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Explosive Earnings: Unpacking Incitec Pivot

Understanding Incitec Pivot IPL and the Australian Explosives Industry

In the last week explosives have been a hot topic, after a cache of ammonium nitrate was detonated in Beirut, killing 171, destroying the port and rendering …

In the last week explosives have been a hot topic, after a cache of ammonium nitrate was detonated in Beirut, killing 171, destroying the port and rendering 30,000 people homeless. In the last week many media pundits have had to get quickly up to speed on explosives, but it is not widely known that the ASX is actually the home of explosives, with the two largest explosives manufacturers in the world Orica (ORI) and Incitec Pivot (IPL) listed on the ASX.

In this week’s Torpedo Friday we are going to look at one of the giants of the explosive’s world and the explosives market leader in the largest market the USA, Incitec Pivot (IPL).

Hugh Dive from Atlas Funds Management has 15 years experience in analyzing the global explosives industry and has visited most of IPL’s sites across the globe. Dive explains how IPL came to be on the ASX, major industry movements, the regulation around IPL including use and storage of explosives and IPL as a possible investment.

July Monthly Newsletter

  • July saw a volatile month for listed real estate, with the sector up in the first half buoyed by the majority of property trusts paying a distribution in late June and improving retail sales data. However, these gains were reversed on news of rising CV-19 cases in Victoria that ultimately resulted in a lock-down in the southern state.
  • The Atlas High Income Property Fund declined by 2.4% during July, a frustrating outcome as most of the month the Fund was ahead of both the index and in positive territory prior to a sell-off on the last two trading days of the month.
  • The last six months have seen very negative sentiment towards real estate and a wider-spread de-rating of the sector. While discretionary retailers face a tough outlook; the largest exposures in the Fund are to supermarkets, industrial and infrastructure real estate, assets that have seen either minimal or even slightly positive impacts from CV-19. In late June, 85% of the Trusts in the portfolio that were due to pay a distribution did so, with one deferred to August. This indicates that high levels of rent are being collected and that not all businesses in 2020 are facing the same challenges.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.

Travelling to exotic foreign shores

Earlier this week fund manager Perpetual opened their cheque book, paying $569 million to acquire a majority stake in Dallas-based fund manager Barrow Handley. They both raised equity and took on debt to acquire what appears to be an American version of themselves. This acquisition has been criticised in the press, with commentators arguing than Perpetual are essentially buying a business with minimal synergies that faces the same challenges that they face at home: specifically, declining funds under management due to their value investment approach underperforming for an extended period of time.

In this week’s piece, we are not going to discuss the new Perpetual deal in detail, as the well-respected fund manager is neither the first nor the last Australian company to make questionable offshore acquisitions. Rather, we will examine the factors behind the many poor, and the few good, offshore acquisitions made by Australian companies

Why do Australian companies expand offshore?

The main reason behind most offshore acquisitions for Australian companies is to gain access to new pools of customers that will drive earnings growth. Typically such growth may be beyond that which Australia’s population of 25 million can provide.

Additionally, many Australian companies operate in oligopolies or are constrained from growing rapidly – through either price competition or acquiring competitors – by government regulators such as the ACCC (Australian Competition & Consumer Commission).

In the banking or grocery industries, neither Commonwealth Bank nor Coles are able to take market share from competitors by dropping prices, as their competitors will immediately match their moves. The other major banks can raise wholesale funds to on-lend to borrowers at roughly the same price as Commonwealth Bank. Similarly, the price at which Woolworths can buy bottle of Coke or a box of Weet-Bix would be identical to the price the manufacturer charges Coles. Any price war would not grow market share, but rather reduce overall industry profitability. Similarly, a move by Commonwealth Bank to acquire the smaller Bank of Queensland would have difficulty getting approval from the ACCC who would oppose any further concentration of the banking oligopoly. The ACCC drew criticism increasing the concentration of the banking industry in 2008 after allowing Westpac to take over St George and CBA to buy Bankwest.

Other reasons touted for global expansion include earnings diversification, since business or regulatory conditions in certain foreign markets may not align with those in Australia. For example, Sonic Healthcare is not likely to face simultaneous fee pressures in their pathology businesses in the USA, Australia and Germany. Similarly, demand for Amcor’s food packaging in Europe is not correlated with volumes of PET soft drink bottles sold in the USA.


Wrong move #1: We are dominant at home, so naturally we will dominate the world!

