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Strategy Re-work
 

Strategy Re-work

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    Strategy Re-work Strategy Re-work Presentation Transcript

    • contact@industreams.com InduStreams.com & Port-Investor.com STRATEGY RE-WORK The crisis changed everything… …a new framework is needed that can survive volatility… …and drive untapped value through strategic decision-making!
    • contact@industreams.com InduStreams.com & Port-Investor.com The missing link Again. All gathered together in the meeting room. Various reports and paper scattered on the table and most likely some power point going on in the background with various market assessments and return calculations. It is time again to make another strategic decision about potential investment x or asset y. Very meaningful if it was not for the fact that decision bases keep changing from session to session. One investment a star one year, the next a dog. How can anyone make meaningful strategic decisions in an environment like that? Frustrating at best - root cause of immense shareholder value destruction at worst. But it’s not for lack of good people on the case or hard work for that matter. No, the solution lies elsewhere. And the good news is that with that solution also comes the potential to substantially improve your return exposure.
    • contact@industreams.com InduStreams.com & Port-Investor.com The problem Value -drivers Decision -base Decision -making a. Value drivers shift constantly, in particular in terms of the perception of future developments. b. Because we base decision-making on decision bases that estimate one return figure, our decision-base shifts every time the value drivers shift. c. This makes for an unstable base to carry out strategic decision-making. With constantly moving parts it leaves us in a terrible position to make critical calls and worst case make us unconsciously destroy shareholder value.
    • contact@industreams.com InduStreams.com & Port-Investor.com The solution Market drivers Decision- making Return exposure Model drivers We need a new framework to work effectively with strategic decision-making. A framework where the parts are not all constantly moving. Instead of just working from decision-base we need to work with the full return exposure including the full potential downside and a conceivable upside (this stabilizes our goal post). We split value drivers into market drivers and model drivers. We control the investment, operating and ownership models for any given investment. This gives us another fixture for our strategic decision-making. Which has many other benefits discussed later. Market drivers will continue to be volatile, but isolating them and understanding how we can negate or even benefit from this volatility leaves us much better prepared to deal with it. With this frame we have a solid structure to make strategic decision-making whilst accepting the volatility that is all around us.
    • contact@industreams.com InduStreams.com & Port-Investor.com What we want to achieve with this The purpose of this framework is helping you put in place an approach that: A. Employs all levers to increase investment returns. B. Aggressively works on reducing downside. C. Creates a robust platform for strategic decision- making. AB C
    • contact@industreams.com InduStreams.com & Port-Investor.com What comes next 1. Paradigm Shifting the paradigm by moving from one-point forecasting to working with full return exposure. 2. Models Employing models and options by identifying the key components of your business model and associated options and flexibilities. 3. Testing Applying a simple test to understand what your return exposure really looks like and how your strategic decision-making is impacting it. Appendix a. Case illustration b. What Hutchison and others are doing This presentation seeks to introduce the basic components, or missing pieces, we have identified as necessary to work meaningfully towards shareholder value creation in volatile market conditions. It presents the key components to work with the framework presented on the previous slide and will be covered in three simple steps and illustrated at the end by a case. This presentation provides a conceptual framework only. For application we encourage you to reach out to us and initiate dialogue.
    • contact@industreams.com InduStreams.com & Port-Investor.com PARADIGM Shifting the paradigm by moving from one-point forecasting to working with full return exposure
    • contact@industreams.com InduStreams.com & Port-Investor.com Step 1. Beyond one-point forecasting When did any projection you ever looked at hold true? If it was a one line projection into the future our guess is never. Just think about investments you or your company have been part of over the last 10 or even just 5 years and how much has changed. But this is not due to prediction failure. It is because of the nature of the markets. Consider the World Bank or IMF, hundreds of economists employed and really a poor poor track record of prediction even just for 1 or 2 year predications. Again it is not because of failure, the world economy is now and increasingly so becoming interdependent – a super complex system that is exposed to volatility of all the world markets. Any form of precision prediction leads to failure, we need to change that and work with the volatility that is all around us, and will continue to be there, in a meaningful way. And the best in the sector are going to be benefitting from it.
    • contact@industreams.com InduStreams.com & Port-Investor.com Step 2. Down and up-side exposure Metrics Estimate Investment size $500mn Net Present Value $241mn Internal Rate of Return 15% -968mn +1,707mn0 +241mn Our downside is known and relevant. We need to acknowledge it and aggressively work to reduce it (in this case mostly made up of investment and concession commitments). Moving beyond a single point view of the world – from only working with decision base to full return exposure (in this example illustrated in the form of a wide spectrum of potential NPV outcomes – for more information see the case in the appendix). Significant upside is ultimately what justifies putting in substantial commitments. We need to actively work to increase our upside. The more the better.
