Hunting for value in break-ups - Part 1

Is value investing dead? This is THE question being debated among investors all over the world as they seek to explain the long underperformance of value strategies. 

The question itself is a loaded one. If you're buying businesses you think will be worth more tomorrow than they are today, you are a value investor. Any long investor, whether they recognise it or not, is either a value investor or a fool. 

Yet for those relying solely on statistical cheapness - either low PERs or low price to book ratios - investing has become a lot harder than it used to be. A devotion to numbers alone more often leads to traps.

Numbers are easy; everyone can see them, and more people than ever are looking. The rise of algorithmic trading has compounded the problem. An ever-growing share of trading volume is being gobbled by robots and computer trading which can instantly assess statistical cheapness. 

If value can be derived from numbers alone, robots and algorithms will find and exploit it faster and more consistently than we will. 

Value investors need to keep evolving. Warren Buffett credits his business partner, Charlie Munger, for steering him towards business quality and away from statistical cheapness. But the quality end of the market is now as crowded as ever. If we're to find value, we need to look where others aren't and to recognise things that others are missing.

Imagine

One tool at our disposal that computers cannot replicate and that data miners cannot exploit is our own imagination. Instead of simply using numbers to show what a company is worth, we need to understand how they can hide what it is worth.

Can a business perform better than it's performing today? Are its margins and returns on capital truly reflective of its potential? What levers can be pulled to crank performance? These are questions we can ask to uncover potential value not evident in the numbers today.

One source of improvement is a break-up. 

Businesses with multiple divisions can be a tremendous source of value; perhaps one division is being obscured or the aggregate accounts disguise the quality of the divisions. For these reasons, and others, value and quality can be hard to identify if it is aggregated. This is the opportunity. 

In this two-part series we will examine three big, blue-chip stocks that are ripe for a break-up. Not all of them are statistically cheap but all carry potential that is not necessarily reflected in the price or in the accounts. 

That potential could be realised by changing the structure of the business and splitting it up.

Origin Energy

Peer at the accounts of Origin Energy and you'll find a business that generates a decent profit. Last year it reported $2.9bn in earnings before interest, tax, amortisation and depreciation (EBITDA) and about $800m in net profit - a return on capital of about 8%. 

For a business with an enterprise value of almost $20bn, that represents an enterprise value seven times EBITDA. The price-earnings ratio is about 16. 

These metrics don't reveal anything special. So far, Origin appears an average business earning average returns and trading on fair multiples. 

The numbers deceive. Origin is, in fact, two distinct businesses. A vertically integrated energy retailer, which generates and sells energy, is mashed together with a large LNG producer that exports energy to Asia. 

Many businesses contain smaller businesses units but Origin - and the others we will encounter in this series - are unique. Each segment hosts different levels of capital intensity, varying levels of cash generation, different market structures and should attract a different investor base. 

By aggregating these two different businesses, the accounts disguise essential qualities about each of them. Let's take each in turn.

An LNG story

Origin has long generated a portion of its own gas while buying the remainder from the market. Over decades it had accumulated some of the largest onshore gas resources in the land. When former chief executive Grant King searched for ways to monetise that huge resource, Origin's LNG business - APLNG - was born.

Origin retains a 37.5% stake in APLNG which today consists of two giant processing facilities that take raw gas from coal seam gas fields, freezes it into a liquid and ships it to Asia where it is regasified and used in local gas markets.

After five years of development, during which APLNG consumed gargantuan amounts of capital, APLNG is finally generating decent cash flow. 

Operating costs for the project come to about US$21a barrel while debt repayments consume another US$18. At oil prices above US$40 a barrel, APLNG can generate cash flow it can distribute to Origin. As debt is paid off, distributable cash flows rise.

Last year, Origin generated about $500m from APLNG and this could double over the next few years as production ramps up. Most of its output is sold on 20-year contracts so this is a relatively stable project that should generate steady returns for decades.

Above average

APLNG isn't quite as predictable or reliable as conventional LNG projects because coal seam gas feedstock requires capital - about $1bn a year - and output can be more variable than conventional wells.

