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Morningstar | Enthusiasm for Coal and TPG Merger Waning but Shares Still Overvalued

Soul Pattinson shares have declined about 20% from recent highs of almost AUD 32 per share in November 2018 but they remain overvalued. Both New Hope and TPG Telecom are trading somewhat above our fair value estimates. However, the overvaluation primarily reflects Soul Pattinson’s market premium relative to the sum of the parts of the underlying assets. We think the premium reflects a view that management can reliably create market beating returns. This is supported by the firm’s strong track record and returns. But we struggle to support the assumption that excess returns will continue. Historical returns rest on two big winners in New Hope and TPG Telecom and replication of that success will be difficult.

We also think future earnings are likely to decline. Our fiscal 2019 forecast of AUD 1.54 per share is underpinned by high coal prices, earnings from TPG Telecom, where the full impact of competition from the NBN is yet to hit and elevated earnings from Brickworks with the building cycle near peak levels. Those headwinds will likely limit dividend growth to a modest 3% to 4% per year for the next five years. A rising forecast payout ratio, from about 40% in fiscal 2019 to about 75% in fiscal 2023, should compensate for the expected contraction in earnings to AUD 0.85 per share by 2023. With Soul Pattinson shares trading around AUD 26, we think the implied fiscal 2019 yield of 2.2% fully franked is low given modest dividend growth. Our fair value estimate implies a yield of 3.5%.

We increase our fair value estimate modestly to AUD 17 per share from AUD 16 per share reflecting the recent uplift in our New Hope fair value estimate to AUD 3.50 per share from AUD 2.70 previously. The higher New Hope fair value estimate reflects an increase in our near- and long-term thermal coal price assumptions, the improved likelihood of Acland Stage 3’s approval and increased coal volumes through the expansion of Bengalla and the development of a new mine at Lenton.

For New Hope, the Queensland Land Court has conditionally recommended approval of the Acland Stage 3 mining lease and environmental authority. There are still a few hurdles to clear before Stage 3 proceeds. However, given the positive Land Court decision, we have raised the odds of Stage 3’s approval to 100%. At Bengalla, we now believe it’s realistic for the mine to incrementally creep its capacity from about 9.5 million tonnes a year to 10.5 million tonnes a year with little additional capital. We see scope to increase production through a minor change in design and improved equipment productivity. We’ve also now explicitly modelled the development of a 1.5 million tonne a year mine at Lenton and assumed a 75% chance of success. New Hope makes up about 25% of our Soul Pattinson fair value estimate.

At TPG Telecom, initial enthusiasm for the proposed merger with Vodafone has taken a hit with the Australian Competition and Consumer Commission, or ACCC, concerned about a potential lessening of competition from the merger. Shares have retreated from highs above AUD 9.00 per share to trade at about a 10% premium to our unchanged AUD 6.10 per share fair value estimate. Regulatory concern around reduced competition is why we have urged investor caution not to assume ACCC clearance, let alone to bake in the potential merger benefits to earnings and valuation for TPG Telecom. TPG also makes up about 30% of our Soul Pattinson fair value estimate.

Outside the two primary investments, it’s likely the market-facing parts of Soul Pattinson’s portfolio will have sold off somewhat with the recent correction, but not sufficiently to impact our fair value estimate. We note the sale of 7.9 million Soul Pattinson shares by Brickworks late last year for more than AUD 26 per share. Brickworks now owns 39.4% of Soul Pattinson, or 94.3 million shares, down from almost 43% previously. The sale of Soul Pattinson shares by related party Brickworks was at an attractive price and cleverly raised cash for alternative investments. That said, it also supports our view that Soul Pattinson’s shares are likely overvalued.