Weighing the value in Soul Patts

Share Advisor’s 2011 Performance report shows how, between 1 Jun 01 and 31 Dec 11, 269 Long Term Buy recommendations delivered an average annual return of 13.0%. That sounds impressive but the general consensus among your analysts is that the figure is too high.

How so? Less than half that number of outright buy recommendations over the same period delivered returns of 13.3% per annum. It’s fair to say that some companies recommended as Long Term Buys should have been Buys. Washington H. Soul Pattinson, though, is probably not one of them.

Since originally recommending it on 17 Jan 07 (Long Term Buy – $8.80), the price has risen 55%, delivering total returns (including dividends and special dividends) of a little under 12% per annum over almost 6 years. Soul Patts is the epitome of what a Long Term Buy should be. Whether it’s still good value is a question we’ll try and answer in this review.

As with sister company Brickworks, the best way to understand Souls’ value is via a sum-of-the-parts analysis. Because the company owns a portfolio of ASX-listed stocks, a market valuation using current share prices is straightforward. Unfortunately, it’s not enough.

None of Soul Patt’s investments currently sit on our Buy list, Paying full market price for them through this vehicle makes little sense. That’s why we’ve also provided a ‘Long Term Buy’ and ‘Bargain Buy’ valuation. The former is based on the prices we’re likely to upgrade to Long Term Buy for the company’s biggest investments, and a generous trimming for the smaller stuff. The latter is based on more severe haircuts.

It makes sense to start with the company’s most valuable investment, its 59.7% stake in listed coal miner New Hope Corporation. The current market value for Soul Pattinson’s 496m shares is almost $2.2bn.

Dark future

In Coal: A dark future ahead? we examined how Mongolian and US coal exports are increasing just as endless growth in Chinese demand is being rightfully questioned. But it’s not all bad news. New Hope is using its well-trained value investing eye and moving into other energy businesses, including conventional oil and gas and coal seam gas. This is a management team with a proven track record of buying and selling intelligently.

Also, New Hope has a whopping $1.5bn of cash and term deposits on its balance sheet. After deducting all liabilities, this alone translates to almost $1.60 per New Hope share. It will take a monumental misallocation of capital for New Hope to not be worth at least this amount.

Since our last detailed review on 6 Oct 11 (Long Term Buy – $13.75), we’ve reduced both the Long Term Buy and Bargain Buy valuation for Soul Pattinson’s stake in New Hope, using $3 per share for the former and $2 per share for the latter. Both should prove conservative.

The company’s second most important investment—its stake in sister company Brickworks—was the subject of a full review on 1 Nov 12 (See Brickworks deconstructed (Hold – $10.97)). There’s little need to cover old ground. The current Brickworks price of $11.40, our planned Long Term Buy upgrade price of $10.50 and outright Buy price of $9.00 shape the valuation in table 1.

There’s been a huge increase in the market price of the company’s investment in TPG Telecom in recent years. At the time of Does Soul Pattinson add up?, 15 Apr 09 (Long Term Buy – $9.99), the TPG stake—then called SP Telemedia—had a market value of $64m. With little net additional investment, that stake has a current market price of more than $500m.

In the interests of conservatism, we’ve lopped off 25% for the Long Term Buy valuation and 50% for the Bargain Buy. We’ve taken the same approach with its smaller holdings in listed investment company BKI Investments, rural services company Ruralco, pharmaceutical distributor API, infant nutritional supplements business Clover Corp and Malaysian-listed pharmaceutical and healthcare business Apex Healthcare.

Minority positions

The group also owns a portfolio of minority positions in mostly blue chip stock such as Milton Corp (itself a blue-chip focused LIC), BHP Billiton and Commonwealth Bank. We’ve used the 31 Jul 12 balance date valuation of $441m for this portfolio, which should prove conservative given the price of nine of its 10 largest holdings has risen since then. Again, we’ve applied a 25% and 50% haircut for our more conservative valuations.

As for the small number of unlisted assets, we’ve made a conservative guess for CopperChem and also Souls Private Equity, with the market valuation for the latter based on the 2011 takeover price.

Lastly, let’s add the value of net cash and deduct net tax liabilities (both of which exclude the fully consolidated numbers coming from New Hope), plus a small subtraction to account for the company’s famously bare bones head office costs.

Totting it all up, we arrive at a market valuation of a little over $18 per share. So you can buy Soul Pattinson shares at a 25% discount to the current market price of its underlying investments. That’s a bargain, surely?

Not really. The current price offers a more meagre 1% discount to our Long Term Buy valuation of $13.76 and a 38% premium to our Bargain Buy valuation. It’s not quite cheap enough to tempt us. If the stock was to fall much below $13, we’d upgrade to Long Term Buy, while a fall below $10 would see an outright Buy recommendation.

For existing shareholders, it’s an easy choice. The valuation is far from stretched and is supported by valuable assets and conservative management. Remember, though, that about a quarter of Soul’s market valuation depends on New Hope’s coal assets. If you have lots of coal exposure through other stocks in your portfolio, you might wish to consider trimming either Souls or those other coal investments.

For everyone else, the stock is little changed since 12 Jul 12 (Hold – $13.40) and remains a HOLD.

Note: The model Income portfolio owns Washington H. Soul Pattinson shares.