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Morningstar | Record Profit for Soul Pattinson; Increasing Our FVE to AUD 16 per Share, but Shares Overvalued

We raise our sum-of-the-parts-based fair value estimate for no-moat Soul Pattinson to AUD 16 per share from AUD 15 previously. The increase reflects the benefit of our higher fair value estimate for New Hope, given higher near-term and longer-term coal price assumptions, favourable movements in the value of other listed and unlisted investments in the past six months, and the time value of money. Soul Pattinson’s fiscal 2018 adjusted net profit after tax increased 17% to AUD 331 million, in line with our AUD 333 million forecast. The result primarily reflected higher earnings from 50%-owned New Hope, as well as increased contribution from the firm’s investments in financial services and associate Brickworks, which benefited from rising housing construction activity and favourable property tailwinds.

Despite the increase in our fair value estimate, we still think Soul Pattinson shares are overvalued, with the share price up nearly 50% in the past six months. Soul Pattinson shares have reacted strongly to higher coal prices and earnings from New Hope, and the proposed merger of equals between associate TPG Telecom and Vodafone, which will consolidate the third- and fourth-largest telecommunications players. We think the market is optimistically extrapolating favourable coal prices, which are unlikely to persist. Coal miners are basking in the warmth of strong earnings and returns driven by high coking coal and record Australian-dollar-denominated thermal coal prices. With coal prices well above their respective levels of cost curve support, strong industry margins and profitability will likely elicit a supply response. We also think new mine supply will be added in China and production restrictions are likely to loosen. For TPG, the market is also pricing an absence of regulatory hurdles to the Vodafone merger and the extraction of cost savings of more than 30% of Vodafone’s current cost base. We think TPG Telecom is also overvalued.

New Hope was the key driver of the result, as its adjusted net profit after tax nearly doubled to AUD 253 million, of which Soul Pattinson’s share is 50%. Soul Pattinson’s share of adjusted New Hope earnings made up more than one third of the group result. The higher coal price was the key driver, averaging AUD 119 per tonne in fiscal 2018, up 23% from fiscal 2017. We expect a further 37% rise in New Hope’s adjusted earnings to AUD 346 million, or AUD 1.38 per share, in fiscal 2019, thanks to the additional 40% share of Bengalla and likely higher coal prices. However, we expect earnings to moderate from fiscal 2020 as coal prices normalise from very favourable levels and production from Acland likely declines. Nonetheless, we still expect moderate earnings growth of about 5% per year for Soul Pattinson from fiscal 2020 to fiscal 2023, primarily driven by higher contributions from TPG Telecom as synergies from the Vodafone merger benefit earnings.

Soul Pattinson is in excellent financial shape with net cash of AUD 500 million, up from AUD 290 million a year ago. Much of this was driven by the improvement in majority-owned New Hope’s balance sheet where net cash doubled to AUD 470 million, thanks to the buoyant coal price. New Hope’s net cash is consolidated on Soul Pattinson’s balance sheet. The coal miner will take on a modest amount of debt to complete the proposed AUD 860 million acquisition of a further 40% of Bengalla from Wesfarmers in the first half of fiscal 2019, but despite this, both New Hope and Soul Pattinson will remain in strong financial shape following completion of the deal.

As expected, Soul Pattinson increased its total fiscal 2018 dividend to AUD 0.56 from AUD 0.54 per share fully franked. Based on adjusted earnings of AUD 1.38 per share, the payout ratio was a comfortable 40%. Despite our expectation for a strong improvement in profit in fiscal 2019, we expect Soul Pattinson to continue increasing its dividend steadily at the rate of about AUD 0.02 per share. Arguably, the slow rate of forecast growth in the dividend is conservative. However, we think it’s reasonable, as management is cognisant of the importance of maintaining strong balance sheet, along with the inherent cyclicality of earnings within the coal and buildings materials businesses in particular.

The company’s unbroken growth in dividends since 1975 is impressive. We think management values the track record and maintaining a strong balance sheet through the cycle is a key enabler. It provides the ability to continue increasing dividends during downturns. That said, the fiscal 2019 dividend yield is just 2.0% fully franked, and growing at about 3.5% per year, the market richly capitalises a cash flow stream heavily reliant on coal prices, the building cycle, and TPG Telecom, which faces a competitive headwind from the National Broadband Network.