On Thursday, New Zealand will be the latest country to review its official interest rates and, like the US, UK and others, will almost certainly not raise them.
This country is due for a rates raise, not least because we have lagged Australia which has made several moves in the past couple of years and the rates were trimmed here to help out with the aftermath of the Christchurch earthquake.
On the other hand, higher rates will attract more investment here and push up our already painfully high exchange rate, which the Reserve Bank and exporters most certainly will not want to see.
Meanwhile, interest rates in the USA have fallen to record lows with 10-year treasury stock trading for around 1.92%, having been as low as 1.87% on Monday. In Europe, the yield on the 10-year German government bond fell yesterday to 1.78%, having likewise visited an all-time low of 1.71%.
Apart from investors chasing safe haven investments in light of the continuing European debt crisis and threats of renewed recession in the US, I believe these low rates also point to a growing expectation that the outlook for the global economy is deflation, not inflation.
This goes against traditional economic theory, which says that pumping lots of extra money into an economy will lead to inflation. While it is true that food and energy are rocketing, the price of manufactured items from clothes to stereos to motor vehicles is falling.
As much as I like the idea of prices falling, a deflationary spiral is much more dangerous and harder to fix than an inflationary one. Also, it punishes those with debts because the real value of those liabilities goes up over time. Given the issues we face with sovereign and household debt globally, that is something to be very, very concerned about.

The New Zealand shareholders Association said today that following constructive talks with AIA Chair Joan Withers, it was satisfied that the new long term incentive plan for AIA CEO Simon Mouter was adequately aligned with shareholder interests. We like the fact that the Airport Company has been up-front in announcing the payments rather than trying to hide them in the annual report, said NZSA Chairman John Hawkins. Such transparency should be the norm and we will continue to criticise directors who fail to fully inform shareholders about these kinds of arrangements..

“While we have reservations about total shareholder return (TSR) being the most appropriate measure to use, we are pleased that some significant performance hurdles must be met for these incentives to be vested”, he said. Hawkins also noted that the company had resisted the temptation to alter Mouter’s existing scheme which was well under water. “This is a lead that several other companies could well note”.

The Association felt the phantom option scheme (which results in cash payments being made) was an improvement on a number of share based option schemes as these dilute other shareholders. “However, we still prefer to see long term incentives paid out with shares purchased on-market. We think this gives the best alignment with shareholders”, he said.

The Association was less enthusiastic about the $750,000 retention payment also announced by AIA. Hawkins said “although we note that performance hurdles are built into this payment, we have told AIA that we do not expect to see a similar deal in the future”.

Succession planning was very important and companies risked being held to ransom by senior executives if they did not give this sufficient priority. Research has clearly demonstrated that with few exceptions, internal promotion achieved the best results, and this is the succession path the NZSA would like to see most companies following.

If retention schemes were to become common, Hawkins said the Shareholders Association would be pushing for a New Zealand version of the recently introduced two strikes rule which forces all directors to resign if sufficient shareholders reject two remuneration reports.

PGG Wrightson (PGW) is proposing to sell its finance arm (PGF) to Heartlands Building Society. The move is not surprising because the new Singaporean cornerstone shareholder signalled this possibility when it made a partial takeover offer for the shares.

Information provided by the company advised shareholders that informal discussions with potential buyers indicated the price offered by Heartlands is as high as can be expected. We also note that Messrs Gould (MD of PGW, but former MD of Pyne Gould Corporation) and Irvine (Director of both Pyne Gould and PGW) are standing aside from the voting as they are pretty obviously conflicted. Never-the-less, they must be rubbing their hands at the prospect of Heartlands capturing this finance house whose lending is so strong in the Canterbury and South Island region.

The price will be based on net asset value. No good will is being paid. That seems extraordinary when PGW are transferring a loan book of $491million with all the doubtful liabilities removed.

Eighteen really suspect loans totalling $90 million will remain with PGW. They will also guarantee a further eight loans totalling some $30 million.

The transfer includes various funding lines – bonds $94million, debentures $265million, deposits $59 million and bank facilities $100 million. Are these really worth nothing? PGW is giving up a performing loans portfolio, a current net profit of $2.5 million, and retaining a group of low quality loans for a cash payment of only $7.5 million. PGW is even committing to take $10million of shares in Heartland. Looking at the recent record and results, that might be the only good investment the PGW board has made in quite some time.

