CIF still offers low-risk upside

In CIF: Risk reduced, upside improved on 6 Jun 12 (Long Term Buy – $1.18) we offered our initial thoughts on the group’s sale of LBC Tank Terminals (which were positive).

But, to ensure we’re not falling for commitment bias or any other possible psychological shortcoming, we’ve taken a fresh look at the group over the past week. The point of this article is to come at Challenger Infrastructure Fund afresh, and highlight the potential risks and rewards for today’s stock owner or buyer.

In addition to its great big pile of cash, estimated to be $415m after the LBC deal settles, CIF will only own one operating asset – UK utility provider Inexus. Whether it owns that asset for long will depend on how things play out over the next few months.

You see, Inexus has a lot of debt, £445m as at 31 December 2011, provided by a banking syndicate. And all of that debt falls due on 31 August this year. The logical providers of debt for Inexus – European banks – are in a world of pain, nervous about any sniff of risk and in need of their cash back.

Great asset, heavily indebted

The problem with Inexus is one of funding, not asset quality. Even today, supposedly under stress, Inexus generates enough cash to pay all of its interest bill and maintenance capital expenditure, leaving surplus free cash flow of £23.8m in 2010, £22.2m in 2011 and, in all likelihood, something similar this year.

Being conservative, we’ll make a few tweaks, including increasing the allowance for maintenance capital expenditure, and knock the number down closer to £15m.

This income stream comes predominantly from inflation-linked regulated revenue on existing infrastructure. The group also earns fees from new connections (which will generate further annuity-style revenues down the track).

In the current depressed UK homebuilding market, new connections are in the dumps, which is something of a blessing in disguise. As a result, growth capital expenditure is also down, and Inexus’s free cash flow almost funds its current level of growth capital expenditure, avoiding further reliance on lenders at a delicate time.

So this is an asset with attractive, inflation-linked revenues that will also offer lucrative unregulated earnings if UK homebuilding improves from today’s distressed levels (a near certainty eventually). The asset itself is an impressive inflation hedge.

As noted, the problem is one of too much debt in a difficult funding environment. Its bankers may well want some or all of their money back in August. We suspect Inexus should be able to arrange some new debt, with its existing lenders or elsewhere, but probably not the full £445m and likely at higher margins than it currently pays (being 225 basis points over the applicable UK reference rate on most of its debt).

Management of CIF has wisely pointed out that there are no guarantees it will be able to arrange fresh debt for Inexus on reasonable terms, in which case the best option would be to hand the asset over to the existing lenders and not invest another cent in it.

So, as we’ve argued for years, the conservative thing to do is assume that CIF’s 82.5% stake in Inexus might be worth zero. So that’s what you’ll find in table 1, a liquidation value for CIF. If Inexus is handed over, winding up CIF and returning the cash is the logical next step and one we’d anticipate management taking.

Table 1 is dominated by CIF’s $415m cash balance, with nothing for Inexus. We’ve deducted $15m for incidentals – including $5m to the manager and other odds and ends. The remaining $400m could support returns to unitholders – by way of capital returns and distributions – of $1.26 per unit. The current security price represents a 6% discount to this estimated liquidation value.

Upside potential

But Inexus might be worth more than zero – after all, it’s generating plenty of cash even after paying today’s interest bill. In this situation, a recapitalisation might make sense.

A well-executed plan, involving rolling over some debt and injecting fresh equity, could build value for unitholders. Ideally, the new debt would be locked in for a long period, say 10 years, but it might not work that way.

Table 2 is an attempt to show how CIF would look after just one of many possible alternatives is executed. We’ve assumed that Inexus’s shareholders have to provide £150m in fresh equity, or £123.8m for CIF’s 82.5% stake. At current exchange rates, this reduces CIF’s cash pile by $193m to $222m.

Alongside the equity injection, we’ve assumed lenders agree to roll over £295m of Inexus’s debt on reasonable terms – make it £300m with the obligatory syndication fee.

Table 2 values CIF’s post-recapitalisation stake in Inexus, not based on what CIF invested but by using various enterprise value/earnings before interest, tax, deprecation and amortisation (EV/EBITDA) multiples.