We see that this is the most common mistaken assumption made by Australian corporates venturing offshore. There is a tendency to assume that the company’s dominance in the high margin, and often lowly competitive home markets, will translate to success in the unfamiliar and frequently cut-throat markets of the USA, Europe and Asia.

Arguably the view that hardwear retailing excellence in Australia can easily be translated offshore was the rationale motivating Wesfarmers when they purchased the number two player in the UK hardware market in 2016. In Australia, Bunnings dominates the $50-billion hardware sector with a 50% market share and earns the highest profit margins of any global hardware chain. The UK hardware market, however, is highly competitive with low margins. In the case of Bunnings UK, the company sent in trusted Australian executives to the UK who replaced the soft furnishings in the acquired hardware stores with large stainless-steel BBQs, power tools, and lawn mowers that sell well in sunny Sydney to consumers with large back gardens. The new range of items were a surprise to UK shoppers entering a Homebase store in Yorkshire that looking for Laura Ashley quilt sets for their terrace rather than a gleaming steel six burner BeefEater BBQ. Over the two and a half years of ownership, this adventure cost Wesfarmers shareholders A$1.7 billion. The eventual sale of Bunnings UK in May 2018 for £1 was actually a good outcome for Wesfarmers it avoided significant closure costs and associated store lease liabilities.

Another example of assuming that strength in Australia will result in success overseas can be seen in IAG’s entry into the UK insurance market after buying the country’s eighth largest motor insurer. In Australia IAG, Suncorp and QBE together have a 70% market share and have successfully limited the penetration of new entrants into the Australian motor vehicle insurance industry, which keeps margins relatively high .Ultimately this adventure cost shareholders $1.3 billion, as IAG found the UK insurance market far more competitive than Australia and the evolving influence of insurance comparison websites steadily eroded the power of long established brands.

In a similar vein, over the last 30 years NAB, Westpac and ANZ have all made significant and largely unsuccessful ventures offshore. After coming out of the 1992 recession in better shape than their peers, NAB acquired banks in Northern England, Ireland and the USA, based on the strategy that their dominance in Australia would translate into other parts of the English-speaking world. Ultimately NAB was unable to run the dispersed set of financial services businesses from Melbourne and this adventure cost shareholders billions. This adventure would, however, have been costlier had NAB not sold their Irish banks to Denmark’s largest bank just prior to the GFC.


Wrong Move #2: Misunderstanding cultural issues

While Australian companies make mistakes investing in the supposedly friendly anglosphere of the UK and the USA, making big acquisitions outside these markets has resulted in more headaches for management teams.

Leighton’s adventure 2007 in the Middle East, in which they paid $870 million to buy a minority stake in Dubai’s Al Habtoor Group in a bid ramp up growth, ultimately ended poorly for shareholders. The company struggled to negotiate the complex political waters of the Middle East, an environment far tougher than the UK or the USA for Australian companies, and had trouble collecting payments on completed construction projects such as an equestrian centre in Qatar. Finally, in early 2020 the company finally exited the Middle East, potentially hastened by the weeklong imprisonment without a charge in 2016 of their CEO in Dubai due to a complaint from their joint-venture partner.

In 1993 Fosters entered the Chinese brewing market, buying a majority stake in the Shanghai, Guangdong and Tianjin breweries. While Fosters was entranced by the size of the Chinese market, local consumers did not warm to the hoppy taste of the Australian beer and preferred cheaper local lagers. After thirteen years of losses, Fosters’ Chinese brewing operations were sold to Japan’s Suntory for a mere $15 million.


Wrong move #3: Let’s buy growth and try something new

This version of an offshore misstep generally occurs when an Australian corporate with excess cash is presented with an opportunity to grow earnings by investing in a new technology in a foreign market. Typically, this involves buying assets from local players who typically have a better grasp on what the assets are actually worth.

A great example of “Let’s try something new” has been BHP’s investments in US onshore shale gas in 2011 and 2012. BHP acquired assets of US$4.75 billion from Chesapeake, and paid US$15 billion for Petrohawk. BHP at the time was flush with cash due to a surging iron ore price. However, extracting shale gas in the US is more of a small-scale modular process compared with BHP’s massive iron-ore and offshore LNG projects. Furthermore, BHP’s purchase was made when oil prices were above $100/bl.In 2018 BHP managed to extricate themselves from their US shale adventure, selling out for US$10.8 billion to BP after having already written off US$13 billion of this investment. While this was a destructive acquisition for shareholders, in July 2020 this looks to be a sage move with oil falling from US$70/bl to US$40/bl over the past two years.
Wrong move #4: Sort of similar to something we already do

This mistake is a close cousin of “let’s try something new” in that the acquisition is made in an area close to the company’s core area of competency and presented to investors as a low-risk form of offshore expansion. Fletcher Building’s purchase of the Cincinnati-based Formica in 2007 for US$ 700 million from private equity was touted as a logical extension to the company’s decorative surface laminates business. In hindsight, this acquisition was made at the peak of the US housing construction cycle for a business that faced ongoing production issues due to site consolidation.

