Has anyone read the AFR article this morning. Did the penny...

Has anyone read the AFR article this morning. Did the penny drop?

For me, when the penny does drop on something, it tends to do so in one of two ways: I either get a small 'ting', a few neurons fire and I say "Ahh, I get it.". This would be like when someone explains how to use a function on my mobile phone that I have been grappling with for ages (like SMS). The other response is more pronounced. It's a huge "bang", a lot of neurons fire and I utter something like "Holy [expletive] !".

The former happens often, the latter not so.

For the past 10 years or so (on and off), I have been trying to get my head around Quantum Physics (QF). (I can't.. but if you are an expert, let's start another thread). One of the many aspects of QF that I can't understand is called 'superposition'. In a nutshell, this is where it is possible for a 'system' to be in all possible states at the same time and it is not until the 'system' is observed that we can tell what state it is in.

Erwin Schrodinger, proposed a thought experiment (which you may have heard of) which is commonly known as "Schrodingers Cat". Put simply, a cat is put in a box with some poison which may or may not be released. Quantum physics suggests that after a while the cat is simultaneously dead AND alive and only when the box is opened, can we tell which state the cat is in.

(I do not advocate trying this at home, but it's a real thought experiment, more details of which are here:
http://en.wikipedia.org/wiki/Schr%C3%B6dinger%27s_cat)

When I get my head around this and other aspects of QF, I'm going to have a huge penny-drop moment. It's a while off yet though and the older I get, the less likely it is to happen.

Anyway, a while back I invented a term "Supersolvency" which is where a company can be both solvent and insolvent at the same time. It's not until someone 'opens the box' that we can tell which state the company is in. AFG and ABS were supersolvent for a while there until the box was opened.. if you get my meaning. Some people think B&B are currently supersolvent but only time will tell.

Many people class CNP as Supersolvent at this stage. I reckon the CNP box has been open to the lending group for a long while. As the light shone in, the lenders realise the cat is well and truly alive and the poison has moved from the CNP box to their own.

We know that GR is trying for a debt-to-equity (D2E) swap and there is acknowledgement that this really is the last course of action for the company. Under this, the banks would swap a portion of their debt into convertible equity. The AFR puts the amount at between 1 and 2 billion dollars. If this was to happen, Centro liabilities would drop by the amount and the lenders would get some sort of preferred equity in its place. This would result in a whole lot more equity on the balance sheet, but as you will realise, there are a lot more shareholders to share it with.

If there is a funny side to this, it's that there is a chance one of the banking syndicate may end up with more that 50% of the shares in CNP. This means they will have to consolidate CNP into their own balance sheet for financial reporting. I would chuckle to myself it this was to happen.

Of course one of the positives of the D2E swap is that the banks will then have a huge incentive for the CNP share price to rise. They have to account for the fair value of the holding in their reporting every 6 months and of course they want to get to the point where their holding is in-the-money so they can convert and over time cash out. All of a sudden, we are all in the box together.

Anyway, let's run the numbers and give the cat some fresh air. I would previously have described this as back-of-the-cigarette-packet calculations, but since all of my vices have been removed recently, these are back-of-the-health-food-snack-packet calculations instead:

All we have to go on a this point is the YE balance sheet. CNP consolidated a number of entities at the end of the year because it held more than 50% ownership. This makes YOY comparison harder, but we have to go with it.

There are $20.6bn of assets and $16.4bn of liabilities. I reckon CNP is going to have to D2E about $2bn of this so we'd be looking at $20.6bn of assets and 14.4bn of liabilities post swap.

The parent entity interest in this is $1.289bn and for the purposes of this example, we have to assume the D2E is done at the headstock level.

We currently have 900m shares on issue (with options, etc. p30 of the 4D). The AFR reckons the lending group will want 80% of the company. So, the $2bn will buy the lenders 3600m shares. This, means there will be 4500m shares on issue post D2E - current shareholders own 20% (900m) and the lending group 80% (3600m).

Current NTA for CNP is 69c, which is (simplified) the $1.289bn of equity minus the ~$670m or so of intangibles, divided by the 900m of shares outstanding.

So, post D2E, the parent interest will be $3.289bn divided by 4500m shares on issue which gives ~73c NTA. This feels about right and actually on a NTA basis, current shareholders are slightly better off. I can't see the company paying dividends for a long while but of course when they do, there are a lot, lot more shareholders to divide it between.

The net result though is that the company is in a better capital position. Total equity across the group will be $6.142bn (Assets $20.576bn / liabilities $14.434bn). Centro will no longer be required to pay interest on the $2bn debt, although to be fair we'll have to wait and see if they issue preference shares which may carry an interest payment (Warren Buffet style).

These are all high-level calcs so I hope you get the gist.

Here's the "ting"... as the more astute commentators have noticed, shareholders are in a stronger position than they might realise.

In order to do a D2E, the company requires shareholder approval and without it, the company will go into administration. This will be a 3-4 year process and there is a good chance the banks will NOT get anywhere near all of their money back. A distressed sale of $20.5bn of assets will cause systemic issues for the other REITs that the banks lend to. Mike Smith at ANZ will see their SP tumble to single digits and lose a large chunk of his bonus this year as will other lenders. Even if one of the other cashed-up REITs is interested in parts of the CNP portfolio, they are not going to want to pay anywhere near book value and so we spiral downwards.

In addition, the services business, which generates $200m for CNP will be destroyed. Rufrano and the senior team will bail and the administrators will be left trying to run the shop.

Shareholders are not going to want to go for anything that dilutes them out of existence. At the same time, the lending group will want a deal that gives them a better chance of getting their money back than administration. This is the fine line GR is currently walking. The rational players also know that Australia probably won't hit recession and even if it does, we and the currently recessed US will in time recover. Leverage punishes you on the way down, but if you can hold on it accelerates your recovery on the way up.

All being well, we may see an announcement prior and a chance to vote on this at the AGM next week. If not, this is going to require an EGM which means more delays and more expense. Having said that though, the company is required to give notice and it's cutting things fine.

If the lending group and shareholders can't agree on a solution, sorry folks, it's bye-bye time for CNP and we'll just become another case study on rapid expansion fuelled by debt. If GR can pull this off, the company will be saved for sure and the risk removed from the current SP. In time, we may start trading closer to discounted NTA, which would be a pleasant situation to be in.

A final note to those of you overcome by doom and gloom...

Every single person (you, me, everybody) involved in the whole bear market this year has learned a great deal. When people say, "I learned a lot" it's usually taken as being a negative, but that is rarely actually the case. We never stop learning and what you learn always, always helps you in the future.

You may have learned how to evaluate companies better, or the power a market has, the power of leverage, the difference quality management can make, the influence the media can have, how to read financial statements.. and so the list goes on.

There's a lot of "told you so" around in the market at the moment and both bull and bear experts are popping out of the woodwork left, right and centre. Sometimes though, one just has to go through an experience to learn about it.

Ask yourself this.. if you gave some money to someone (like a university, or a mentor) and asked them to teach you what you learned this year, could they?

I doubt it.

Will want you have learned this year make you a better, wiser person in the future?

Almost certainly.


Now, I am prepared to offer up a $100 to anyone who can explain quantum physics to me. I reckon it'll be money well spent....