There's a risk of gas production coming up short and of Origin having to fill its processing facility with expensive third-party gas. That will raise costs and lower margins. Oil prices will fluctuate but floors and caps are embedded in contract prices so the most extreme oil price volatility doesn't hurt as much.

APLNG is a decent asset with a relatively predictable stream of cash flows. The project generates about $6bn in revenue from which it makes about $2.6bn in operating profit and about $1.3bn in free cash flow after paying capital expenditures and interest costs. 

This business should look similar in 10 or 20 years' time and brings together vital resources with expensive infrastructure. It no doubt has some strategic value.

My generation

The retail business, which was sweated to pay for APLNG, looks remarkably different.

Origin's energy business is the largest retailer of electricity and gas in Australia. In an industry with thin margins and high fixed costs, that scale matters and has historically delivered high returns and generous cash flows. It still does: last year the energy business generated over $1.8bn in EBITDA.

Yet these earnings are under threat. The electricity industry is being slowly but thoroughly disrupted (we discussed this in more detail in Electricity disrupted back in 2014). In summary, the rise of renewable energy, in particular solar energy, is challenging the century-old business model of distributed power.

Rather than being generated at a central location and transported, power is increasingly being generated where it is consumed, lowering demand for the grid and ruining economics for some generators. 

Origin is better placed than most because its generation fleet consists largely of flexible gas plants that fire up at short notice to fill peak demand periods. 

Generation is immensely profitable for Origin; it accounts for the bulk of its energy profits - and all of the growth. This can't be sustainable. 

A typical generator might make about a quarter of its profits each year from just 36 hours of demand. High and frequent peaks in prices make generators profitable but those peaks are disappearing as renewables flatten the price curve. This has already forced some coal generators out of the market.

A retail tale

On the retail front, higher electricity and gas prices have turned once feeble consumers into value vultures. Churn in Origin's customer base has increased 50% in five years and Australia now boasts the highest churn rates in the world.

For retailers, this means customers are more expensive to lure and keep. Technology has enabled new competitors such as online only Click Energy. Margins in retail still appear reasonable but are, in fact, fragile.

It's hard to be optimistic about the long-term future of the energy retail business. Energy is a mere commodity to be sold at the lowest price and generation assets probably won't retain their value. Regulation has soared and, in Victorian markets, all retailers are being forced to lower margins. Other states are likely to follow. 

What has historically been a scalable, high cash flow business for Origin now looks fiercely competitive with lower margins and higher capital intensity. The retail model itself may have to evolve. 

The success of the LNG business disguises mounting problems in retail. Those who recognise retail's woes are unlikely to pay a fair price for the LNG business. Neither business is being adequately valued in the current corporate structure.

Imagining value

After a traumatic, debt-induced bust following the oil price collapse, Origin has recovered admirably. Debt has been repaid, costs cut and non-core businesses jettisoned. Dividends have been restored.

But although it appears to be improving, Origin is, in fact, a business torn. 

The LNG business is stable and growing; the retail side faces greater uncertainty and capital intensity. There is little reason to think that these businesses belong together and, if management doesn't separate them, someone else probably will.

As the LNG business ramps up, Origin's share should generate about $1bn in cash flow, which is probably worth about $10bn to the company. With a huge processing facility and large gas resources, this ought to be a target for global energy producers.

Where does that leave the retail business? The ACCC is unlikely to allow it to be acquired, but it has enough scale and profitability to stand alone, and a more focused management would be better placed to deal with disruption in the industry. For the moment, it still generates close to $2bn of EBITDA, which is probably worth an enterprise value of $15bn or so.

Separately, the two divisions could be worth almost $14 a share to Origin - or about $10 a share after deducting debt. The share price today is just over $7 share.

That doesn't quite allow enough margin of safety for an upgrade to Buy, not least because that value is unlikely to be recognised within the current structure. However, a split of the two businesses would release latent value and we're increasing our Buy price from $5.50 to $6.50 to recognise that.

It's important to emphasise, though, that the value is unlikely to be recognised within the current structure; so if an opportunity appears it may need plenty of patience. We wait in hope, but for the time being we'll stick with HOLD.

In Part 2 we will look at the break-up cases for Caltex and Newcrest Mining.