Australia | May 26 2008
By Chris Shaw
Gearing up is an acceptable form of funding for companies as they expand and undertake new projects but cash flow expectations and strength of balance sheet imply an appropriate level of gearing for each different company. For Babcock & Brown Power ((BBP)) Citi estimates a reasonable level of gearing would be in the order of 55-60%, the group’s problem being the latest update from management indicates the actual level is closer to the 70% mark.
This means a refinancing is required, particularly as management has revealed a further $300 million is needed as project financing for the Tamar project in addition to the $3.1 billion the company is already attempting to refinance. While around $2.7 billion of this is to be done at rates of 135-150 basis points above the bank bill swap rate, Macquarie notes the remaining amount is being put into a corporate facility at a significantly higher rate.
This means the group’s capital structure needs to be reviewed and adjusted and in the broker’s view the only options are to either sell assets, cut distributions or raise some form of equity, none of which will are likely to be well received by shareholders.
As a result the broker retains its Underperform rating, while Citi has downgraded the stock to Hold from Buy on the expectation the capital situation will be addressed by a heavily discounted rights issue. Citi has also lowered its distribution estimate for FY09 to 17c as it sees the current payout as unsustainable given the refinancing issue, this putting the broker well below the market given most analysts are expecting payouts in the order of 21.5c to 27c per share next year.
Others are likely to follow Citi’s lead in lower distribution expectations though as Merrill Lynch makes the point the shares are currently implying a yield of more than 20% this year and this suggests the market doesn’t see the payouts as sustainable, though the broker as of yet has not lowered its forecast of a 26.5c distribution both this year and in FY09.
While the refinancing issue should be resolved in the next couple of months, a bigger issue for JP Morgan is that of management credibility, which the stockbroker suggests is now very low given the revelation of additional funding being required. This leads the broker to suggest while the stock appears to offer value investors are best to adopt a cautious approach. The stock is now at a large discount to its discounted cash flow valuation but this is regarded appropriate given the risk of an investment in the company.
There is also a flow-on implication for parent company Babcock & Brown ((BNB)), as it has made it clear it will stand as a lender of last resort for Babcock & Brown Power if required with respect to the $360m to be refinanced in the corporate facility. While the group has the balance sheet capacity to do so, Merrill Lynch doesn’t expect it will be required, though UBS sees some scope for this to occur given BNB management has made it public they were willing to do so.
UBS also argues an equity raising is not likely at current share price levels as it is not the most effective way of dealing with the refinancing given the current share price weakness and with nine of the 11 banks involved obtaining final credit approval it expects the refinancing will soon be completed.
As a result it suggests the share price fall on news of the financing shortfall is an over-reaction and so it retains its Buy rating on the stock. It has cut its price target to $1.95 against $2.55 previously, while ABN Amro and Credit Suisse also have Buy ratings on the stock with targets above $2.00 per share.
The FNArena database shows three Buys compares with five Holds and Macquarie’s Underperform, with an average price target on the stock of $1.82, down sharply from $2.46 prior to the update and well below the median price target according to Thomson One Analytics of $2.40.
Shares in Babcock & Brown Power today are slightly higher and as at 11.00am the stock was up 6c at $1.24, while shares in parent Babcock & Brown were down 34c at $12.38.