    • contact@industreams.com InduStreams.com & Port-Investor.com Step 3. Domain exposure -968mn +1,707mn +1,707mn -968mn Market Model Here we add domain exposure. Our return exposure is not directly dictated by market drivers, they are translated through the models we put in place (we could call it our business model). This distinction serves to provide us with a way to work meaningfully with market volatility and understand how we can work with our business model to alter our return exposure.
    • contact@industreams.com InduStreams.com & Port-Investor.com Step 3. Domain exposure (2) Market Domain Model Domain  Volume  Rates  Unit costs  Tax  Interest rates  Etc.  Concession terms  Operating model  Expansion, phasing and other options  Funding and ownership model  Deal structure  Etc. Market drivers (or x) Return (or y) Models (or f(x)) Consider your return as the combination of market drivers and the business or investment model you employ to turn those drivers into return. Another way to think of this would be to consider the market drivers as represented by “x” and your business or investment model as “f(x)” that together produce “y” (the returns). Some samples of what goes with which domain have been outlined in the table.
    • contact@industreams.com InduStreams.com & Port-Investor.com MODELS Employing models and options by identifying the key components of your business model and associated options and flexibilities
    • contact@industreams.com InduStreams.com & Port-Investor.com Working with models and options In the previous section we set the stage for utilizing the models we employ as a separate lever that deserves more focus and should be a key pillar in our strategic decision-making framework. In this section we provide a brief introduction to identifying and relating to the various models. In general we have seen various ways to analyze and break down the components of the model, but we are seeing some similarities and find the below diagram (see next slide) as a reasonable framework to use. Identifying the key components is important. As important, however, is to understand what flexibilities, entitlements and options you are in possession of (or want to be in possession of). We use one label here to describe them all as “real options” and they permeate all walks of the different models, from minor flexibilities (in e.g. the adjustment of labor force) to bigger “optionalities” such as expansion options and similar (see subsequent slide for illustration). In a world that is fully predictable, options have no value, but, as we will see, in volatile circumstances they can be extremely valuable.
    • contact@industreams.com InduStreams.com & Port-Investor.com Model identification framework We see three key focus areas or models that the best operators and investors focus on. Each with different impact and relevance time horizon wise as well as in terms of project versus shareholder level (see diagram and associated description for explanation). Investment Operating Ownership Concerning everything that relates to the scope, footprint, design, investment, obligations and entitlement that create the frame for the terminal to operate in the market. With the given frame of the investment model the operating model concerns the actual usage and deployment of shorter term resources to operate and provide services. Pertains to the individual shareholders and how they each derive their returns from the shareholding in the project or terminal company through the combination of the investment and operating models.
    • contact@industreams.com InduStreams.com & Port-Investor.com The importance of real options Investment Model  Concession, land and usage terms  Investment commitments and terms  Expansion and phasing terms  Etc. Operating Model  Customer agreements and terms  Fixed staff and admin cost structure  Variable staff and consumption  Etc. Ownership Model  Funding structure  JV and partnership terms  Dividend payout  Etc. Real Options
    • contact@industreams.com InduStreams.com & Port-Investor.com TESTING Applying a simple test to understand what your return exposure really looks like and how your strategic decision-making is impacting it
    • contact@industreams.com InduStreams.com & Port-Investor.com Introduction Without a proper testing tool to understand how our decision-making (including the use of model components) impacts our return exposure we are blind. This section covers our approach to a simple but comprehensive testing tool. It should enable you to understand whether you are making changes for the better or in reality sub-optimizing or worst case trading off small upsides for big downsides. But first one further perspective of why this matters.
    • contact@industreams.com InduStreams.com & Port-Investor.com Which investment would you choose? Metrics Estimate Investment size $500mn Net Present Value $241mn Internal Rate of Return 15% Metrics Estimate Investment size $500mn Net Present Value $241mn Internal Rate of Return 15% Metrics Estimate Investment size $500mn Net Present Value $241mn Internal Rate of Return 15% 1 2 3 These may appear similar, but they are not. Consider the next slide...
