if called, would end in mid-October. Last year’s interim dividend was paid in early October.

At the end of the four months, if the market capitalisation is above $2.5bn the review is automatically cancelled and no further action is required.

If at the end of the four month review, the market capitalisation remains below $2.5bn, BNB would be required to execute any course of action agreed with the lenders. If there is no agreement, a minimum two thirds of the lenders by participation have the right to serve notice on BNB to repay the corporate facility within 90 days. A minimum two thirds of the lenders have to want this. One third or a half isn’t enough.



The risks now

There are several key risks now:

* The market cap remains below $2.5bn at the end of the four months, the banks and BNB are unable to agree on a course of action, and at least two thirds of the banks enforce fire sales of assets on BNB’s balance sheet or liquidate the whole company. This is the worst case.

* Something unforeseen and unexpected goes wrong inside the B&B group, which breaches a covenant not disclosed to the market. We’ve talked about the risks created by the interaction of the complex accounts and reliance on debt during a credit crisis.

* The company framed its $750m+ FY08 earnings guidance to be conservative, based on recurring income and transactions coming up this year. The guidance is at risk if the debt review somehow makes one of the assumptions unjustifiable, for example intending buyers of wind farms scheduled for sale this year back away or institutions currently investing in offshore wholesale funds pull out.

* S&P’s placing yesterday of B&B International, the vehicle for US executives’ pre-IPO shares, on credit watch with negative implications, triggers a covenant not disclosed to the market.

* B&B Power is unable to refinance the shortfall in its capital expenditure funding, leaving BNB to provide bridging finance. This precludes other scheduled transactions or debt repayments, creating risks to the earnings guidance and/or lenders’ sentiment towards BNB

* Directors and auditors decide to write down the carrying value of BNB’s investments in its funds to mark this to market, rather than leave it based on the book values of the hard assets in the funds. Currently the carrying values are equity-accounted proportions of the net asset values in the funds. On that basis there could be writedowns only if the fund auditors write the assets down within the funds, but the fund assets are mostly performing well and there has been no general deterioration to the extent the fund security prices have fallen.



Our comments

It’s prudent to assume BNB’s market cap will still be below $2.5bn four months from now. The conversion of B&B International shares into BNB ordinary shares, and the exercise of the $5.00 options, would increase the market cap somewhat but not enough to stop determined sellers from forcing a sub-$2.5bn total again.

Triggering the market cap review clause doesn’t in itself mean the financial position of the underlying business has changed – unless the business needs to raise equity. Banks impose market cap review clauses because falls in borrower share prices to certain levels make equity raisings either impossible or too dilutionary, and this reduces the security of the banks’ loans.

We expect the company to try to negotiate the market cap review threshold lower or have it removed, though the banks retained it the last time the corporate facility was refinanced, which was in March. At that time the threshold was reduced. Now the threshold has been passed, and by a wide margin, the banks are unlikely to remove it. If it were removed there would be a substantial recovery in the share price.

A much higher valuation than current prices is warranted but this assumes BNB is a viable concern operating in a reasonable climate, and also assumes the support of the banks. Our view is the banks don’t have to do anything. BNB said yesterday it remains well within all debt covenants and its operating cashflows, interest cover and liquidity are strong. The covenants on the corporate facility are net asset coverage of 1.8x and interest cover of 3x. The $220m equity raising in March strengthened the balance sheet.

At the AGM shareholders heard the asset development pipeline has never been stronger, with significant revenue growth to flow. There will be strong locked-in growth in recurring revenue this year from the specialist fund and asset management platform. Just today BNB announced an impressive deal: the negotiation, structuring, financing and advice for a consortium of investors on the £3.6bn acquisition of Angel Trains, a European rolling stock provider from the Royal Bank of Scotland. Interestingly this bank is a lead bank in the syndicate providing the corporate facility. Angel Trains is a “business-as-usual” transaction for BNB. At the height of the credit crisis in March, the same banks now entitled to a review increased the size of the corporate facility to $2.8bn and extended its duration to 2011 for only a small increase in margin. If the banks do nothing now, then nothing will happen. BNB will continue as a profitable company. The banks haven’t forced Allco and Centro into liquidation, and they were in worse financial positions than BNB. To force asset sales would, in our view, not be in the banks’ best interest.

But being in discussions with bankers is never comfortable. There is a difference between what the banks should do, or what we think they will do, and what they decide is in their interests. Australian and international banks face rising bad debts from several quarters and might decide to become more risk-averse. Seven months from now, when they might be entitled to force asset sales on BNB, they might do so if they feel sufficiently nervous. At least there are no suggestions of irregularities, fraud or dishonesty within BNB, and no questions about management’s integrity. This is vital for retaining the banks’ confidence.

However, the company has not handled the disclosure of the market cap review mechanism satisfactorily. We and many others were under the distinct impression the clause would be triggered only if the market cap fell below $2.5bn and stayed there every consecutive day for four months. It now turns out the market cap only has to fall below $2.5bn on one day for the review process to start. This is a far weaker condition. The truth wasn’t made clear to the market.

From the outset we’ve said BNB is a higher-risk stock and not for conservative investors, particularly those reliant on their investments for income. The triggering of the market cap review clause means this is more the case than ever. While we think the company will survive, conservative risk-averse investors should not own this stock.

A sustained recovery in equity markets and especially global financial stocks was already a precondition for a recovery in BNB shares. Now BNB itself has even more work to do to regain the confidence of the market. This will take a long time. BNB needs to improve disclosure and ensure a debacle like B&B Power’s sudden refinancing shortfall never happens again. It needs to continue to do deals like Angel Trains, demonstrate the values of the assets in the listed funds and launch enough wholesale funds to prove its business model is not broken. It certainly needs to reduce gearing. There will be calls for a change of management culture and, maybe, leadership.

We did not predict this week’s spike in oil prices, the damage it would wreak on equity markets and the opportunity it would provide for sellers to smash BNB’s share price. The whole episode has been astounding. At the time of our last review just three days ago BNB’s market cap was $3.5bn, a full $1bn above the $2.5bn trigger – and our impression of the four-month review period was tougher than the reality has turned out to be. Our core scenario was the credit crisis would gradually end and BNB would continue to be able to refinance. We also didn’t predict the B&B Power refinancing debacle, which was out of character from this group and is a central cause of this week’s selloff. BNB shot itself in the foot with this huge mistake. The trigger of the market cap review clause has substantially increased the risks in owning BNB shares and we are forced to downgrade to Hold. Much depends on the size of the holding in an individual’s portfolio.

Now a review of BNB’s debt has been triggered the company could fall under the control of its banks. We have moved from valuing BNB as an ongoing business to NTA. 85% of BNB’s NTA on December 31 plus the March $220 capital raising is $6.06 per share. Our earnings and dividend forecasts obviously assume BNB continues as an ongoing business. If the banks were to allow BNB to continue there would be substantial share price upside. Some of the asset portfolios on the balance sheet are now worth more than the market cap.

With BNB now trading below NTA there is the possibility of a takeover or MBO. A purchaser would acquire a high-quality development pipeline and many capable staff.