Huntley's Recommendation: Babcock & Brown LimitedRecommendation:...

Huntley's Recommendation: Babcock & Brown Limited

Recommendation: Buy

BNB buys and develops infrastructure and real estate assets then sells them to investors. Earnings growth potential derives from institutional investors appetite for infrastructure assets and BNBs global network which identifies real estate and infrastructure assets for sale, and the company's longer-term record at investing profitably for its own account. The competitive advantage behind the pipeline of deals and 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. It is not for conservative or income-oriented investors.

Event11-Aug-2008
Today BNB downgraded its earnings guidance. The May AGM heard the company was on track to deliver on its 2008 guidance of NPAT of at least $750m. The new guidance is for FY08 earnings to be less than the FY07 group NPAT of $643m. The interim result will be 25-40% below the $250m 1H07 result. See Event Analysis for full details.

Business Impact: Global real estate markets have fallen heavily this year, particularly in Europe and North America where, obviously, BNB earlier overpaid. The range for the interim result reflects management’s uncertainty about whether it has taken enough provisions. Visibility in the timing of some transactions is low because the credit crisis and market volatility have delayed decisionmaking at counterparties. There are no changes to our earnings forecasts. We have cut our dividend forecasts. The writedowns and the general vulnerability to capital market conditions mean further writedowns in the second half cannot be ruled out, and although the 1H08 result pre-provisions will be above pcp there is also the possibility of damage to second-half operating earnings and cashflows.

Forecast Impact: --

Recommendation Impact: The share price is likely to remain marooned with a discount for management credibility/uncertainty. Our $12.00 valuation applies a 9 PER to our 131.3c FY09 EPS forecast. The 50% discount to valuation makes BNB a Buy but the stock remains only for investors with the most risk tolerance and a long-term horizon. We recommend all other investors wait until the credit crisis is over, BNB’s writedowns have ended, and the company acts on the outcomes of its major business review, which are yet to be announced.

Event Analysis
Market volatility, overpayment hit BNB earnings
BNB has bowed to the inevitable and downgraded its earnings outlook. The May AGM heard ‘while global capital markets remain difficult BNB remains on track to deliver on its 2008 guidance of a Group Net Profit of at least $750m. The impact of provisions and writedowns in the first half and the timing of wind asset sales this year is likely to result in all growth being generated in the second half of the year.’ The new guidance is for FY08 earnings to be less than the FY07 group NPAT of $643m, which was $562m after the US executive minorities. The interim result will be 25-40% below the $250m 1H07 result. The downgrade is due largely to non-cash impairment provisions against equity-accounted investments, especially real estate, Everest Babcock & Brown and assets held in the Corporate & Structured Finance division. The writedown against EBB follows writedowns against intangible assets on EBB’s own balance sheet. We understand this is the only reason BNB would write down its investments in the specialist funds. It’s therefore significant there are no writedowns against investments in other specialist funds. This apparently indicates the other funds are set to report no or minimal writedowns this reporting season. Before provisions the 1H08 result is expected to be above 1H07. BNB says the infrastructure and operating leasing divisions continue to benefit from strong industry dynamics and have strong global positions.

Our comments
Global real estate markets have fallen heavily this year, particularly in Europe and North America where, obviously, BNB earlier overpaid. The real estate writedowns are spread across Europe, North America and Australia. At the time of the FY07 result management said it was most worried about the real estate division. The company could have qualified the $750m guidance more carefully at the time. Obviously it didn’t expect the extreme market volatility since then. The range for the interim result reflects management’s uncertainty about whether it has taken enough provisions. Visibility in the timing of some transactions is low because the credit crisis and market volatility have delayed decisionmaking at counterparties. The new guidance is for FY08 earnings to be less than the FY07 group NPAT of $643m. We assumed a downgrade and applied a 25% discount to the former $750m guidance. The outcome was a forecast of $563m or $467.8m (EPS 131.3c) after deducting the US executive minorities. We’ll keep this forecast and already had the same for FY09. We have however cut our dividend forecasts to 40c for FY08 and FY09, assuming directors will prefer to protect retained earnings. Like a great many market participants, including ourselves, BNB management did not predict the market volatility of recent months. Still, management’s credibility in the eyes of many will sink to a new low with today’s announcement even though parts of the business are doing well and risk management was evidently adequate there. The writedowns and the general vulnerability to capital market conditions mean further writedowns in the second half cannot be ruled out, and although the 1H08 result pre-provisions will be above pcp there is also the possibility of damage to second-half operating earnings and cashflows. The share price is likely to remain marooned with the possibility of less leverage to any recovery in investment markets given an extra discount for management credibility/uncertainty. Our $12.00 valuation applies a 9 PER to our 131.3c FY09 EPS forecast. The 50% discount to valuation makes BNB a Buy but the stock remains only for investors with the most risk tolerance and a long-term horizon. We recommend all other investors wait until the credit crisis is over, BNB’s writedowns have ended, and the company acts on the outcomes of its major business review, which are yet to be announced.