    • contact@industreams.com InduStreams.com & Port-Investor.com Now, which investment would you choose? 1 2 3 Scenario NPV Best case +1,707mn Base case +241mn Worst case -968mn Scenario NPV Best case +1,707mn Base case +241mn Worst case -293mn Scenario NPV Best case +3,438mn Base case +241mn Worst case -293mn
    • contact@industreams.com InduStreams.com & Port-Investor.com The key problem As discussed before the central problem is that the information from a single point or a base case does not provide nearly enough information for us to assess, manage or make decisions about investments or existing assets and portfolios. What seems however to be the case is that most manage their assets and enter into investments using just a one line projection and relating to a decision base case only. We need a new tool for testing investment and asset value. The three cases presented also happen to be from the same investment (as you will see in the case below) just with slight differences in the investment model, exemplifying the importance of testing how we can change our return exposure through working with models.
    • contact@industreams.com InduStreams.com & Port-Investor.com  Is an easy method of testing what is at least a conceivable spectrum for your investment.  Tests for the full downside.  Tests for upside potential.  Allow for graphic and numeric understanding of how your investment responds to changes in your investment, operational and ownership model.  Is constructed by simply looking at 100% variance on current outlook or base case up and down for the main value drivers (in the sample is used average rate and volume for just one time period). As with all investing there are no perfect options, but any approach that takes in a substantially wider spectrum than just one point, base case or single line projection is vastly superior. Our approach: The 9 Point Test
    • contact@industreams.com InduStreams.com & Port-Investor.com What ultimately matters Mainly relevant as a point of reference. Downside is non-speculative and very real. We need to obsess about reducing it. Upside, although speculative, shou ld ultimately be the purpose of investing when dealing with any investment where a specific payoff point cannot be forecasted with any certainty. It is not only the worst and best case that matters it is the space that defines up and downside and thereby in reality an average across the 9 payoff points. As mentioned there are many options to use a greater goal or testing metrics than what is mostly used today (single point estimates). What really matters is to have a meaningful way of relating to a relevant spectrum and with that up- and downside (and the relation between the two).
    • contact@industreams.com InduStreams.com & Port-Investor.com Now - how does your investment stack up? Great! Very limited downside and substantial upside. An even sided gamble… As much upside as downside. Terrible! Tremendous downside and little upside. Now consider the strategy you employ and the associated agreements and parameters governing your investment (the investment, operating and ownership models). Which of these diagrams does it assimilate?
    • contact@industreams.com InduStreams.com & Port-Investor.com APPENDIX CASE ILLUSTRATION
    • contact@industreams.com InduStreams.com & Port-Investor.com Introduction The three samples used above (in the testing case) all have the same starting point (and are from the same investment).  20 year concession  1,500 meters of quay and 100ha at cost of $500mn  Capacity 1.5mn TEU (ramp-up period of 6 years)  Average rate at $200 per TEU, average variable cost at $50 per TEU  Fixed cost at $5mn per year  Concession cost at $50mn per year (fixed)  25% corporate tax rate  10% discount rate In the following we make adjustments to the investment model and test to see the changes it makes to our return exposure.
    • contact@industreams.com InduStreams.com & Port-Investor.com Sample 1 – Starting point As capacity is capped at 1,5mn TEU volume only has an impact up to the base scenario thereafter only avg. rate increase make a difference. The lowest payoff point mainly consists of investment and concession liabilities. Return spread (NPV in USD) Base case +241mn Average +211mn Maximum +1,707mn Minimum -968mn Max./Min. 1.76 times
    • contact@industreams.com InduStreams.com & Port-Investor.com Sample 2 – Concession and phasing terms To get from Sample 1 to Sample 2 we amended the concession structure as follows with no change to the base case:  Previous fee $50mn per year  New fee $44.25 per TEU  PV value of concession fee remains $426mn (at 10% discount rate) as per base case And added a phasing option:  Previous commitment at $500mn  Option introduced to phase in 2 parts of $250mn per phase Return spread (NPV in USD) Base case +241mn Average +488mn Maximum +1,703mn Minimum -293mn Max./Min. 5.81 times
    • contact@industreams.com InduStreams.com & Port-Investor.com Sample 3 – Expansion option Finally we combined these adjustments with an expansion option to reach Sample 3 (from Sample 2):  Capacity capped at 1.5mn TEU in base case  Option introduced to double capacity by investing additional $500mn Return spread (NPV in USD) Base case +241mn Average +801mn Maximum +3,438mn Minimum -293mn Max./Min. 11.75 times
    • contact@industreams.com InduStreams.com & Port-Investor.com How average return exposure has increased 1 2 3 +211mn +488mn +801mn When comparing the investment case above for average return exposure (NPV) you will see a noticeable difference between that and the base case. We have shifted the entire return distribution more almost $600mn to the better by just using a few of the basic levers from the investment model..
