Soul Patts and Brickworks: The great unwinding - Part 1

It's a case of resolutions at ten paces; have your proxies ready. Venture capitalist Mark Carnegie and Perpetual's head of equities Matt Williams have launched a plan to unwind the Brickworks and Washington H Soul Pattinson cross shareholding. It's a structure aimed at stopping potential corporate raiders that's been in place since 1969 – the last of its kind on the ASX. Practically it allows the Millner family to control both companies with a 5% investment in each.

The upstarts claim the current structure is overly complex, preventing the market from recognising the value of each business. This makes sense: complex structures and multi-divisional businesses often create opportunities for that very reason (for example 21st Century Fox, Caltex or FKP). Once untangled, the market value of Souls and Brickworks should rise.

In this first part of a three-part series, we'll take a detailed look at the proposal and begin the process of valuing the pair, by assessing the non-Souls portion of Brickworks' assets. In Part 2, we'll look at the non-Brickworks portion of Souls' assets and, finally, in Part 3, we'll pull it all together to value both companies and look at where this leaves us with respect to the current proposal.

The proposed transaction has two parts. First, Souls owns 27% of TPG Telecommunications, worth $954m at current prices. The break-up proposal would see these shares distributed to Souls shareholders, including Brickworks, which owns 43% of Souls.

Secondly, Carnegie and Williams want to unwind part of the current cross-shareholding by having Brickworks sell its $1.5bn Souls stake back to Souls. The pair have proposed that Souls pay at least $15.75 per Brickworks share, with the exact amount based on the market price in 12 months' time. Payment will be split between a $250m cash payment now and a promissory note – which is a fancy word for an IOU – to be paid in up to twenty four months' time. Payment could be made from a combination of Soul's $174m in cash reserves, its $520m blue-chip share portfolio, and the $1.2bn cash hoard within the 59.7% controlled New Hope (reviewed in detail here).

Following the transaction, Brickworks would own its namesake building materials division, an investment property portfolio, swathes of potential development land, 11.5% of TPG and a large IOU from Souls.

Souls would be left with its basket of investments, including 44.3% of Brickworks (see Chart 1). The cross-shareholding will be no more. According to Perpetual/Cargenie between $180m and $250m in tax would be payable, depending on the price paid for Brickworks' stake in Souls, a sum that should be more than offset by the increasing value of both Brickworks and Souls shares. Brickworks management disagree and are awaiting a ruling from the ATO.

This simplified structure also opens up the possibility of changing Brickworks' directors and management, which isn't likely with the current structure and is partly why instituting the change will be tough.

Vote Yes

Carnegie and Perpetual currently own 12.5% of Brickworks and 11.7% of Souls between them and have called an extraordinary general meeting (EGM) of Brickworks shareholders for 25 November. Shareholders on the register before 23 Novemberwill be able to vote on the proposal, although current management are attempting to delay the meeting. Paperwork will be sent shortly. A meeting of Souls shareholders has also been requested, but no firm date has been set. We recommend voting for the proposal (more information can be found here).

Success rests on whether Soul and Brickworks can vote their respective stakes in each other against the deal. Here there is debate. Carnegie and Perpetual think they can't; Brickworks and Souls think they can. The lawyers will figure it out, but with legal minds in disagreement, trying to predict a likely outcome is a fool's errand. Without more certainty about the outcome we don't recommend punting on the proposal's success.

Brickworks' share price has risen 10% in response, baking a slim chance of success into the current market price. If the proposal fails, Brickworks' share price will most likely fall back again.

The decision whether to hold now needs to be based on a clear understanding of the value of the underlying assets. We'll start by looking at Brickworks' non-Souls assets.

Brick by brick

Brickworks' namesake building products division, which sells bricks, roofing, timber paneling, precast panels and masonry products, has suffered over the past decade as housing starts, especially in NSW, have stagnated. Fashions too have changed. New houses are being built from a broader mix of materials, dragging on the demand for bricks. This is a highly cyclical business exposed the ebb and flow of residential construction activity. Earnings before interest and tax (EBIT) have been equally volatile, ranging from nearly $100m in 2004 to $29m in 2012.

Management has been putting up a good fight. It has ruthlessly cut costs, closing plants where it can and selling more, fancier, higher-margin, bricks, such as the unique bricks created for the new Frank Gehry designed building at Sydney's University of Technology.

The future is looking brighter too. As Graham Witcomb explained in Homebuilders spring to life from 11 Nov 13 (Avoid – $0.595), low interest rates and a chronic lack of supply has seen building approvals – a leading indicator of future construction activity – rise swiftly this year.

Weighting it up, we'd pay up to 10 times EBIT for cyclically low earnings (as they are now) and a much lower multiple, say no more than three to four, for cyclically high earnings (as they were in 2004).

An adjustment also needs to be made for rent, as it owns its sites and we're going to include the value of that land separately. We estimate the rent to be about $15m a year, and adjusting for this, leaves an EBIT range of $14m-$89m. We estimate that the operating business is worth between $140m and $300m, and we value the land on which it sits at $348m, plus $78m of buildings for the 'fair' valuation and $320m combined for our 'cheap' valuation.

Land aplenty

Elsewhere, the company's investment and development division – which turns old brick production sites into industrial developments – holds a 50% stake in a joint venture that owns 13 industrial properties, mostly located near the logistics-friendly junction between the M7 and M5 freeways in Sydney's west.

The book value of these properties is $607m based on capitalisation rates of 7.5-8.3%. The joint venture also owns land yet to be developed with a book value of $262m. After deducting bank debt of $351m, the joint venture has a book value of $518m and Brickworks' share comes to $259m. For our 'cheap' valuation we've notched the capitalisation rates up 2%, which brings the value of Brickworks' stake down to $200m.

Related to the property portfolio is 755 hectares of undeveloped land. At current market prices it's worth about $70m, but it could be worth triple that once it's developed. We're happy to use the market price for both our 'fair' and 'cheap' valuations as both ignore the potential for development gains.

Totting up all the assets, then deducting the net debt of $320m and allowing for a tax liability of $171m, we arrive at a valuation of $239m–$564m, or $1.62–$3.83 per share, in addition to Brickworks' stake in Souls. What's clear is that, against a market valuation of $13.52 a share, most of Brickworks' value lies in its Souls stake.

In Part 2, due to be published on Monday, we'll value the second piece of the puzzle, Souls' non-Brickworks assets, and in Part 3 we'll bring it all together, reassess our recommendation limits and recap what it means for PPT/Carnegie proposal.

For now, with Brickworks' share price down 7% since Unwinding Souls and Brickworks from 25 Oct 13 (Hold – $14.56), we recommend you HOLD.

Note: Our model Growth Portfolio owns shares in Brickworks, while our model Income Portfolio owns shares in Washington H Soul Pattinson.