The Australian Competition and Consumer Commission has said it won’t oppose the acquisition of Asciano by a consortium including Qube, Canadian investor Brookfield Infrastructure Partners and a number of investment funds. The ACCC believes that the transaction won’t lead to a "substantial lessening of competition" in the various port and rail markets affected.
Asciano’s assets will be split between various members of the consortium, with Qube gaining ownership of half of Asciano’s Patrick Container Terminals (‘Patrick’) business in a joint venture with Brookfield Infrastructure and its partners.
Patrick provides container stevedoring services at Port Botany, East Swanson Dock in Melbourne, Fisherman’s Island in Brisbane and in Fremantle, which are the four largest container ports in Australia. Management views the transaction as "transformational", with significant synergies arising from the integration of Patrick into the company’s existing logistics and infrastructure network. Further benefits should accrue as Qube’s Moorebank development in western Sydney is completed in coming years.
These benefits and the oligopolistic nature of Patrick’s assets mean there is some justification for Qube and its partners paying $2.9bn (including debt) for Patrick. Yet at around 14 times 2016 earnings before interest, tax, depreciation and amortisation (EBITDA), we think this is a high price given increasing competition and the cyclical nature of Patrick’s business – in 2009 container volumes in Port Botany fell five per cent even though Australia didn’t officially enter a recession.
The duopoly enjoyed by Patrick and DP World in the container stevedoring market was broken with the entry of Hutchison in Brisbane and Sydney in 2013 and 2014 respectively, and a new competitor is due to begin operations in Victoria later this calendar year.
Global stevedoring contracts tend to last three to five years with only two or three contracts awarded each year. So it will take time for Hutchison and the new Victorian-based competitor to build their market share. Unlike Patrick, they are global operators and so possess the necessary resources and staying power to at least make a decent fist of competing with Patrick and DP World.
Patrick is also affected by ongoing consolidation of the global container shipping line market along with potential lease increases when its Fremantle lease is renewed. Its lease expires in May next year and the Western Australian Government has proposed to extend it for two years.
As competitor DP World has recently learned with its Port of Melbourne facilities, port facility landlords can potentially demand much higher rates to renew these leases or during periodic market reviews. Increasing competition will reduce Patrick’s ability to pass these higher prices onto customers.
Qube’s other major growth opportunity is its Moorebank development in western Sydney. The company should generate significant earnings from the intermodal freight precinct once it is fully developed, not only from logistics but also from industrial property development and management. Moorebank will also reduce the company’s exposure to commodity prices in favour of higher container volumes, something we like given the recent impact on its earnings from the commodities downturn.
Taking into account the Patrick acquisition, which is due to complete shortly, Qube is trading on a forward price-earnings ratio of 23, a high multiple given the company’s mediocre return on equity of around 6-7 per cent. The multiple is still at 20 times in 2021, when earnings from Moorebank should start to make a significant impact.
A lot can happen between now and then. A recession, for example, would probably significantly reduce Qube’s earnings due to its high fixed costs and sensitivity to economic growth. Yet at current prices investors are assuming nothing will go wrong. As colleague James Greenhalgh recently wrote in relation to Domino’s Pizza, if something does go wrong with a highly priced stock, it can be very painful for shareholders.
On this basis, we don’t see enough margin of safety to justify buying and we’re downgrading to HOLD.