    • contact@industreams.com InduStreams.com & Port-Investor.com APPENDIX WHAT HUTCHISON AND OTHERS ARE DOING
    • contact@industreams.com InduStreams.com & Port-Investor.com Introduction It used to be all about the markets, well, mostly at least. Which markets are hot and which are not (and “picking the winners”). Whereas this is still something the global port investors clearly obsess about, a clear difference is possible to spot for those who have been around some years in the sector. In short, they are starting to focus much more on the models they use to invest and extract value from their portfolios. And as part of that they employ models that assume much more volatility in the markets than previously. In this short piece we will be illustrating this trend with a few samples and uncover some of the key things the best in the market are doing differently.
    • contact@industreams.com InduStreams.com & Port-Investor.com What Hutchison and others are doing (1) One of the most notable cases was the Hutchison Port Trust IPO in Singapore. In one single move Hutchison Port Holdings (HPH) transformed their return exposure completely for all their Pearl River Delta (PRD) assets when they IPO’ed them on the Singapore Stock Exchange. Not only did they secure a substantial part of the potential future cash flows they also placed themselves in a role that gives them many times the upside compared to the stake they have left in the game. In 2010/11 when HPH was faced with decisions concerning their PRD portfolio, including their very profitable Hong Kong and Shenzhen activities, they probably looked at something resembling the spread of potential returns shown on next slide.
    • contact@industreams.com InduStreams.com & Port-Investor.com What Hutchison and others are doing (2) Note: The figures used are just samples, they do not reflect specific estimates (and we are only talking about HPH here rather than the wider set of owners behind the assets for simplification). Market drivers Return (NPV) -$5bn +$5bn Market drivers Return (NPV) -$5bn +$5bn The diagram displays a spectrum from the least optimal to the most optimal market conditions and a corresponding value of the HPH PRD assets (in NPV) when matched against a potential sale (or in this case proceeds from an IPO) at $5bn.
    • contact@industreams.com InduStreams.com & Port-Investor.com What Hutchison and others are doing (3) In the diagram to the left (previous slide), HPH would be assuming that under reasonable market conditions they would enjoy the same future cash flows as what they would gain in proceeds from a sale and obviously would gain more by retaining their holdings under more favorable conditions (and vice versa). Whether HPH saw more downside than upside has been speculated on and it is of course entirely possible that they might have been looking at a flattening of the upside potential as illustrated in the diagram to the right given the market supply/demand situation and associated rate environment. That however is not so relevant to the issue at hand. The interesting part is the constellation they put in place as part of their divestment. Had they just divested the majority of the holdings you could argue that they would have simply reduced up- and downside. But instead they made a managing role for themselves, not entirely different from the more traditional PE structures, in which they receive bonus based on performance. BUT this was done without adding to the down side (see next slide).
    • contact@industreams.com InduStreams.com & Port-Investor.com What Hutchison and others are doing (4) In short HPH substantially reduced their down side and instead put in place a structure that would allow them exposure to a potential upside many times that of the capital deployed. Market drivers Return (NPV) -$5bn +$5bn Market drivers Return (NPV) -$5bn +$5bn
    • contact@industreams.com InduStreams.com & Port-Investor.com What Hutchison and others are doing (5) A more recent example would be the China Merchant Holdings International (CMHI) acquisition of part of the CMA terminal portfolio for a reported amount of €400mn. Very simplified the return exposure might have been as outlined above in the diagram to the left. But it is possible, as was rumored, that CMHI negotiated a guarantee providing them with a minimum return for the first 7 years of 7- 8%, substantially reducing the potential downside of the investment (as outlined in the diagram to the right). Market drivers Return (NPV)+€400mn -€400mn Market drivers Return (NPV)+€400mn <€250mn
    • contact@industreams.com InduStreams.com & Port-Investor.com The general trend The stated examples are just a few snippets of what is visible to the public when looking at press releases and other such sources. From direct deal involvement it is clear to us that in particular the more established operators and investors are starting to behave very different in their investment and portfolio management approach. It does, however, not look like an across the board change in the way these organizations work internally. Governance and procedures seem to remain the same. As example in the form of some one-line projections to support a business case that goes to the board. But in these organizations are people who have been through many investment cases and today sit with what is often a mixed bag of assets. These decision- makers are not relying on prediction accuracy anymore. So what are they doing?