PGW is effectively selling a complete business, albeit one in the doldrums, on a Price Earnings ratio of 3, when the market is according the shares a P/E of 28. These Directors are men with little faith in their own ability.  PGF has consistently produced over $5.5million after tax over the past five years. That Northington and Partners should find this arrangement fair to shareholders in PGW is beyond belief. Of course, if you hold shares in PGC and Heartland as Mr Gould and Irvine do, you would probably be feeling pretty conflicted but happy.

This is another related party transaction of the type which has almost knee-capped our leading rural servicing business over the past five years. At a time when New Zealand is experiencing record high farm prices, the leading rural supplier is in trouble. It can only be bad governance.

Alan Best

NZSA Director

Many of you would have read the article in the NZ Herald on the 30^th April showing the latest 12 months CEO pay survey. The Herald claimed that average CEO pay increased by 14% compared to the average for all workers of only 1.7%. There were some problems with this table. The Herald figures were often not comparable due to unusual one off items and there was no attempt to relate the payments to the year in which they were earned. The dramatic variation from +194% to -80% in the earnings relative to the previous year tended to obscure the more modest rises gained by the majority.

Perhaps the real value of this survey is the way it highlights great variations in pay policies between individual companies. In many cases the rewards seem entirely unrelated to performance. The Shareholders Association has been grilling some directors about their remuneration policies and will continue to do so where there is a lack of alignment with shareholder returns.

However, despite any shortcomings in the Herald survey, there is no doubt CEO and directors pay has increased at a much faster pace over the last few years relative to shareholders returns. When the subject is raised with the consultants who work in this area, they claim our CEO’s and directors are under paid compared to those overseas. Yet you never see them accept the same argument when it comes to the average worker’s pay. Other points they over look are cost of living differences, house prices, school fees, life style etc. compared to overseas domiciled CEO’s. As an example playing golf, going sailing and to the beach is so much easier in NZ, Try and do these things in most overseas cities.

We should not be surprised. . Remuneration consultants are hopelessly conflicted as they are often providing information to the very people who pay them and will ultimately benefit from the “advice”. In addition, their research is often so shallow and lacking in rigorous analysis it is laughable. The real pity is that each time a board accepts these ever higher “recommendations” they unwittingly set a pay level which becomes the new norm.  This ratcheting of expectations has been a significant factor, aided and abetted by boards that seem to have forgotten how to say “no”.

As well as paying over the odds, some companies spend a fortune recruiting a hot shot CEO from outside, but new research suggest they could be wasting their money.

The study by consultants A T Kearney and the Kelley School of Business at Indiana University discovered that outside appointees have a significant higher failure rate and a shorter tenure than those promoted from within. According to Paul Laudicina, Chairman and managing partner of A T Kearney: “Recruiting at the top is far more likely to be costly and disruptive than seeding succession from within”.

The report’s authors studied non-financial companies in the S&P 500 index between 1988 and 2007. They indentified 36 that routinely promoted chief executives from within their own ranks. These outperformed the others in the index across seven metrics. The research also found the medial compensation, including salary, bonus and equity incentive, for external CEO was 65% higher than the great majority of those promoted internally. Yet 40% of outside CEO’s lasted two years or less, whilst almost two thirds were gone by their fourth year. Locally, we only need to see what happened at The Warehouse.

The study suggests that coming from outside gives external chiefs a feeling that they have a “mandate for change” and the freedom to assert their will on the company almost immediately. Frequently, this leads them to make changes before they fully understand the company, its culture and its most valuable asset – its people. Their arrival is often quickly followed by the departure of other senior management members- and the results are not always positive. Not only does the company frequently lose high performers, but they often end up working for competitors which increases the pressure on the original business. One could relate this to Telecom.

The only thing outsiders seem consistently good at is rapid cost-cutting and divestment. But over time those opportunities dry up.

This is why the NZSA have been telling company boards they should take a more pro-active approach to succession planning and rely less on importing outside talent. It seems to us that this is one area of risk management that needs a serious re-think, especially at some of our larger companies.

Des Hunt

NZSA Director

Once again we have seen what was once a very good company fall on bad times. Questions have to be asked about how this has been allowed to occur.

