Hockey calm amid deficit storm

GIVEN the collapsing terms of trade, the $10.6 billion blowout in the budget deficit over the past six months was to be expected.

GIVEN the collapsing terms of trade, the $10.6 billion blowout in the budget deficit over the past six months was to be expected. What may have surprised people is how sanguine Joe Hockey appears to be about his rapidly deteriorating bottom line.

With tax receipts expected to be down $6.2bn this financial year and almost $32bn over the next four years, welfare spending blowing out in a slowing economy and the big structural savings in health, social welfare and education stymied by the Senate, the surplus previously forecast for 2017-18 is now expected to be a $11.5bn deficit.

Over the forward estimates there has been a $43.7bn deterioration in the forecast budget outcomes and the new projections indicate that the elusive surplus won’t be achieved until 2019-20.

Yet Hockey’s tone was more upbeat than the apparently gloomy set of numbers might have warranted.

That might be partly because, despite the steep decline in revenue and the Senate’s obstructionism, the Abbott government has been reasonably disciplined in its spending, largely offsetting new spending with reductions to existing programs (most notably foreign aid programs).

It might also be that while at the moment it appears that the budget faces only headwinds, next year there may be some more helpful influences.

The lower dollar, the lower oil price, a surge in infrastructure spending and, perhaps, even lower interest rates should put some kind of floor under activity levels and rekindle some growth in non-resources sectors of the economy previously throttled by the strength of the dollar.

The official forecasts are for real GDP growth of 2.5 per cent this year, strengthening to 3 per cent in 2015-16, although nominal GDP for 2014-15 is expected, thanks to the collapse in commodity prices, to be only 1.5 per cent — the lowest level of nominal GDP growth in more than half a century.

The deficit itself is, of course, stimulatory. That’s why economists and treasurers refer to ‘‘automatic stabilisers’’.

As with the May budget, Hockey has made it clear that the government isn’t going to respond to the deterioration in the fiscal outcomes by trying to offset them with near-term cost reductions that could drive a weakening economy into recession.

As it is, the unemployment rate is expected to edge higher, from 6.25 per cent to 6.5 per cent over the next two financial years.

The fiscal strategy has always been about treading fairly gently while the economy is vulnerable, with the structural changes to spending Hockey put forward in May designed to provide a medium to long term glide-path back to surplus and lower commonwealth debt.

One positive that Hockey could point to is that, whereas last year’s mid-year economic outlook had commonwealth debt reaching $667bn in 2023-24 and continuing to rise, this year’s statement anticipates debt of just under $500bn in 2023-24 and for debt levels to be falling.

That medium-term improvement in deficits and debt remains the strategy, but the execution is proving difficult, thanks to the external circumstances and an intractable Senate where, as Hockey is fond of pointing out, Labor is even voting against cost-savings measures that it proposed to introduce while it was in government.

Hockey attributed $3.4bn of the budget blowout to the Senate delays while also saying that the price of getting measures through the Senate (mainly to get the support of the crossbenchers for the repeal of the mining tax) was $7.2bn over the forward estimates. He still has $34bn of measures tied up in the Senate.

Labor, naturally, takes great delight in seeing Hockey experiencing the same kind of revenue losses (and opposition frustration) that plagued Wayne Swan during a lengthy term as treasurer that produced nothing but burgeoning debt and deficits.

In Labor’s case, the fall-off in the rate of revenue growth did, however, coincide with significant growth in spending — some very large lumps of which (in health and education) were locked in beyond Swan’s forward estimates and left for the Coalition to fund.

Recall in driver’s seat

IT’S a novel takeover defence when the target dismisses a $2.2bn offer out of hand while arguing that combining with its bidder would generate $US250 million ($303m) a year of synergies. The nature of Recall Holdings’ response to the bid by Iron Mountain, however, says that Recall’s board isn’t opposed to the concept of the long-touted merger with the dominant player in its sector, but purely to its terms.

The board makes a compelling case for the deal, as long as Recall shareholders get a fair share of the value it would create.

The Recall argument actually has two planks. The first is that the starting point of $7 a share represents too skinny a margin over Recall’s stand-alone value.

While Iron Mountain would argue that speculation about the possibility of a bid has inflated the recall share price, a premium of only 11.7 per cent to the three-month volume-weighted average of Recall shares does appear to be light on value. Recall makes the point that over that period it has upgraded its earnings guidance for this year and made a meaningful acquisition.

It believes that if Recall can deliver on the board’s growth expectations over the next three years — double-digit growth in revenue and earnings before interest, tax, depreciation and amortisation — an independent Recall could be worth more than $11 a share and potentially more than $12.70 a share in three years’ time.

The larger case, however, is that in an offer proposal that is weighted towards Iron Mountain scrip — 82 per cent of the offer consideration is in paper — the terms don’t share enough of the upside with Recall shareholders.

Recall has known for a long time that Iron Mountain would eventually come knocking. Iron Mountain looked closely at the company when Brambles conducted a sales program last year before opting to demerge the group in the absence of an acceptable offer, and therefore was prepared for the approach.

It has undertaken a detailed analysis of the potential synergies from combining the two companies to come up with its $US250m a year estimate. It says that estimate is conservative, given Iron Mountain’s own record of extracting synergies from last year’s acquisition of Cornerstone Records Management.

On Recall’s numbers and at the $7 a share price offered, its shareholders would get only 4 per cent of the value the combination would release if Iron Mountain achieved the $US250m a year of synergies.

Recall would, at its current market value of about $2bn, represent a little less than 20 per cent of the merged group. If its shareholders were to receive 20 per cent of the synergistic value, the offer price would need to be closer to $8.50 a share.

The extent of the weighting of the offer to Iron Mountain scrip means the US group is unlikely to succeed with anything other than a generous offer. There will be a lot of Recall shareholders who won’t want (or won’t be able) to hold shares in a US company.

The current scrip-dominated mix of the offer consideration is, in the absence of an obviously generous control premium and a reasonable share of the value the combination would unlock, going to make it very difficult for Iron Mountain to generate any momentum for the offer or put any real pressure on the Recall board to do anything other than hold out for a much higher price.

Iron Mountain needs the board’s endorsement, given its approach was conditional on access to due diligence and a unanimous board recommendation. US companies generally don’t like making offers without conducting a due diligence investigation.

Recall shareholders will also be very aware that Recall is, as it has been for a long time, a compelling opportunity for Iron Mountain and that won’t change if its current approach fails to gain any traction. Even if it walks away today, Recall will remain on its radar for years.

There’s not a lot of downside for the board or shareholders in rejecting the approach and potentially, with or without Iron Mountain (but particularly with the US group), potentially considerable upside.

John Durie is on leave.