Stock Of The Week

By George Whitehouse – StockVal Investment Analyst

Washington H. Soul Pattinson and Company (ASX:SOL) is one of Australia’s oldest companies.

When Caleb Soul and his son Washington opened their first store at 177 Pitt Street, Sydney, in 1872 neither of them could have imagined that over 130 years later their single pharmacy would have evolved into such a significant Australian company. Further, they could not have anticipated the diversity of business operations that are now part of SOL.

Listed in January 1903, the company has transformed over time into an investment house with a portfolio encompassing many industries – its traditional field of pharmacy as well as building materials, resources, equity investments, media and telecommunications, merchant banking and funds management.

”Gone are the days when the company was known purely as a chain of chemists.”

Management has been grounded in successive family members with one of the strengths being stability. A number of decades ago SOL and Brickworks (ASX:BKW), whom we analysed last week struck up a strategic alliance via a cross shareholding arrangement. At the time it was thought that both companies were vulnerable to takeover due to being run conservatively without debt and paying dividends. The strategy has certainly been successful, decades later SOL holds a 45% stake in BKW and BKW holds a 48% stake in SOL.

The main operating subsidiaries include New Hope Corporation (60%) and Pitt Capital Partners (78%). Associated companies include Brickworks (44.6%), Australian Pharmaceutical Industries (25%); TPG Telecom  (28.2%); Clover Corporation (28.6%);  Arrow Energy (16.7%) and Ruralco Holdings (23.5%).

The majority of SOL earnings come from two sources, the listed companies – New Hope Corporation (ASX:NHC) and Brickworks (ASX:BKW).

Listed in September 2003, NHC is a coal miner and is involved in coal seam gas investment and R&D for coal to liquids. NHC has large reserves and a solid balance sheet. Production is primarily thermal coal and is mostly exported with a smaller component consumed locally. The business owns its own coal terminal at the Port of Brisbane. NHC is exposed to currency, coal price fluctuations and possible regulatory changes associated with climate change. The high cash levels are currently diluting total return on equity and this must be employed or returned to shareholders. The experienced management team will address this issue and the recent offer for Macarthur Coal shows the intent of management.

Like BKW, NHC seeks to profit from the encroachment of urban areas. Land stgelopment offers a potential future earnings stream as the business holds significant land around Ipswich and Acland on the Darling Downs.

NHC has produced a wonderful return for investors since listing in September 2003. However as with most commodity type businesses there is more than a passing resemblance between the commodity price chart and the stock price chart.

Interestingly it has been estimated that there are over 847 billion tonnes of proven coal reserves worldwide. Coal is not a rare commodity. This means that there is enough known coal to last us over 130 years at current rates of production/consumption. In contrast, proven oil and gas reserves are equivalent to around 40 and 60 years at current production levels. (www.worldcoal.org)

A crucial part of successful investing is in understanding what drives the return on equity of a business over the long term. Then trying to understand what could change that would influence the returns.

Investors in NHC, SOL and indeed BKW need to ask themselves the following questions: Are coal prices headed toward $200/t or are they headed toward the lows seen in 2000 of around $20/t? What impact will climate change policies have on the industry?

These questions are extremely difficult to answer but they do affect the required return for an investor considering either of the above companies for investment. They are clearly factors outside the control of these companies which can affect both profits and profitability.

For instance, SOL’s investment in NHC today has a price of around $2.5 billion and SOL’s market capitalisation is around $3.5 billion. SOL’s value is thus quite sensitive to the thermal coal price.

Australian Thermal Coal, FOB Newcastle

Source: www.indexmundi.com

Both NHC and BKW produce commodity products; have little pricing power and no meaningful moat. Except for intermittent periods when demand exceeds supply, as we have seen recently with thermal coal, buyers will typically have the power in pricing negotiations. Current higher prices are likely to attract new supply to the market.

BKW earnings are exposed to the residential building sector. Despite significant geographic diversification the company is not immune to the effects of the building cycle and tough competition.

All the investment banking requirements of the operating and associated companies are served within the group via Pitt Capital Partners.

There are not many businesses that have been listed for over a century and have management today from the same family as the founders with a long term focus on growing shareholder value. The current chairman Robert Millner has been a director since 1984 and succeeded Jim Millner who played a large part in transforming the business over the preceding decades from its foundations into the investment house it is today. Both value investors Jim and Robert shared common themes to their approach to investments including; not being keen on debt, holding significant cash so they can be opportunistic, doing their homework, buying quality assets cheaply and then rarely selling. The business has seen plenty of booms and survived all of the subsequent busts. Management has a history of backing their ideas with significant investments and not diversifying for the sake of it. Current management certainly has their interests aligned with shareholders.

In the recent half year report, management have noted the stake in Arrow Energy is likely to be realised as a result of takeover by Royal Dutch Shell and PetroChina resulting in a pre-tax gain of around $350 million. Recently the ACCC has noted they will not oppose the transaction.

The business is expanding its coal terminal at the Port of Brisbane and noted it is on schedule and within budget with completion expected later this calendar year. The expansion will increase capacity to 10 million tonnes per year somewhat greater than NHC current production of 5-6 million tonnes.

Valuation

SOL displays the attributes of a good business and has provided shareholders with an attractive total return of 18.5% p.a. over the last decade, significantly higher than the 8.8% p.a. achieved by the All Ordinaries Accumulation Index.

Management has not used debt in the last decade. This conservative position is a hallmark of the Millner’s approach to investment.

Cash currently represents a significant part of the balance sheet and it has been a common theme for this business to hold reasonable cash reserves to allow for opportunistic acquisitions as they present themselves.

Management has been disciplined with their capital management and has not issued a new share in the last decade. Dividends have been regular with frequent special dividends, all fully franked.

The business returns, by nature of the unique attributes of the operations and investments have been lumpy over the past decade. Excluding adjustments for one off gains the NROE has been as high as 74% in 2009 and as low as -4% in 2001.

Conservatively we have selected a NROE of 14% as the Adopted Performance Forecast (APF) and a Required Return (RR) of 13%.

When we adopt the same APF and RR our valuation will always be equal to the equity per share. Another way to think about it is if a business is producing the return we require for investing in that business the sensible price to pay is the equity per share employed by that business. It is only when the business profitability is higher than our required return that we can pay a price higher than the equity per share and still achieve our required return.

In this case our APF is marginally above our RR and as a result our valuation is marginally higher than the equity per share for the business.

Using the above inputs and the equity per share StockVal produces the following values,

The above valuations are based on analysts’ forecasts and are subject to change without notice.

Today SOL has a market capitalization of around $3.5 billion. The equity stakes in NHC and BKW currently stand at around $3.4 billion. Add to this net cash of $1.7 billion, most of a small investment bank and an assortment of other equity holdings and this business looks interesting. A key to success investing in SOL is the performance of NHC and BKW businesses.

SOL is a business that has stood the test of time and today has strong balance sheet and conservative management that provides a significant safety net in troubled times.

Clime Asset Management and StockVal are part of Clime Investment Management (ASX:CIW).