Did it have the right leadership at the top? Was the previous chairman Keith Smith qualified and experienced to lead a rural company? What risk management was in place to avoid the mistakes made with the New Zealand Farming Systems Uruguay investment? How could the directors and senior management get things so wrong in an industry where New Zealand is a recognised world leader? 

Then there was the failed acquisition of Silver Fern Farms.  Many more questions need to be answered about why this offer was made without having final confirmation that finance would be available when it went unconditional. Once again, where was the risk management in this transaction? A major concern is that these transactions were going on while the company already had a high level of debt. Its operating results were not too bad, but the cash was squandered by the directors.

Many things do not add up and those responsible who still remain should consider stepping aside when a heartland company like this slips downhill.

Of course, these problems have occasioned massive changes at the top of the company. Keith Smith was replaced as Chair by Sir John Anderson. Craig Norgate and Baird McConnon resigned. George Gould (the former MD of Pyne Gould replaced Sam Maling, who also resigned,) and has now been appointed as Managing Director. Presumably this is a stand-in position until the outcome of the sales process is known. Tim Miles resigned as soon as the restructure of the two divisions, Seeds and Rural Services, was announced. Before him, the General manger of transformation, Jason Dale left, causing the immediate secondment of a PWC partner to assist. The new directors from Agria, Xi Tai and Alan Lai have barely got their feet under the table when they have launched an insiders’ bid.

Further, they have declared an interest in disposing of the Finance company which has only just appointed its independent directors, Mike Allen and Noel Bates. It is interesting to note that seasonal finance is fundamental to farm servicing. The finance company is performing reasonably well and currently holds a government guarantee. When Wrightson sold finance to Rabobank on a previous occasion, they had to work hard to reconstruct the activity because their farm servicing business could not provide a complete package without it.

We have serious doubts about whether a change of ownership will benefit the company. When selling a 51% share to just one party, surely there is a risk the other 49% are going to be in a disadvantaged position in the longer term. This is especially worrying when very little detail is being given to shareholders during the negotiating period. What faith can they have in a board of directors making such a recommendation? Those who thought there was some kind of boardroom power play in action which would extract a better price will have been sorely disappointed with the announcement this week that the only other interested party has withdrawn from the bidding process. This makes the assessment of the Agria bid all the more important.

Reading between the lines Messrs Smith, Anderson, and Thomas are equivocal about the transaction, and so are the independent advisors Grant Samuel. Both Fran O`Sullivan and Brian Gaynor have raised some very  important issues regarding this proposal which shareholders and other interested parties should read before it goes any further.

We are selling some valuable agricultural intellectual property in this company. Do we want this to go overseas?  We could lose a prime asset – an asset developed partly with taxpayer “Primary Growth Partnership” funding, which still has potential on the world scene.

We have been told by three of the directors that Agria will refocus on the core business. We would have thought that if the directors had focussed on the core business and had an active risk management policy in place from day one, the company would not be in the position it is to-day.

In summary, we agree with a number of commentators that this is a key New Zealand asset that should stay under New Zealand control. Surely we have the resources, experience and skill to run an agricultural company like PGG Wrightson? Or is this another case where the old boy club of directors has failed to foster the new breed of young entrepreneurs who can manage with both vision and prudence? Selling a 51% share right now surely can not be the best option for all shareholders.

Des Hunt and Alan Best

NZSA Directors

 At first glance, international ratings agency Moody’s Investors Service announcement it may cut the credit ratings of the four major Australasian banks appears a heavy blow.

Ratings downgrades usually raise banks’ borrowing costs and lead to their customers having to pay more for their loans.

However, if Moody’s does downgrade – and putting organisations on negative watch suggests only a 33% chance of a downgrade – it will only bring its ratings in line with those of rival ratings agency Standard & Poor’s.

Moody’s currently rates the four big Australian banks “Aa1” while S&P rates them “AA” with a stable outlook. S&P’s “AA” is the equivalent of Moody’s “Aa2” rating. The third major ratings agency Fitch’s ratings of the banks is in line with S&P’s.

Credit Suisse analysts says Moody’s is likely to either downgrade all four major banks or none of them.

“A downgrade is unlikely to affect earnings by more than 1%. While not a positive this is not a major setback for the banks,” they says.

Moody’s move is a response to the heavy dependence of the Australasian banks on wholesale funding – it calculates it averages 43% of total liabilities.

While the Australasian banks proved among the strongest during the global financial crisis (GFC), Moody’s says markets can tighten during times of uncertainty.

“The GFC has underlined the speed with which shifts in investor confidence can impact bank funding,” said Peter Winsbury, Moody’s senior vice president, in announcing the review.

However, the Australasian banks have been working on the problem for some time.

“Since the onset of the GFC in 2007 we have increased our stable funding by increasing customer deposits and long-term wholesale debt and reducing our use of short-term wholesale funding,” said Lyn Cobley, group treasurer at Commonwealth Bank of Australia which owns ASB Bank and which is the largest of the Australasian banks.

CBA has also significantly increased its holdings of liquid assets.

ANZ Bank’s group treasurer Rick Moscati said his bank understands the rationale for the review. ANZ/National Bank is New Zealand’s largest bank.

“We have also been working hard to reduce our reliance on wholesale funding which now accounts for about one-third of ANZ’s funding mix.” As well, short-dated offshore wholesale debt now accounts for less than 2% of ANZ’s funding requirements, Moscati said.

It seems whenever a rural services company becomes overly debt-burdened directors think the answer is to sell the finance arm.

That was what Wrightson did in 1997/98, only to turn around and start building a new finance book, the one PGG Wrightson’s cornerstone shareholder Agria is now proposing to sell and for the same reason as the first sale.

Across the Tasman, Elders decided on exactly the same strategy last October, selling its 40% stake in Rural Bank to Bendigo and Adelaide Bank, which already owned the rest of Rural Bank.

The A$176 million (NZ$231.2 million) proceeds represented about 1.2 times book value. That suggests PGG Wrightson Finance might fetch about $120 million, based on its December 31 accounts.

However, that includes the convertible rate notes issued to Agria late last year. They are treated as equity for accounting purposes but would have to be either refunded or converted to PGG Wrightson shares if PGG Wrightson Finance was sold.

That means the equity in the finance company is actually about $65 million. So perhaps PGG Wrightson might realise $78 million, if it’s lucky – given its relatively small size any multiple on book value would likely be less than 1.2 times.

In valuing all of PGG Wrightson’s equity between $400 million and $490 million, independent advisor Grant Samuel estimated the company’s net debt at $220 million so selling the finance company might get that down to about the $150 million level.

Peter Rae at Aegis Equities Research, which is owned by Morningstar, estimated Elders sale of its Rural Bank stake allowed it to cut net debt to A$275.1 million at September 30 on a pro forma basis, cutting net debt to equity to 27% from 43%.

Deutsche Bank analysts say Elders is now less likely to breach its debt covenants as a result of the sale.

Bendigo and Adelaide Bank managing director was clearly pleased with the deal: it provided his bank “with greater exposure to a well performing business with sound credit quality and strong returns.”

Similarly, PGG Wrightson Finance is a sound business, although it still had about $34 million in problem loans to highly indebted dairy farms at December 31 after writing off a further $5.7 million in the latest six months. After the write-off, net profit for the six months was $1.3 million, down from $3.3 million in the same six months a year earlier.

Elders is still able to offer its farmer customers financial services through a deal with Adelaide and Bendigo Bank. As Rural Bank managing director Paul Hutchinson said: “Nothing will change from an Elders’ customer perspective. They will still access Rural Bank products through their local Elders branch, just as they always have.”
The most likely buyer of PGG Wrightson Finance is Building Society is Building Society Holdings (BSH), which aspires to become the “heartland bank.” However, price might be a sticking point. The BSH merger of Marac, Canterbury Building Society and Southern Cross Building Society was done at book value.

Presumably, PGG Wrightson would strike a similar deal with BSH which is already planning to continue with the brand names of the various companies it is made up of.

BSH managing director Jeff Greenslade confirms his company “would certainly have an interest” if PPG Wrightson Finance were to be put up for sale but wouldn’t comment on what it might be worth.

The recent announcement by the Prime Minister that limited asset sales would occur if a National government is re-elected has resulted in hysterical and often factually inaccurate claims.  Balance is hard to come by, and we risk people making a snap judgments based on populist propaganda.

 There is no doubt that many of the deals done in the late 1980’s were hasty, poorly thought out  and resulted in the robber barons of the day enriching themselves at the peoples expense. Understandably, many people are wary despite the very different process proposed.

 The NZSA Board has considered the matter and supports the concept of partial privatization. This is not a political statement, but is based on logic. It is interesting to explore the main concerns raised by opponents of the proposal.

• Asset sales will only benefit the rich.. There are currently 1.6 million people in KiwiSaver, mostly ordinary working people. Established infrastructure companies with decent yields appeal to KiwiSaver providers. So the reality is that directly or indirectly almost everyone will participate and benefit.
• It didn’t work before! Most of the previous sales were “trade sales”. They were not sold via the sharemarket to a broad range of owners. Did the government of the day really believe the Brierley Investments and Fay Richwhites of the world would suddenly change to stable long-term investors? What is now proposed is quite different, with a transparent sharemarket float and a significant degree of disclosure required.   
• The assets will end up owned by foreigners. This statement defies belief. The Takeovers Code requires a jump to a controlling stake once a 20% ownership threshold is reached. Just how this could be achieved if the government owns over 50% is not addressed by the critics. 
• Yes but they will sell the rest to their mates later! We believe this would not be an option politically under any scenario that is likely in the foreseeable future.
• Power prices will go through the roof. The market is already both competitive and highly regulated. Power prices are underpinned by the cost of providing new generation. The move towards “greener” energy involves considerably higher marginal costs because of higher capital expense and lower efficiency. Like it or not, electricity costs will continue to rise over time. This has nothing to do with ownership.
•  Government ownership is just as efficient. Ronald Reagan famously said “One way to make sure crime doesn’t pay would be to let the government run it.” Ports of Auckland, 100% owned by Auckland City have pursued growth regardless of return. The results are dismal.  Ports of Tauranga have a 55% local body ownership, but follow normal public company business disciplines resulting in far superior outcomes. In the NZ electricity sector, Contact Energy and Trustpower have consistently outperformed the SOE’s.
• But we already paid for it!  This ignores the fact that the government is gaining a cash asset in return. Perhaps the problem lies in the way successive governments have spent their cash?

Of course, to make the case, there must be net positives.

• The proposal will increase the options available on the share market. The increased pool will encourage KiwiSaver providers to invest more in NZ than they otherwise could. Strong capital markets ultimately matter more than who wins the World Rugby Cup!
• The Government is strapped for cash. This may be a self-inflicted problem, but still must be addressed. The amount raised if the sales proceed is modest, but it allows for a reduction in debt or the funding of other capital expenditure. It may only be a drop in the bucket, but that is one drop less for future generations to have to find. Whether to Include incentives for local purchasers (including KiwiSaver) to buy and retain shares is one question still to be addressed.
• This whole proposal is important as NZ Inc is pretty much at the limit of its ability to borrow – currently $300 million per week. We are in a very deep hole that no amount of wealth redistribution or increased taxation will solve. We can only progress through investing in genuine income producing assets and infrastructure.
• The NZSA believe the proposal will improve company performance.. Too many SOE directorships have been given as a political favour. A lack of accountability and/or political direction inevitably results in sub-optimal decision making. Air New Zealand is a good example of a partially privatised company in action. It is well managed, innovative, dynamic, customer centric and profitable. These are not terms usually associated with airline companies!  
• Over time we expect partially privatised companies should be able to raise their dividends which will offset the impact of government owning less of the asset.

You can be sure that the NZSA will watch and participate in the process on behalf of all individual investors.

John Hawkins

NZSA Chairman

(The full text of this abridged Scrip Newsletter article is available to current NZSA members at www.nzshareholders.co.nz. )

One thing PGG Wrightson shareholders should consider as they assess China-based Agria’s bid to gain control of the company is whether Agria’s intention to sell the finance company is the correct strategy.

It’s second time around for the company to be contemplating such a sale.

The first time, back in the 1997/98 financial year when it sold its finance business, then the jewel in the company crown, to Rabobank, the executives then in charge of the company were adamant the sale was vital to the company’s survival.

That was questionable.

By the early 2000s Wrightson was again building a new finance company – in August 2002, then chief financial officer Simon White described the finance offering as “an integral part of putting services together. It provides the glue that cements our business.”

