Investors Desert Australia's Babcock & Brown
Babcock & Brown, the Australia-based financial institution that is best known for its management of infrastructure funds, has become the latest victim of jittery sentiment towards financial institutions and shows how quickly investors are prepared to withdraw their support once they sense trouble.
Like most other financial institutions, Babcock & Brown has been under pressure since October last year, but the sell-off gained pace last week when the share price tumbled from A$11.16 a share to A$5.25, resulting in the company losing more than half of its market value. The stock fell 45% on Thursday and Friday alone after analysts drew attention to the fact that the company's market capitalisation was within real danger of falling below A$2.5 billion ($2.35 billion), which would allow its creditors to call for a review of a A$2.8 billion loan that was closed only in mid-April. Not surprisingly this spooked investors even more and the share price predictably slid below the key level of A$7.50 a share on Thursday to a close that translated into a market cap of A$2.3 billion. Friday's losses reduced the market cap to A$1.8 billion.
However, it seems it isn't the loan review that has unsettled investors and triggered the wave of short selling—although observers say it could add to the woes if the lending banks start to doubt the company's ability to service debt—but rather a lack of confidence in the management. This was compounded by a company announcement made on Thursday which revealed that certain information provided previously in relation to the market cap clause of its corporate debt facility, hadn't been completely accurate. Specifically, the four-month review can be called for as soon as the company's market cap falls below A$2.5 billion and, if it remains below there at the end of the review period, a minimum two-thirds of the lenders could require Babcock & Brown to repay the debt facility within 90 days—or to take any other action agreed upon as part of the consultation between the company and the lenders during the review period. Previously the company had indicated that the market cap would have to remain below A$2.5 billion throughout the entire review period, while the Thursday statement said it is enough that it is below on the first and final days—a clarification that obviously increased the risk that the clause will come into play.
Also, some analysts noted that they hadn't previously been aware that the company will have to ask permission from their lenders to pay dividends or interest on subordinated debt during the review period. Again, this could become an issue if the 25 banks that are part of the corporate facility start to doubt the company's cash flow and payment abilities and decide to reserve the company's cash to ensure they get paid.
Given that the facility was signed less than three months ago and that Babcock & Brown reiterated its A$750 million net profit guidance for 2008 only two weeks ago there should be little reason for the banking syndicate to take drastic action. However, "with credit markets still tough and global banks still facing rising bad debt charges the risk is that some lenders may decide to use the market cap clause as a self-defence mechanism in order to pose stricter controls on Babcock & Brown should its market capitalisation remain at current levels for a prolonged period," argue analysts at Citi in a report.
The slide in the share price prompted analysts at Merrill Lynch and UBS to downgrade the stock to "neutral" from "buy", while Citi downgraded its recommendation from "hold/high risk" to "hold/speculative risk". Standard & Poor's ratings agency placed the company's BBB-rating on credit watch with negative implications and said if the fall in the share price results in the banks serving notification of a review, the rating "will likely be downgraded by one or more notches and remain on credit watch negative, pending progress on any review".
Merrill Lynch analyst Kieren Chidgey said in a research note that "while the sharp fall in Babcock & Brown's share price on Thursday was more reflective of sentiment and targeted selling activity rather than fundamentals, the consequences are the same". He added that the bank now sees "little potential for outperformance given the long road ahead to restore investor confidence in the B&B brand and the risk overhang surrounding Babcock & Brown's debt" and suggested that significant action will be required, including significantly improved disclosure, lower gearing and enhanced risk assessment as well as a change in management culture and potentially also the leadership.
Babcock & Brown is the first financial institution in Asia-Pacific to find itself in this dire situation since the subprime crisis took hold in August last year, and while its problems aren't directly related to subprime, the performance of its infrastructure and property funds has suffered from the subsequent poor credit and equity market environment. The Australian company's confidence problems are also not too dissimilar to those plaguing Lehman Brothers. The US investment bank suffered a first run on its shares in March amid rumours that the bank was having liquidity problems, but was able to restore confidence through verbal reassurances—albeit temporarily it now seems. Last week investors were once again dumping Lehman stock after the bank pre-announced it had made a $2.8 billion loss in its fiscal second quarter and would seek $6 billion in new capital to bolster its balance sheet—leaving investors feeling somewhat misled about the severity of the impact from its subprime-related investments.
This time Lehman clearly felt the need for more decisive action to regain the confidence of investors and on Thursday it replaced both its chief financial officer and its president. It is unclear still whether this will help. Indeed, some observers suggested it only added to the concern about Lehman's future and speculation remained rife over the weekend that the bank may have to be sold to a larger competitor in a rescue mission similar to JPMorgan's bailout of Bear Stearns earlier this year. However, after falling 30% in the previous four days, Lehman's share price rebounded 13.7% on Friday.
Whether a similar management reshuffle will be necessary at Babcock & Brown remains to be seen, but analysts have already started to suggest it may have to sell some key assets to reassure its lenders that it will be able to service its debt. Some potential assets that could come on the block include the company's wind power projects in Europe.
Adding to the woes, the company's power unit, Babcock & Brown Power, may also have sell assets to make up for a loss of profit caused by a disruption to the natural gas supply in Western Australia following an explosion at Apache Corp's Varanus Island plant earlier this month, analysts say. In addition to those operational concerns, the power unit is in the process refinancing a A$2.7 billion loan, which may come under some further scrutiny following this week's events. And on top of that, Babcock & Brown was supposed to provide an additional A$360 million of funding to its power arm, which is now looking less likely to happen. Babcock & Brown Power's share price slid 52% on Thursday and Friday.
In the meantime, Babcock & Brown's management is keeping up the appearance of it being business as usual and on Friday announced that its European infrastructure fund was part of a consortium of investors that has signed a definitive agreement to buy Angel Trains, a leading European rolling stock provider, from the Royal Bank of Scotland for an enterprise value of ý3.6 billion ($7 billion). Babcock & Brown said it advised the consortium, structured the transaction and arranged long term financing in excess of ý2.8 billion. The consortium also included AMP Capital Investors, Deutsche Bank and funds advised by Access Capital Advisers.
Analysts at Merrill said the deal is a positive for Babcock & Brown in light of the fact that the deal flow is likely to slow considerably following the deterioration in investor confidence. However, they added that it will have little impact on their outlook for the company.
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