Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Company changing events?

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Normally when a company announces a significant acquisition or major new investment it is trumpeted as a company-changing event that will dramatically boost earnings or change market perceptions of a company, both of which should be beneficial for shareholders. Whilst the valuation or market capitalisation of a company listed on the ASX can vary dramatically with market sentiment, in reality a company's business normally changes quite slowly and often the company-changing investment can actually be negative. In this piece we are going to look at recent company changing events that were both positive and negative for shareholders, along with a potentially company-changing event for a company we own in the Core Equity Portfolio; Origin Energy's APLNG project.


New acquisitions

When a company trumpets a new acquisition as being "company-changing or company-transforming", it is hard not to be skeptical. Historically, management teams both generally overpay for the asset and wildly overestimate the synergies they can extract. A classic example of this which still looms large in the minds of many investors is Rio Tinto's 2007 acquisition of Canada's Alcan. Rio Tinto paid US$38.1 billion for Alcan in a hotly contested bidding war and estimated at the time that it could extract US$600 million in costs per year. This acquisition ultimately turned out to be company-changing, but not in the way originally envisaged. The heavy debt load taken on to acquire Alcan resulted in a deeply discounted rights issue at $28.29 per share in 2009 to raise $19 billion. Further, the bulk of the aluminium assets acquired were eventually written off and all senior management involved including the chairman departed the company.

Rio Tinto was not the only Australian company making a company-changing acquisition in 2007. It takes a lot of guts to outbid some of the world's largest and most successful private equity firms, but in 2007 Wesfarmers did just that after stumping up a staggering $22bn to buy the beleaguered supermarket operator Coles. The price paid represented a breathtaking 29x earnings and necessitated a capital raising of $3.7 billion two years later to pay down debt. Whilst Wesfarmers' acquisition of Coles is not viewed in the same light as the Alcan acquisition, seven years later Coles has yet to return the cost of capital and Wesfarmers' earnings per share remain 30% below what it was prior to the purchase.

When acquisitions are company-changing?

Occasionally an open market purchase can be company-transforming, but this is rare and normally only occurs when the business being sold is a small part of a very large company and the seller has limited understanding of the business being sold. In 2006 BHP sold Southern Cross Fertilisers to Incitec Pivot for $155 million. BHP had acquired this asset as part of its takeover of WMC Resources. This proved to be a company-transforming event for Incitec Pivot, as the acquired business has delivered $1.7 billion in profits since 2006 and allowed Incitec to acquire Dyno Nobel to become the second largest supplier of explosives globally.

Similarly in 2009, Amcor acquired Rio Tinto's Alcan packaging business for A$2.5 billion which has since proved to be a company-changing acquisition for Amcor. As with BHP in the above example, Rio Tinto had acquired a business as part of a larger acquisition and the miner had very little interest in running a global packaging company. Amcor not only acquired their major European packaging at a very attractive price from a motivated seller, but the acquisition moved Amcor to become the largest global packaging company in healthcare, food and tobacco. Further, Amcor was able to double the profit margins of the acquired business which has led to the company growing earnings per share by +128%, despite facing increases in raw materials and unfriendly moves in the Australian dollar.

New projects

Management teams also seek to deliver a step-change in a company's earnings by making a major investment that may involve a few years of reduced dividends and higher debt levels as the project is built, but with a significant payout promised upon completion. In 2007 uranium producer Paladin embarked on a major expansion project at their existing mines in Nambia along with a the Kayalekera mine in Malawi. These were envisaged to be company transforming projects for Paladin Energy that had a market capitalisation of $5 billion. Cost overruns and production shortfalls, combined with a collapse in the uranium price post the Fukushima Daiichi nuclear disaster has seen Paladin's share price fall from $10.44 to $0.39!

Woodside Petroleum's recently completed Pluto offshore LNG project is an example of a project that is actually company transforming. Pluto began construction in 2008 and was completed in 2011 at a cost of $15 billion. During this period Woodside shareholders saw no growth in their dividends. Pluto LNG was successfully commissioned and has since proved to be a company-changing event. Woodside has sharply increased their earnings per share by 94% and has used the cash flows generated by the new project to rapidly pay down debt, with the company moving from a net debt to equity ratio in 2011 of 42% in 2011 to a net cash position today. Woodside shareholders are enjoying not only the doubling of dividends but the additional financial flexibility that these additional cash flows bring.

Future company transforming projects

As Origin Energy's APLNG project nears completion of the first LNG train in 2015, we consider the company will begin a major transformation of its earnings profile. The project, located in Queensland, converts coal seam gas from gas fields North West of Brisbane, into liquid nitrogen gas for transport to Chinese and Japanese customers. By 2018 as production reaches full capacity the project could generate an additional $1bn of profits for Origin Energy. With current earnings for the integrated energy company totalling around $700m, we calculate that APLNG's contribution could more than double earnings and transform the stock.

The common theme around successful acquisitions that are actually company transforming, is that a larger disinterested company sells a non-core business to a smaller specialised company that can run the acquired businesses more efficiently. Rarely does a company transform itself by acquiring a business in a competitive bidding process. In a competitive process the acquiring company generally pays too much and takes on too much debt to fund the acquisition. Looking forward we still believe that Origin Energy's APLNG project could well be the next company transforming project, when shareholders start to see the positive impacts of steeply increasing cashflows from LNG shipments to their Asian clients. We see that this should not only sharply reduce Origin Energy's debt but also allow the company to reward its patient shareholders.


This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities

Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.

Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.


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