Chris Lee & Partners Ltd

TAKING STOCK 15 December

 

FOR many investors, the year of 2016 might seem to have been a little like ‘’the last of the summer wine’’.

The year has produced only a few individual investment disasters, as discussed later in this newsletter.  Most investors have enjoyed stable returns.  Equity investors have on average had single-figure capital gains, a figure well below the peak, but nevertheless positive and very satisfactory.

The wealthy have in many areas doubled their wealth in the past three years (including house prices).

After the first two months of the calendar year, when nerves drove markets lower, share prices recovered here and globally, our currency remained strong, property prices kept rising, dairy prices slowly recovered and many in our export sector, in areas like wine and fruit, had bumper years.

Any investor who had income returns exceeding bank rates and a little capital gain would be unrealistic if he regarded 2016 as a bad year.  In 2017 such a result will probably be seen as of gold star merit.

In general terms, tourism numbers and the tourism spend rose sharply, land prices in areas like Central Otago rose, farm incomes exceeded expectations, unemployment numbers fell, the gross national product figures grew, mortgage rates fell, immigration continued to grow, ever more New Zealanders travelled overseas, and Auckland house prices reached new heights.

Granted, the earthquake of November 14 was an awful shock, and a reminder about the random events that can ruin a good party.

But any report card on NZ’s headline progress would likely be favourable, and unlikely to focus on the hidden dirty secrets, like our river qualities, our dysfunctional families, our prison numbers and inequality.

The decision of our Prime Minister to retire probably reflects the views of the Taking Stock writer – we have had another comfortable year.  Thank heavens and let the politicians bask in the glow.  Or retire.

If John Key is as smart now as he must have been when he navigated his way in Merrill Lynch to multi-million dollar bonuses, he would know that the days of basking in relative comfort might not be everlasting. (He must have been smart in corporate politics, for that was his skill.  Analysis was never his field of endeavour, management was his impressive skill.)

By year end New Zealand faces a new world order, with the likes of Trump and Putin battling for primacy, Trump promising to undo global trade, Putin signalling his willingness to go to the brink to maintain Russian aspirations.

China has shadow banking problems that cannot disappear by decree, Britain is unlikely to be allowed to exit Europe in any orderly way, the European Union would dissolve if Italy, followed by France, voted to exit the EU, and meanwhile the pollution of the globe grows, despite sane accords to promise that pollution would reduce.

Currency wars, trade wars, civil wars, and international wars are all occurring, or threatened.

This will not surprise those who read the forecasts of these events, by European business leaders, in previous consecutive years.  (These were recorded in our client newsletters.)

All sane people will hope that compromise creates solutions but as I write, the likes of Trump offer little comfort.

It is clear to me that New Zealanders should be humming Fred Dagg’s refrain ‘’you don’t know how lucky you are’’ but now is not the time for full-throated singing.

The year of 2016 was a good year for investors, especially those who seek diversity in fixed interest, where there was a record number of new issues.

But every forecaster would see the same clouds appearing – banking problems, shortage of NZ savings leading to slightly higher long term interest rates and rationing of bank lending, disturbances in currency markets and inevitable trade disruptions.

In 2017 we have an election.  There might be value in placing a bet on Peters as the next PM, leading a coalition that could gain control if the biggest party in the coalition cedes leadership to the ageing opportunist, Peters, sipping his whiskey at the Last Chance Saloon.

Key’s resignation will not cause the government to be derailed now.  Indeed Bill English, from what I have observed, easily has the mind, values and style to find more aspirational solutions than any of his predecessors.

But in 2017 the dark clouds drifting down from other parts of the globe will change the mood of the country.  English will be tested.

New Zealand is not immune to the type of protest that is changing the global scene.

I expect some matters of concern to investors in New Zealand are inevitable.

1. Long term interest rates will rise a little.

2. Bank lending will tighten.

3. Corporates will offer more attractive instruments to obtain retail investor support, replacing what was previously cheap bank support.

4. The NZX will increasingly be debt rather than equity driven, as leading NZ companies seek to move their prime listings to Australia.

5. Companies which have sought investor support by dedicating their profits to the dividend pool, like banks, will begin to regard survival as a core strategy, rather than growth.  Yield stocks might lose value.  Dividends may not keep rising.  Some may fall.

6. Foreign capital might be harder to attract.

7. Investors in funds that track an index might find that this strategy works out okay only in times of rising confidence (and works very badly in average or poor years).

But I would expect our KiwiSaver industry to keep investing in New Zealand, underwriting liquidity for our NZX equity securities, and I expect immigration and tourism to be strengths of our economy at least in headline terms.  I do hope our KiwiSaver funds are governed by fund managers, not salesmen, without capital market training and experience.

I expect many of our leading companies will continue to enjoy growing profitability.

Last year at this time, I forecast in Taking Stock mayhem in world markets, believing that the disadvantaged would be heard in rising volume, and believing that the increasing selfishness would extinguish international accords, like the TPP.

Perhaps that forecast was more just an observation of what was happening and a display of what were lineal outcomes, rather than a guess.

For 2017, much of the western world can expect rising unemployment, rising mortgage rates, debt default, banking difficulties, regional currency and trade wars, but hopefully no act of madness from any lunatic leaders, of which there are now several.

The good news is that for most of us, life will go on.

We don’t know how lucky we are.  Fred Dagg was right.

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Winners in 2016

At year end the shareholders of Fletcher Building will have renewed hope that its bumbling record for wasting money on poor acquisitions is behind the company.

Its success in winning big ticket contracts will be judged on the margins achieved from the contracts, but Fletchers will also be enjoying its control of the South Island repair work, after the various earthquakes.  Its dominant position has never been adequately regulated, enabling FBU to exploit the privileges conferred on it by the Crown.  Shareholders will be pleased about this.

Auckland Airport, Port of Tauranga, Mainfreight and EBOS are four other companies to have satisfied their shareholders.

Auckland Airport is receiving record numbers of incoming tourists and a growing number of airlines wanting to deliver planes full of people.

Its infrastructure is stretched, its facilities improving but still in some areas rather basic.  It is exploiting its land bank and will one day resemble an international airport.

Port of Tauranga had a five-for-one share split during the year and has continued to grow despite variations in its log exports.

Cruise ships head that way in bigger numbers and it continues to benefit from its inland Auckland port.

Mainfreight has been an outstanding NZ company, as has EBOS for many years.

Fonterra and the dairy sector finish the year in good heart.  If Fonterra wants to lift its image in China I can think of one retiring politician it might want to engage.

The retirement village providers – