Taking some off the table

Babcock and Brown Capital (BCM), the publicly listed, private equity investment fund has undergone a number of developments since our last update back in March. The fund’s initial investment, a 57.1 percent stake in Irish telco eircom, has continued to progress nicely, and in July, BCM purchased Golden Pages, Israel’s largest directory and local search business.

Following these investments, BCM had around $457 million in cash and marketable securities. The fund’s current portfolio is shown below.

Being a private equity type vehicle, the fund’s investments are highly geared (particularly eircom) and this spooked investors during the height of the credit crisis in August.

At the time, we spoke with BCM and encouraged them to use their large cash balance to institute a share buyback, given our view that the share price correction was overdone. This was obviously the opinion of other investors and by the end of August, BCM announced its intention to undertake an on-market buy-back of up to 5 percent of its ordinary shares. This helped to stabilise the share price and the stock has recovered nicely since the mid-August rout.

As shown on the daily chart, BCM’s price action has certainly been volatile over the past six months. From a high of $5.65 in June, prices declined to a corrective low of $3.57 in August before rebounding to a high of $5.08 last week. In our opinion, this latest rally reflects a revival of upward momentum, improving the near term outlook.

Considering the gain of more than 42 percent over the last two months, it would not be surprising to see prices pause for consolidation in the near-term. However, any such pause should prove temporary with a price gap between $4.50 and $4.45 offering near term support.

The underlying strategy of BCM is to buy monopoly type assets and enhance their value through a variety of measures. For example, BCM took advantage of last year’s easy credit conditions to refinance their eircom investment, which resulted in a return of around 50 percent of the fund’s initial equity investment.

On the operational front, eircom’s strategy is to grow the mobile phone and broadband division while holding earnings from the mature fixed line business steady. This strategy is largely on track with the mobile and broadband business posting strong growth. However, fixed line earnings are slightly behind forecasts.

Another value creating initiative recently completed was the sale of its radio mast site operation for the equivalent of $258 million. The proceeds will be used to fund eircom’s ongoing investment program, and therefore reduce the need for BCM to inject additional investment capital.

In the same way that Telstra is undergoing a significant investment program in Australia, BCM have outlined a capital expenditure program for eircom. Over the next three years, eircom will spend up to 250 million euros to modernise the network, including fibre access for Dubliners and a 3G mobile network. This is in addition to an annual spend of around 250 million euros.

More significantly for BCM shareholders, management are pushing for a break up of the Telco into separate network and service companies. The rationale is that the market would significantly re-rate eircom’s network assets under a separation scenario.

In a recent presentation, BCM pointed out that European infrastructure monopolies are valued between 8 and 12 times EBITDA (earnings before interest tax depreciation and amortisation) whereas the market currently values eircom around 6 times EBITDA.

There is therefore considerable potential to create value for BCM shareholders through the eircom investment. However, none of this is evident through the income statement, with BCM posting a loss for the year of around $130 million. Most of this loss consisted of a restructuring charge for a voluntary redundancy program at eircom.

BCM’s accounts are a good example of how private equity operates. Big non-cash charges for depreciation and amortisation, as well as a large tax-deductible interest expense, all but erase accounting profits. Therefore, no tax is paid. In fact, BCM received an income tax benefit of $4.6 million in 2007.

But at the all-important cash flow level, the eircom investment is performing strongly and along with the non-operational enhancements mentioned above, BCM are hoping the market focuses on the cash generation of the business rather than accounting profit.

This may take time, as the market has demonstrated a considerable amount of uncertainty regarding BCM’s valuation, as the stock’s volatility attests. Currently, the market appears to be valuing the stock around net asset value. As at the end of June, BCM’s net asset value (another name for shareholders equity) was $4.66 per share.

The purchase of Golden Pages, in addition to a number of other value enhancing developments since year-end, would likely have increased BCM’s equity component from the quoted June figure.

The main risk with BCM, as we have pointed out on other occasions, is the high level of gearing. At June 30, net debt to equity was around 500 percent. We also pointed out that this was par for the course in terms of private equity financial structures, and that the assets behind the debt deliver highly stable cashflows. Moreover, the majority of the debt is long term – 8 to 10 years.

While we are comfortable with the debt structure in the context of the investment vehicle, it increases BCM’s risk profile markedly in the event of any left field developments. One of these developments could be an economic slowdown in Ireland.

The country’s housing market has been one of the strongest in Europe, benefiting immensely from low eurozone interest rates. The housing market strength was one of the key reasons behind BCM’s interest in eircom. While we don’t claim to know the dynamics of housing in Ireland, a slowdown on that front would have implications for eircom’s growth strategies.

We therefore believe it prudent to take some profits off the table with a sell-half recommendation. As we mentioned earlier in the article, there have been a number of value enhancement initiatives undertaken by BCM (with more in the pipeline) and the share price is yet to reflect these initiatives, so we believe some exposure, albeit reduced, is warranted.

As such, Fat Prophets recommend Members sell half of BCM.