If you valued a recapitalised Inexus at an EV/EBITDA multiple of about 9.5 or less, then participating in the recapitalisation would destroy value for CIF shareholders (ie the equity stake would be worth less than the £123.8m injected). But there’s an argument to say that this asset – with its steady, inflation-protected revenue stream – is worth 10 times or more.

By way of comparison, CIF recently sold its stake in LBC Tank Terminals on an EV/EBITDA multiple of 10 – and LBC is a lower margin and less predictable business. Closer to home, Envestra – a business quite similar to Inexus – trades on an EV/EBITDA multiple of roughly 11.5.

Table 2 highlights the overall valuation per unit for CIF based on the various multiples attached to a recapitalised Inexus. Using a multiple of 10 for Inexus, CIF would be worth around $1.40 per unit. On a multiple of 12, it'd be worth around $1.80.

Different approach

Alternatively, you could think about it on a cash flow basis. Inexus generated £50m in cash EBITDA in 2011. Let’s knock it down to £48m for a conservative 2012 estimate.

If Inexus managed to arrange its £300m of debt for a 6% floating interest rate (more than 500 basis points over the appropriate reference rate) or, better yet, 6% on a 10-year bond (more than 400 basis points over the 10-year UK government bond yield), it would incur annual interest of £18m. Maintenance capital expenditure requirements are minuscule, but let’s conservatively deduct £5m in lieu.

So, taking a combined £23m away from the £48m cash EBITDA, following a recapitalisation Inexus could be generating free cash flow of about £25m, and perhaps more than £30m in more normal times or if the group can get a better interest rate on its debt.

This £25m could be used to pay pre-tax distributions to CIF and other shareholders, or to invest in growing Inexus for future profit and distribution growth. If the asset was handed back to the bankers, that £25m would flow to the benefit of the next owner. For an equity injection of £150m, current Inexus shareholders ensure the benefits flow to them. It’s a pre-tax return on investment of more than 15%.

It seems like a reasonable deal for what will become a fairly conservative investment, and explains why CIF’s management is likely to be working hard on debt rollover and recapitalisation options right now.

Renovate then sell?

In addition to building value, a sensible equity injection offers a potential bonus. Despite a long beauty parade as part of CIF’s strategic review, no bidders have yet stepped forward to buy Inexus at a price that makes sense for CIF to sell.

We don’t think that’s for want of interested parties. Rather, the conservative investors who might be the natural owners of an inflation-linked, regulated monopoly (much like the syndicate of superannuation groups that bought LBC Tank Terminals earlier in the month) won’t want to touch Inexus until its debt problems are solved.

And the other type of bidder, the one who doesn’t mind getting dirty for a bargain, can’t really step into the void as it makes little sense for CIF to sell for a low multiple which would barely cover the existing debt. Those bidders are instead waiting and hoping Inexus won’t be able to roll over its debts, to try and pick up the asset for peanuts from antsy bankers.

By doing the recapitalisation itself, CIF would increase the chances of a higher bid for Inexus down the track from the first group – long-term financial buyers – or perhaps an existing industry participant, although there are no guarantees.

CIF is currently trading below its liquidation value of more than $1.20. One could imagine some of that value being destroyed in a poorly executed Inexus recapitalisation, but we think the chances of that are fairly slim.

And, for those prepared to take a longer-term view on the value of Inexus after any debt rollover and equity injection, or bet on some corporate action soon thereafter, there’s a fair bit of upside to the current share price. Partial debt forgiveness – a possibility but certainly no likelihood – could further boost values.

Having gone through the exercise, we’re adjusting some of the prices in our recommendation guide downward to reflect the new situation. The Long Term Buy price has been reduced a little, to a small discount to liquidation value. And, all else being equal, were the stock to trade at $1.50 tomorrow we’d suggest you Take Part Profits. That ‘get out’ price might be raised again if Inexus is refinanced astutely.

Because the situation has become less risky, given that much of its value is already in the bank, we’re increasing our recommended maximum portfolio weighting from 4% to 5%. For now, as on 6 Jun 12 (Long Term Buy – $1.18), CIF remains a LONG TERM BUY.

Note: The model Income and Growth portfolios own Challenger Infrastructure Fund securities.