Slater+ Gordon’s acquisition of Qunidell’s professional services division in 2015 for A$1.2 billion also falls into this category of offshore acquisition blunders. Whilst this infamous acquisition made Slater+Gordon the number one personal injury law firm in the UK, it also added claims management companies, insurers and insurance brokers – businesses somewhat adjacent to the company’s core litigation practice. Arguably this move helped contribute to equity holders losing 99% of the value of their investment in the company as it both burdened the company with too much debt, and bought a business without undertaking sufficient due diligence.

Shortly after the purchase of Quindell, the UK government announced plans to limit the proceeds from personal injury claims and Quindell came under investigation for accounting practices that inflated earnings.


Wrong move #5: A bit of everything

No discussion of poor offshore acquisitions would be complete without including Rio Tinto’s 2007 acquisition of Canada’s Alcan for US$38 billion, which manages to tick most boxes of a poor offshore expansion. This acquisition arguably was made to fend off a takeover from BHP and led to Rio acquiring smelters in exotic places such as Iceland (“Sort of similar to something we already do”) and engineered products and packaging (“let’s try something new”). Ultimately, US$30 billion of this acquisition was written off and resulted in a highly dilutive equity issue in 2009.


Mistakes go both ways

It would, however, be disingenuous not to mention that foreign companies also make comparable mistakes in buying domestic assets at high prices from canny Australians.

Japan’s Kirin Breweries and UK’s SAB Miller have written off portions of the Lion Nathan and Fosters brewing assets, as sales of iconic Australian beers such as Toohey’s and Victoria Bitter have declined with drinkers turning to smaller craft beers. Similarly, Woolworths South Africa are surely cursing the day that Australian shareholders accepted their $2.1 billion dollar offer in 2014 for David Jones. Profits at the troubled retailer have declined by 70% over the past six years and half of the acquisition cost has been written off.


Offshore acquisitions that worked

It would be wrong to claim that all offshore acquisitions end in tears for Australian investors. A number of Australian companies have made major offshore acquisitions that have driven earnings growth for a number of years and propelled the company into a major global player in their industry. Amcor has leveraged a range of successful acquisitions to become one of the largest manufacturers of flexible packaging and rigid plastics, ironically making their most successful acquisition from Rio Tinto.

Similarly, CSL made major acquisitions in 2000 and 2004 in Switzerland and Germany and is now the largest global producer of blood plasma-derived medicines. Computershare has grown through acquisition to become one of the largest global share registry businesses, successfully buying and improving the profitability of various global banks’ unwanted registry businesses.

Sonic Healthcare has made 50 acquisitions over the past 20 years in Europe and the US. Sonic’s shareholders have enjoyed rising profits due to doctors requesting greater numbers of tests per patient, and being able to run higher volumes through their increasingly automated labs. The company is now the third largest medical testing company in the world with significant market positions in Australia, Germany, Switzerland, the UK and the USA. Sonic’s global lab network has processed millions of Covid-19 antibody tests in 2020.

The common theme through these successful offshore expansions is that the Australian companies have focused on a particular niche where the Australian company has some form of comparative advantage. This is very different from buying foreign banks, where the Australian company brings no intellectual capital or technology to the table, often buying one of the weaker companies in a competitive market as this is seen as “cheaper” and thus earnings accretive.

Our Take

Perpetual’s adventure into the very competitive American funds management market is unlikely to be the last questionable foreign acquisition by Australian corporates. Management teams are incentivised to grow earnings, and large offshore acquisitions with huge potential markets are often presented as a quick way to achieve this goal.

Atlas is very wary of companies announcing major offshore acquisitions, as for every successful acquisition there seem to be several that end in tears. The common theme is one of excessively optimistic due diligence which underestimated the level of competition in the new foreign markets. Additionally, it is often very difficult to manage a diverse global business across multiple time-zones from a head office in Sydney or Melbourne.

This article also appeared in Livewire