Update No. 192 – 05/12/14

You know what hasn’t been discussed enough in the Australian business media the last few weeks? The Medibank Private IPO. Better add my two cents…

I will start at the beginning that in my view, the Government (Federal, State, Local – whatever) has no business being involved in businesses that are profitable, stable and suited to private ownership. Don’t mistake me for one who thinks the Government should never get involved in businesses, just that once they are properly financially viable, they should be sent to private hands and the capital released should go to building new productivity increasing infrastructure, provided debt levels are low enough to handle economic shocks. In my view, ideally net-debt to GDP should be no greater than 20%, if levels exceed that, priority should be given to bringing it to well below that range before investing in new infrastructure.

So I am generally in favour of privatisation, and I think it spurious that those that point out that the cost of the equivalent debt for the federal government over the next 10 years would have been perhaps 2/3 or less than of the dividends the ownership of Medibank would have returned to them. Such calculations neglect the performance improvement in privately operated businesses. The Federal Government, under the present rules effectively retains 30% ownership of any asset it privatises (current corporate tax rate) through the taxation revenues it will generate. Given the inevitable improvements in performance under private ownership, there is a better than average chance that the privatised Medibank will return more to the Government by way of taxes in the decade of the 2030’s than the entire profits it would have seen under full ownership.

Lovers of Government ownership forget capital is finite. If the Government needs more capital, it can either come to you the taxpayer, or lighten the load by ‘recycling’ capital by privatising mature Government owned assets. Privatisation has tended to be a better outcome for taxpayers because raising the taxation burden, all else equal is shown to slow economic growth.

So the Government has about $5.5 billion or so of newly acquired capital, what should it do with it? As stated above, if our net debt/GDP ratio is too high to give a meaningful buffer in the event of a major economic shock or recession, the best option is to retire debt.

The second alternative is reinvestment into new infrastructure that improves productivity, thereby enhancing GDP, thereby increasing the tax take, thereby enhancing the lives of the future citizenry. Think about it like this. Australian GDP is about $1,500 billion (very roughly). Depending on where you source your data, the tax take at all levels of Government is roughly 27% of GDP or about $405 billion (some place it up over 30%, but I think 27% is about right). Medibank was earning for the Government NPAT of circa $250 million annually, say $300m. In order for the Government to ensure as much revenue from increased tax take, it simply needs to find an infrastructure project/s that will add $1.111 billion ($300m/27%) to GDP, or increase it by 0.000741%. A second airport for Sydney is mooted as a $6 – 8 billion project. These things always seem to cost more than expected, but I do not find it hard to imagine a second Sydney airport would give at least a couple of billion dollars in uplift to national GDP. If the second airport became the primary air-freight terminal, the productivity uplift through fewer trucks on the CBD fringe would nearly add that alone.

The third option is to return this newly acquired capital to citizens through transfer payments, unfortunately this easy option is chosen too often, and under these circumstances the wonderful benefits of privatisation are lost forever.

If you don’t believe that corporate profits, GDP and Government tax take are intrinsically tied together, have a look at this paper by Yardeni research (.pdf).

EGP participated in the Medibank IPO, the massive scaleback of larger applications meant it debuted in our portfolio as our third smallest holding. The reasons for taking on the position were threefold.

Firstly, and most importantly was valuation, although the offering was not cheap at around 22x earnings, with the downward trajectory of the cost base, the more conservative (than peer group) reserving and mandated revenue growth it would take serious managerial missteps for EPS not to grow markedly (high single to low double digits for a few years hence), with a sound fully franked dividend to go alongside. The view I took of valuation at the likely $2 issue price was a mid-teens IRR over a reasonable term. This is below what I usually target when starting a position, but my third reason will explain why.

Secondly, was the moral view that Government privatisation should be encouraged. I would not risk our funds based on this point unless the valuation was also satisfactory, but given the valuation allowed for the prospect of returns at the low end of what I consider a satisfactory result, it was worth participating to ensure the Government had a good response so future such privatisation options are seriously considered.

Finally, the third reason was as part of my efforts to ensure we have some highly liquid holdings to offset some of the quite illiquid holdings EGP take, almost 50% of MPL has changed hands since listing, so it’s certainly liquid.

Our December quarter offer to invest goes out this week and I am hopeful of further increasing the proportion of the fund held outside of my direct control, but to ensure unexpected requests for redemption can be promptly dealt with, it naturally requires steady increases in the liquidity metrics of the fund holdings.

If you would like to receive the offer to invest, email me at Tony@eternalgrowthpartners.com and I will send you a copy of the invitation to invest e-mail. As I indicated with last week’s blog, I am quite excited about the prospects of a very good calendar 2015 year. As such, Sue and I will be adding roughly double our customary quarterly contribution. I hope fellow holders will do the same – Tony Hansen 05/12/2014

EGP Fund No. 1 Pty Ltd. Down by 1.14%, trailing the benchmark by 2.01% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 68.35%, leading the benchmark by 38.15% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}