"re-equitisation" theory in practice

My debut purchase of TPI shares was at the same time as the 50cps re-capitalisation exercise around this time two years ago.

At the time I calculated the margin of safety to be sufficient enough to justify investing in the company.

It occurred to me that the deep under-valuation at the time would ultimately deliver pricing of the stock towards is intrinsic value, especially since the debt reduction focus articulated by management would see rapid “re-equitisation” of the Enterprise Value of the company

[“Re-Equitisation”: when, assuming a constant EV/EBITDA multiple, Net Borrowings reduce and the Equity value rises to fill the space vacated by Net Debt in the Enterprise Value formula].

I find it a useful exercise to review cases like this, when the theory has translated into practice.


To demonstrate this let’s take a look at the numbers:

In FY2011, TPI had the following key financial metrics:

EBITDA = $425m
Net Interest = $177m
NPAT = $44m

Net Interest Bearing Debt = $1.56bn
Shares on Issue = 1.077bn
Share Price = $0.50
Market Cap = $540m
i.e., Enterprise Value = $2.1bn

And therefore, valuation-wise:
EV/EBITDA = $2.1bn/$425m = 4.9x

And solvency metrics:
NIBD/EBITDA = $1.56bn/$425m = 3.7x
EBITDA/Net Interest = $$425m/$177m = 2.4x

Clearly, this was a heavily-indebted business, and the financial risks were obviously part of the explanation as to why the stock was valued at less than 5x EV/EBITDA


Immediately after the $250m capital raising that occurred in November 2011, the metrics were changed to the following:

Net Interest Bearing Debt = $1.31bn
Shares on Issue = 1.579bn
Share Price = $0.50
Market Cap = $790m
i.e., Enterprise Value = $2.1bn

And therefore, valuation-wise, nothing had changed (since at that point all that had happened is that a debt for equity swap had taken place):

So EV/EBITDA = $2.1bn/$425m = 4.9x (as before).


But solvency metrics had improved somewhat:

NIBD/EBITDA = $1.31bn/$425m = 3.1x
EBITDA/Net Interest = $$425m/(177m less $25m) = 2.8x (pro forma basis, assuming interest expense falls by $250m @ 10% borrowing cost, i.e., $25m)

So, the capital raising at the time was a relatively modest one, in the context of the EV of the company, and its impact on the solvency metrics is relatively limited. (NIBD/EBITDA falls by 0.6x and EBITDA-to-Net Interest rises by 0.4x.)


But let’s look at what happens in the subsequent two years:

By 2013, surplus cash flow as well as the sale of under-earning assets, results in the following salient financials:

Net Interest Bearing Debt = $978m (down from $1.31bn after the capital raising)

EBITDA = $412m (EBITDA lower due to sale of several businesses)
Net Interest = $116m (lower due to lower net debt)
NPAT = $68m (higher due to lower interest expense, despite lower EBITDA)


Now, assuming that the EV/EBITDA multiple remained unchanged over time at 4.9x, as it had been in 2011 (we’ll later in this missive take a look at what the EV rating actually did), then we can solve for the implied Market Capitalisation and the resulting share price as follows:

EV/EBITDA = 4.9x
=> EV/$412m = 4.9x
=> EV = $2.0bn

So, Market Cap = EV less NIBD = $2.0bn less $978m = $1.026bn
Shares on Issue = 1.579bn

=> Share Price = Market Cap divided by Shares on issue = $1.026bn divided by 1.579bn = $0.65

In other words, following simple debt reduction, the “re-equitisation” alone of the EV (i.e., excluding any change in the valuation multiple) results in a $0.65 share price, up from $0.50 in 2011.

That’s 30% share price appreciation.

And note that return is delivered despite EBITDA having fallen.


Now let’s take a closer look at what happens to the solvency metrics:

For 2013:

NIBD/EBITDA = $978m/$412m = 2.4x (Recall that the 2011 figure was 3.7x)

EBITDA-to-Net Interest = $412m/$116m = 3.5x (2011 = 2.4x)

So clearly, this company’s debt situation – while not completely out of the woods yet – is in far better shape than two years ago.

The financial risk is clearly diminishing with time.

And as one of the axioms that pertain to the valuation of securities dictates: the less risk, the higher the valuation.

And we see this in the rating of the stock, which – at the current share price of $1.07/share – translates into a Market Cap of $1.69bn, and EV of $2.67bn, and therefore an EV/EBITDA multiple of 6.5x. (up from 4.9x, recall, in 2011 at the start of the process).

So, at $1.07/share vs the purchase price of $0.50/share... that’s a total return of some 115% in two years.

I think this is a great case study of “re-equitisation” theory being realised in practice.

And don’t forget – and this I think is a very significant lesson to value investors – this excellent share price performance was delivered even though the macroeconomic backdrop for the company over the past two years was simply horrible, and even brought about a few profit warnings and numerous downgrades by analysts. And the exit of the CEO.

Such is the power of “re-equitisation”.

As the EV continues to “re-equitise” over the next two years, and as the stock continues to be re-rated on the reducing financial risk, I believe the stock will continue performing well for shareholders.


Prudent Investing!

Cam