Babcock disaster looms 

The passengers are screaming at the back of the Babcock bullet train. The driver Phil Green and his crew are working frantically in the engine room to avert disaster. They have two levers left to pull.

The first is pulling a partner with deep pockets, the second is flogging the wind assets fast.

Forget the evil hedge fund “shorting” angle. Forget the strong fundamentals and solid assets spiel.

The destruction of Babcock & Brown’s stock price – although expedited by margin calls and panic selling – can be put down to a loss of confidence in management and a balance sheet that is recklessly leveraged and overwhelmed by related party revenues.

Of the $2 billion in revenue at December balance date, a mere $25 million came from external advisory sources. The rest comprised base and performance-fee income, and advisory income, from Babcock’s “captured vehicles”.

A large chunk of this satellite income is not repeatable; it is “one-off” and most of the satellites themselves are over-geared and heading for asset writedowns.

This is why the hedge funds are “short” – those who managed to borrow stock, that is. And this is also why no big institutions have gone “long” and come to the rescue yet.

Make no mistake, if the value is there somebody will pounce and make a fortune. And at least one major corporate has already run the numbers.

The ability of all the Babcock entities to raise either new debt or equity is severely curtailed. The independent directors of the satellites will now be leery about forking out fees to the parent. The parent itself only recapitalised at $13.65 a share a couple of months ago.

These factors render an equity raising extremely difficult. As for credit, the bankers will look at Babcock’s ability to fund the $11 billion in debt already on the balance sheet – and its ability to raise fresh equity at a reasonable price. Neither option looks palatable.

This brings us to the two levers.

A white knight is possible but due diligence would take some time and any corporate saviour would demand to rank above the current equity holders. It would demand security and the dilution would further damage minority shareholders.

The second lever is wind. Babcock has already said it is selling some wind assets. These are excellent assets. Babcock got into the wind game early and despite hiccups in its Babcock & Brown Wind (BBW) vehicle has shown acumen in the business.

Asset sales from BBW probably won’t help the parent much. The parent has its own wind assets to sell as well. But are they enough to stave off the banks?

In the December accounts, assets under development (in wind, real estate and electricity) are valued at $1.6 billion. Thanks to regulatory and political pressure in Europe on its power companies to expand into renewable energy, Babcock does have a market. It can sell these things at a profit. Whether that profit is enough though would be debatable.

Once the assets are sold they won’t deliver income anymore, so we get back to the vexing matter of how this company can deliver future earnings.

Besides its balance sheet, a vital factor in the encroaching demise of the financial engineering firm is confidence.

Over the past month Babcock management has taken a serious hit to its credibility with research analysts. In the past, the analysts appeared happy – at least in their written research – to take Babcock at its word on future earnings, refinancings and other matters.

That credibility has gone and the Babcock model relies on market confidence to drive up stock prices, refinance, raise equity and produce demand for its spin-offs.

This morning’s research notes are instructive on this issue.

Citigroup downgraded its risk rating on Babock to speculative from high. A hairy-chested punt in other words. The comments on credibility were telling.

“Management previously indicated that the BNB market capitalisation had to remain below $2.5 billion for four consecutive months and that any rise above this level would reset the four-month period. This now seems not to be the case. We had not been aware of permission being required to pay dividends and subordinated note interest.

“We also note that any issuance of ordinary shares or conversion of US-held BBIPL shares into BNB ordinary shares effectively reduces the share price that triggers this review clause. On our estimates, full conversion of BBIPL shares into BNB ordinary shares would reduce this review clause trigger to $6.58 (given 1:1 conversion of BBIPL shares would add 46 million BNB ordinary shares).”

UBS, which is Babcock’s top-line broker of choice for selling equity, also questioned management guidance on the market cap clause.

“Given previous discussions with the company we understood that the market cap must stay below $2.5 billion for 120 consecutive days. Management today announced that this review clause is cured if its market cap exceeds $2.5 billion at the end of this 120 day period. Of importance bank approval is required for dividends.

“We believe BNB could (1) ask the syndicate to waive the market cap clause (discussions are currently underway), (2) accelerate sell-down of assets such as its wind pipeline, (3) Corporate action (such as a MBO or break-up) cannot be ruled out.

“We have moved from an ongoing business valuation of $25 to a price target of $6.80 based on 0.9x NTA until this issue is clarified. Our rating is now ‘neutral’.

The covenants of the facility are:

Net asset coverage ratio of 1.8x

Interest coverage ratio of 3x”

Macquarie and JP Morgan strangely did not put Babcock research in their usual morning notes. Merrill Lynch however put “credibility” in a headline in its research.

“BNB’s admission on Thursday that the debt review event is cured only if its market cap is above $2.5bn four months hence rather than continuously throughout is a further blow to management’s already fragile credibility following its unexpected capital raising in March and stumble over the BBP refinancing – which is still not a done deal.”

The credibility issue has deteriorated since the travails of satellite Babcock & Brown Power when the analysts began to write in their notes that they had been misled on the refinancing.

ABN Amro did not mention credibility but it said the risk had increased and the sale of the wind assets could lift the stock price:

“We understand from management that BNB is looking to divest wind power assets by the end of 3Q08, i.e. before the end of the four-month review period. If BNB can successfully unlock value from these development assets sitting on their balance sheet then this should be a catalyst to lift BNB’s share price. However, there now appears to be little margin for error for BNB.”

Besides the question marks over the $750 million profit forecast for this year – which Phil Green recently confirmed but most analysts are now discounting – the issue of asset values looms large for Babcock.

Besides the wind assets on the balance sheet there are significant property assets the group bought at the peak of the market last year. They may have to be written down, along with $350 million or so for the carrying value of the parent’s $1.9 billion interests in its satellites.

Looking at the GPT joint venture, the market now appears to be valuing the properties at 100% but has discounted Babcock’s interest. If the equity is wiped out, an implied value of 80 cents in the dollar would apply to all the properties.

Were this to be implied to the $2 billion in real estate held for sale in the parent and the $1.6 billion in real estate held for investment, a 20% discount to that $3.6 billion in assets would destroy the remaining equity in the group.

A recovery in world markets would help but the consensus view would be that property has peaked.

Ironically, although Babcock is shaping up as a slow-motion train wreck, it boldly announced the acquisition of British operation Angel Trains today. Price tag … $7.5 billion. Babcock’s own portion of the debt in that deal will presumably add to the $46 billion of debt across its empire which is visible.

Just contemplating that number, $46 billion, is pause for thought.

And, in another late breaking irony, ANZ has just suspended margin lending on B&B.

Michael West

Business Day

business.theage.com.au

13 June 2008