That hasn’t changed. Last year, Wrightson was talking about its aspirations to “evolve from a ‘ticket-clipper to ‘trusted adviser’,” using its finance company to cement its relationships with farmers.

Even though its $550 million finance book accounts for just 1% of New Zealand’s rural lending, it counted its finance division as a key competitive advantage since the co-operatives against which it competes have limited access to finance.

It was already moving out of providing term loans for such things as dairy conversions to concentrate purely on providing seasonal finance and working capital.

Some analysts think selling the finance company, most likely to Building Society Holdings which aspires to become a “heartland” bank, but keeping its brand and Wrightson taking fees for acting as the middleman, is a sensible strategy.

Agria “are of the view that to actually own the book isn’t necessary but they still want to be able to offer finance,” says John Cairns at Forsyth Barr.

“They would say finance is core because it facilitates sales of goods and services in other parts of the group. It anchors the business,” Cairns says.

Another analyst argues the world has changed since the global financial crisis and continuing to own the finance company and dealing with all the funding issues is a headache Wrightson doesn’t need.

But PGG Wrightson Finance appears to be doing particularly well, despite what it calls “a challenging environment.”

Its net profit rose 14.1% to $8.9 million in the year ended June last year and details of how it fared through to December will be released next week when Wrightson issues its response to Agria’s bid.

Continued funding has been a headache for many finance companies but Wrightson Finance seems to be coping well. Its debenture reinvestment rate in the six months ended June was 82% – at its worst during the depths of the crisis it dropped as low as 65% for a single month.

While Wrightson Finance is among the select few still covered by a government guarantee, chief executive Mark Darrow says since October last year around 60% of its deposits – again they are mostly its farmer customers – was into non-guaranteed debentures. That suggests ongoing debenture funding shouldn’t be a problem.

In August last year, nearly 90% of its listed bond holders voted to extend their maturity by a year to October this year. The coupon rate is 8.25% but those bonds have traded between 6% and 8% over the last 12 months, suggesting bond holders are comfortable investing in the company.

Did New Zealand banks escape the worst of the global financial crisis (GFC) simply because the structure of our housing market is fundamentally different to the US?

Two key differences between New Zealand’s system and that of the US are:

1. Mortgages in the US are effectively non-recourse (legally, this only applies to a number of states but effectively it’s nation-wide. A Westpac paper published in 2009 noted in states where mortgages aren’t non-recourse it is “prohibitively expensive to chase borrowers for any discrepancy between the realised value of the house in a foreclosure versus the outstanding debt”). That means when a mortgage becomes worth more than the house, the owner can just hand their bank the keys and walk away. In New Zealand, if a home sells for less than the mortgage, the borrower still owes the bank the difference.

2. Mortgage interest is tax deductible for owner-occupiers in the US but isn’t in New Zealand.

Effectively, the US system encourages borrowers to be irresponsible. Because they are able to walk away if need be, US borrowers don’t need to worry so much whether they can afford a mortgage (remember those 100%-plus loan-to-valuation mortgages that became rife during the boom!).

And the tax break gives US home owners a big incentive to be mortgaged to the hilt.

In New Zealand, the incentives are all the other way, encouraging people to limit how much they borrow and to repay their mortgages as fast as they can.

The US system also encourages lenders to be irresponsible.

According to Westpac, securitisation, where a bank parcels up a number of mortgages and then sells pieces of them to third party investors, accounts for less than 1% of home loans in New Zealand but about 75% of US mortgages.

That means US banks don’t need to worry so much if they’re lending to people who can’t afford their mortgages because those mortgages will soon be off their balance sheets and somebody else, not the bank who writes the loan, feels the pain if things go bad.

“A much greater degree of securitisation meant that those issuing loans were often not those taking the repayment risk. There is direct evidence that this explicitly eased lending standards,” Westpac says

New Zealand (and Australian) banks, however, feel the pain directly when mortgages go bad.

The political desirability of encouraging home ownership was a key driver in shaping the US system. However, in the early 1990s about 74% of New Zealanders owned their own homes compared with about 64% of Americans, according to Westpac.

While the US ownership rate crept up over the last two decades, it peaked at about 69% and, as foreclosures mount, has been falling rapidly and is now probably below New Zealand’s rate of about 67%.