The recent collapse of the latest attempt to break the Brickworks (BKW)-Soul Pattinson (SOL) cross-shareholding means SOL and its related party listed companies will continue in their current relationship to each other. This implies SOL should continue to be valued as it is now. The event is an opportunity to re-examine valuations of this important and controversial company. In summary, we like the stock but note it is trading significantly above value.
In 1969 SOL and BKW made a strategic alliance via a cross-shareholding intended to protect against hostile takeovers. So far this has been successful. The following diagram depicts the relationship and the current corporate structure of both companies.
The cross-shareholding is the last relationship of its kind on the ASX, and although it has protected against hostile takeovers it is controversial because:
- The cross-shareholding makes it harder to value BKW and SOL and thus deters investors and particularly many major institutions. This dampens both share prices.
- SOL has to equity-account NHC’s approximate $1.1 billion of cash. This dilutes return on equity across the whole group, distorts valuations and makes it difficult to assess management performance.
- The capital structures of group companies differ and are hard to rationalise. NHC has $1.1 billion of cash and no debt and SOL is ungeared, but BKW has $280 million of net debt. Clearly the decision by NHC regarding its cash affects BKW’s performance, but it has no apparent say in this capital allocation.
- There is a lack of consistency in the arrangements created 45 years ago. The structure benefits TPM with a strong and stable major shareholder, but unlike BKW it is unencumbered by a cross-shareholding.
- The large cross shareholdings reduce the liquidity of both of the stocks.
Last October, fund manager Perpetual Investments and activist investor Mark Carnegie made a detailed proposal to remove the links between the two companies, arguing this would unlock $2.2 billion in shareholder value. Carnegie and Perpetual together owned 12.5% of BKW and 11.7% of SOL.
Perpetual and Carnegie proposed SOL (1) cancel its shares held by BKW in return for cash and interest bearing promissory notes, and (2) distribute SOL’s shareholding in TPM to SOL shareholders on a pro-rata basis. More detail on the proposal is available on the activist website.
However the proposal depended on the ATO not imposing capital gains tax liabilities on the demerger. Two weeks ago, against Carnegie and Perpetual’s assumptions, the ATO said it would not grant CGT relief. The long-delayed shareholder meeting to consider the demerger proposals was subsequently cancelled. Carnegie and Perpetual said they would litigate.
Perpetual granted Carnegie a $30 million option to exercise if he succeeded at breaking the cross-shareholding. Despite this we never thought the proposal would succeed given the failure of similar previous attempts, for example by Sir Ron Brierley, and the determination by BKW and SOL chairman Robert Millner to protect the cross-shareholding.
A superior stock for conservative portfolios
One of Millner’s arguments for conserving the current structure is the long-term growth in BKW’s and SOL’s earnings and dividends. SOL has a superior record of dividend growth under its progressive dividend policy, whose objective is to hold a diversified portfolio of assets which generate a growing income stream for distribution. As a point of general advice SOL is one of the best stocks we could recommend (at the right price) for patient capital in conservative portfolios. Total shareholder returns over five and 10 years are average annual rates of 9.9% and 11.2%, respectively.
The majority of SOL earnings come from three sources, the listed companies – New Hope Corporation (ASX:NHC), TPG Telecom (ASX:TPM) and BKW. As such, underlying performance is largely dependent on the performance of these entities. Lack of space prevents us commenting further here; detailed valuations are available in StocksInValue.
Forecasting a recovery in profitability
We think SOL is worth $13.76 per share:
Our adopted NROE (normalised return on equity – includes franking credits) of 13.5% is a long-term, through the cycle view of SOL’s profitability. Growth has been slow in recent years because NROE has been very low, averaging 7.9% over the last five years. However, the 10-year average NROE is over 20%, supporting our forecast for a recovery. Recent profitability has been depressed by SOL’s holding in NHC, whose earnings are depressed by low thermal coal prices, $A strength and a large cash pile. But we think thermal coal prices have bottomed and we expect $A depreciation.
We adopt a low required return of 12.5% reflecting resilient, diversified earnings and the liquid, debt-free balance sheet. NHC and TPM have no gearing while BKW has low gearing of 17.8%.
The Distribution to Reinvestment (D-RI) split is skewed to D. SOL has a progressive dividend policy and a very large stockpile of surplus franking credits.
Using these adopted value metrics we derive an equity multiple of 1.1x, an FY14 valuation of $13.76 and an FY15 valuation of $13.93. Valuation growth is slow due to the high D and moderate NROE.
We recommend a low 10% margin of safety, reflecting this company’s very conservative profile and below-average earnings volatility.
By David Walker, Senior Analyst StocksInValue, with insights from Adrian Ezquerro of Clime Asset Management.
Clime owns shares in NHC and BKW. SOL is on Clime’s watch list.