    • contact@industreams.com InduStreams.com & Port-Investor.com A. Avoiding prediction failure (1) It used to be the general belief that by putting enough resources to work you should get a fairly precise estimate of a potential set of market drivers. Drivers that in turn could be used to make a business case and in general form a business model around to optimize returns for the specific investment in question. Market drivers Return (NPV) Market drivers Return (NPV) -$500mn +$500mn -$500mn +$500mn
    • contact@industreams.com InduStreams.com & Port-Investor.com A. Avoiding prediction failure (2) But with a market now littered with projects that in the worst case have no cargo or prospects of getting any material such, this is changing. As mentioned for some reason it still seems to be the norm in terms of the actual governance and process surrounding decision-making for investing and asset management but the experienced executives are not buying it. And so they simply assume a much larger potential fall-out range (see right diagram versus left diagram above). For a more in depth look at market volatility in the port markets, please see: www.port-investor.com/market-volatility
    • contact@industreams.com InduStreams.com & Port-Investor.com B. Thinking in business/inv. models (1) With that backdrop it becomes important to distinguish between market drivers and the model you employ to transform these into return. Another way to think of this would be to consider the market drivers as the variable “x” and the business or investment model employed as “f(x)” and the returns generated from these as “y”. Market drivers (or x) Return (or y) Business/investment model (or f(x))
    • contact@industreams.com InduStreams.com & Port-Investor.com B. Thinking in business/inv. models (2) A few examples given below on what constitutes the aspects considered in terms of drivers versus model. Market (drivers) Model (inv./business)  Volume  Rates  Unit costs  Tax  Interest rates  Etc.  Concession terms  Operating model  Expansion, phasing and other options  Funding and ownership model  Deal structure  Etc.
    • contact@industreams.com InduStreams.com & Port-Investor.com B. Thinking in business/inv. models (3) And of course the goal for these operators and investors is to create a model that looks like the model to the right and avoid the one to the left (or transform it). In other words working to employ a model that provides most possible upside and least possible downside when considering a wide range of possible market scenarios.
    • contact@industreams.com InduStreams.com & Port-Investor.com B. Thinking in business/inv. models (4) This is in stark contrast to what most are still doing today, which is optimizing factors in the model around a decision base or single point rather than the whole spectrum. Working with increased focus on the model itself also has the benefit that through the full cycle from pre- to post-investment, you have control of the model, you make the decisions that govern it. Not so for the market drivers which you can at best try to impact. Or to put it another way, you may not be able to dictate the terms for e.g. a specific concession but ultimately you decide whether or not to take it. Ironically despite this, mistakes by investors in terms of the models employed have previously at large been ignored (although they have been in full control of these). This as opposed to market prediction mistakes that have been discussed in great detail (despite the obvious limitations constituents have in this regard).
    • contact@industreams.com InduStreams.com & Port-Investor.com C. Using “real options” (1) In a world that is fully predictable options have no value. But in a world with plenty of variance they are tremendously valuable. And what is more, they permeate all walks of the models we employ and thereby our return exposure. As very simple illustration we can use put options and expansion options (or exclusivities that secure upside) to illustrate how real options impact return exposure (see next slide). In the left diagram restrictions or lack or options or entitlements is curbing the upside, whereas a put option is used to limit the downside in the diagram to the right.
    • contact@industreams.com InduStreams.com & Port-Investor.com C. Using “real options” (2) Real options or flexibilities and entitlements come in all shapes and forms. Some are very obvious and easy to spot whereas others are more complicated and hidden in legal terms or inherent in e.g. the chosen operating model. Market drviers Return (NPV) Market drivers Return (NPV) -$500mn +$500mn -$500mn +$500mn
    • contact@industreams.com InduStreams.com & Port-Investor.com Disclaimer This presentation is issued for information purposes only and does not constitute an agreement, offer, obligation or invitation to enter into transactions or investment business. With this presentation, INDUSTREAMS LIMITED does not act in any way as your advisor. This presentation is not intended as, nor should it be, a substitute for consulting with INDUSTREAMS LIMITED. Whilst this presentation has been produced from sources believed to be reliable, the information, views and opinions expressed in this presentation are provided as of the date of this presentation and remain subject to verification, completion and change without notice. No representation or warranty whatsoever (whether express or implied) is or will be made as to, or in relation to, the accuracy, reliability or completeness of the information contained herein or in the appendices to this presentation. INDUSTREAMS LIMITED will not be liable towards you or any third party for any eventual damage you may incur, caused by the information contained in this presentation and its appendices.