running the numbers

Folks,

Sentiment has really moved against Centro in the last few days. As I said yesterday, the information vacuum from the company is being filled by speculation and misinformation from the media. This is very unhealthy and the company will need to act to fill this vacuum quickly to avoid an absolute meltdown in what little confidence is left.

To get to the nuts and bolts of what is at stake, I have spent time running the numbers on the 3 options Centro is currently considering. To their credit, these were the options outlined right from the beginning and they have stuck to them all the way through. To recap, they are 1) New debt facilities 2) Sale of CAWF/CAF 3) Equity injection.


Option 1 - New debt facilities

Under this option, Centro would convince the existing lenders to extend the facilities for a number of years OR find replacement lenders for the amounts involved. If this option was used on its own, it would mean Centro would keep the current gearing levels but get back into the cycle of reducing debt by spinning off assets into co-owned structures and continuing to charge management fees.

The maths on this option are reasonably compelling.

The effects of lower US interest rates may actually cancel out the additional risk premium demanded by US lenders. In Australia, I suspect they will have to pay a higher rate because of both risk and rising interest rates.

In the absolute worst case scenario: 200bp increase in the US and 240bp increase in Australia (In effect double what the company themselves said the increase would be). This comes out at around a 6c per share impact. Added to this is the cost of the "$40m of anticipated upfront one off refinancing costs associated with the current debt restructure" (p8 of the Centro presentation 17/12/07), which amounts to a one-off 4.73c per share in 2008.

So, aside from any other impacts, worst case increased interest and debt restructuring costs amount to 10.73c per share impact in year 1 and 6c per share for years 2 onwards. The current EPS prediction is 38c, so this would bring EPS down to just over 27c for 2008.

I just simply don't think this option will happen alone. The lenders are obviously putting significant pressure on Centro to reduce debt and the company now has the additional burden of reputational risk and reduced creditworthiness. Anything with the name Centro on it is going to be tarnished for the foreseeable future which will make spin-offs hard. I think Centro will find existing or new lenders who will be happy to roll over a large chunk, but not all of the debt. In my opinion, this then means they will have to consider one of the other two options as well.



Option 2 - Sale of CAF / CAWF

As a bit of background:

CAF (Centro America Fund) contains 32 US properties worth $1.1bn. It was formed after the Heritage acquisition in the US. 41% of the fund is owned by CNP, 50% is owned by DPFI (which is 67% owned by CNP) and only 9% is owned by 'external' investors. As you can see, CNP has direct or indirect control over most of the fund.

CAWF (Centro Australia Wholesale Fund) contains 28 Australian properties worth about $2.5bn. It is 50% owned by CNP and 50% owned by DPF (which is 51% owned by CNP). Again, CNP has direct or indirect control over a large part.

CAF and CAWF are accounted for at fair value and according to the 2007 report, the 41% stake of CAF is carried on the balance sheet at $252.6m and 50% stake of CAWF at $885.4m. Depending on the values of the underlying properties, this may have changed up or down by now but for the purposes of this, let's assume it has stayed the same.

The fact that CNP is considering selling both of these, suggests it is trying to raise around $1.1bn which we could reasonably expect would be used to pay down just under 1/3rd of the outstanding CNP debt. Because of the co-ownership, CNP can really only sell its portion of the holdings in CAF / CAWF. Forcing the co-owners (DPF and DPFI) to sell their part as well will not go down well with other investors. On the one hand this will make CAF / CAWF harder to sell but on the other hand it has the benefit of still generating fee income if CNP can continue to manage it. This would appeal to a super fund (or similar) who will want the income from, but not the running of, the fund.

Trying to work out exactly how big an impact selling CAF / CAWF would have on the CNP earnings is bloody hard. Although the annual report discloses the income for each, it is only for a portion of 2007. I gave up on this.

So, as a best guess proxy I have used the following methodology: CNP earns revenue of around a 9.7% on assets. Assuming they can get book value for CAF / CAWF, a 9.7% return on the $1.1bn worth of assets from these two funds is about $107m per year revenue. Selling them will reduce CNP revenue by about that amount. However, using the proceeds to reduce debt by $1.1bn will also reduce interest payments (at 6.3%) by around $69m per year. So the net impact of the sale would be a $38m per year reduction in earnings or 4.5c per share. This is overstated on the one hand as CNP will still be earning fee income from the fund, but understated as the interest rate used is unlikely to be this low moving forwards.

The current EPS prediction is 38c, so I would estimate the sale of CAF and CAWF reducing this to 33.5per share. The upside of course is that we will have a healthier balance sheet and at 8x earnings, the share price will be around $2.68.


Option 3 - Equity injection

Going on the same assumption as option 2, let's look at CNP trying to raise equity of $1.1bn from someone. This could be private equity, sovereign fund, etc, etc.

Here are 3 scenarios from which you can extrapolate others:

a) Persuade an investor to put $1.1bn of equity in at the current share price (around 50c).

CNP would have to issue 2.2bn more shares which would make a total of 3.05bn shares on issue. So where we currently own 100% of the company, we would end up owning about 28% of the company. As a result of the injection, the company could retire $1.1bn of debt which would reduce interest payments by $69m per year.

The net result of this, with 3.05bn shares on issue, is an EPS of around 12.8c. At 8x earnings, the share price would be around $1.03. The equity investor would be getting around 25% EPS return on their money PLUS an increase of over 100% on their share price.

(If the company suggests this option, my advice is to vote NO)


b) Selling 1/2 of the company for $1.1bn and use it to retire $1.1bn of debt

CNP would issue 850m more shares at $1.29 (850m x $1.29 = $1.1bn), meaning around 1.7bn shares on issue in total. This would cut EPS to around 23c per share. At 8x earnings, this will give a SP of $1.84.
The investor would get an 17.8% EPS yield (23c / $1.29) and a 42% increase in share price.


b) Selling 1/3 of the company for $1.1bn and use it to retire $1.1bn of debt

CNP would issue 425m more shares at $2.59 giving around 1.275bn shares on issue. This would cut EPS to around 30.7c per share. At 8x earnings, this will give a SP of $2.45.
The investor would get an 11.58% EPS yield and a small decrease in share price.



These numbers are quite rough but you'll get the gist. In a nutshell though, options 2 and 3 are very attractive to potential investors which is why I think there has been so much interest. As shareholders, we don't do too badly out of it given the current situation.

Option 2 would be easier as it doesn't require shareholder approval to issue more shares. Having said that though, if a credible big-name equity investor came along at the right price, it would get my vote to have their money and credibility on the share register.

Assuming Glenn can get one or more of these across the line, Centro looks likely to make it through this mess. Meanwhile, I think it's going to get very choppy because of sentiment rapidly moving away from the company. In my opinion, if you can hold on and stay liquid for the long-haul, you will be highly rewarded.