Raiders' favourites?

"The fools are dancing, the bigger fools are watching."
'” Barton Biggs, Morgan Stanley investment guru

OK, I admit I’m a sceptic. I don’t believe the private equity phenomenon will last. I’m having a déjà vu moment; I’m feeling the same way I felt in early 1999. Back then it was “dot-com”. Today it’s private equity. In the late 1990s I was about a year too early and spent that time watching in disbelief as dot-com soared ever higher. In 2006, as in 1999, I’m probably too early. And maybe I’ll spend the better part of the next 12 months watching in disbelief.

To me, private equity is nothing more than gearing a business up with debt that the public markets would never tolerate. The gearing can be achieved through all sorts of hybrid instruments including senior and subordinated debt. But whereas the weighted average gearing ratio of the publicly listed stock market is about 35%, private equity has been known to gear up to 300%. On a weighted average basis, and excluding some outliers such as Aristocrat, the Australian equity market has an interest cover of over 16 times.

Private equity interest covers can be as low as 1.5 times. Now as a professional analyst, my alarm bell always started to ring very loudly if a company’s gearing started to rise above 100% and interest cover fell below three times. But 300% gearing and interest covers of 1.5 times! At those levels there is simply no room for error in judgement, economic conditions or execution!

Why worry? Be happy

The private equity phenomenon is sweeping world equity markets. Building like a tsunami, private equity has washed over the Australian market during the past few months. In Australia, private equity deals averaged less than $2 billion a year from 2001 to 2005. According to ABN, this year they have already exceeded $12 billion, a sixfold increase. And this doesn’t include all the formal approaches made by private equity that for various reasons have not yet led to a deal '”the $15 billion offer to buy Coles, the $3.8 billion APN buyout and last week’s $10 billion-plus Qantas approach.

Clearly, in terms of size, there have been far more formal approaches made than done deals. These trends are being mirrored internationally. Market analyst Dealogic calculates private equity took more US public companies private (spending $US178 billion) in the first 10 months of this year, than in the prior five years combined.

In a way, this is almost a perfect scenario for equity markets. Approaches are being made for big deals. Companies are obliged by the continuous disclosure rules to publicly announce these formal approaches. That drives up the share price of not only the potential target company but also most near comparable companies as well. Perfect. Everyone is happy.

But in my view deals are increasingly starting to look almost frantic. Until the mooted Qantas deal, most private equity deals were concentrated on companies that displayed defensive earnings streams and cash flows; that is, they were non cyclical so they could comfortably support increased debt funding. Typically, consumer and medical industries felt most of the action. Private equity would also look at “turnaround” candidates or non-core businesses that perhaps had been neglected by their parent. Growth businesses with strong market positions were also highly sought after.

But what private equity has definitely avoided in the past has been cyclical industries such as the media, airlines and mining. In the past few months private equity has committed billions for two media deals and, as stated, has approached Qantas for a $10billion-plus buyout. So far, mining has not attracted either formal approaches or innuendo, but maybe that will change too.

So who’s next?

In looking at who might be next on the private equity “menu” I screened more than 300 Australian stocks for two main financial parameters. The first was the degree of current under valuation and the second was the strength of the current balance sheet. I ranked the 300 stocks on the basis of potential takeover returns. Based on these criteria, many cyclical, particularly resource stocks appear prominently. As stated above, to date private equity has avoided such companies, but perhaps the Qantas approach suggests a change in focus.

Qantas appears in the top quartile of potential targets as does Pacifica, which recently agreed to be taken over by Bosch. Other top quartile candidates include Coates Hire (high interest cover), the contractor MacMahon, asbestos sufferer James Hardie (very high interest cover), BlueScope Steel, and McPhersons. Telstra also just makes the top quartile. While taking all of Telstra private is unlikely, in a particularly insightful piece of research last week, Macquarie suggested Telstra could do a PBL/Seven type deal with its directories business. Macquarie suggested such a spin-off into private equity could release about $9 billion in capital, which could be returned to shareholders.

Up to this point resource companies have been considered unlikely private equity candidates, simply due to their cyclical earnings and dependence on highly volatile commodity prices. With that caveat, resource companies that screen well as private equity candidates include the oil companies Santos, Oil Search, and Woodside, as well as Oxiana, Macarthur Coal and Alumina. Alumina has long been mooted as a takeover target but the most likely suitor is Alcoa. This is because Alumina’s main asset is its 40% shareholding in the Alcoa alumina business AWAC.

Oxiana is regularly featured as a potential takeover target. Any takeover of Woodside would have to be led by Australian interests, as an attempt by Shell to take it over was rejected by the Federal Government several years ago. In addition to the normal resource risks, Santos adds “hot Java mud risk” (following a serious accident at its pipeline in East Java). Separately, Oil Search has “PNG” risk. The following table highlights the expected return from these “quartile one” companies in the third forecast year (2008-09 for June year-end companies) as well as the current forecast interest cover, two years hence.

Among industrials in the next quartile of potential private equity candidates is the usual array of cyclicals within the steel (OneSteel), building materials (CSR, Boral and Wattyl) and contracting industries (Leighton and Downer). Again, contractors are unlikely candidates for private equity simply because they are so dependent on securing new contracts. The ACCC rejected a takeover bid for Wattyl by Barloworld in July.

PMP also pops up as a candidate. PMP has already disclosed that a preliminary approach has been made. Personally, I think it would be a very brave takeout simply because of the highly competitive nature of the (declining) print industry. Other industrials include Ten (an obvious choice after both the Seven and Nine deals), Amcor (speculation about a takeover has been around for months), and Coles which of course rejected an approach recently. NZ Telecom (which has regulatory risk), Nufarm (agricultural risk), Orica (chemical and resource exposure) and Salmat also appear in this quartile.

Resources stocks appearing in the second quartile of potential private equity candidates include BHP Billiton and Rio Tino, and perennial takeover target Iluka. I suspect BHP’s market cap of $160 billion makes it too big to be a target, as does Rio’s $100 billion market cap. The following table highlights some key parameters for these “quartile two” companies. Like the first table, the expected return is based on the third forecast year and interest cover is that which is forecast two years hence.

Mike Mangan has been a professional market analyst since 1987. He currently has stock positions in BlueScope Steel, OneSteel, Telstra, Woodside, Alumina, Amcor, Ten, BHP Billiton and Iluka.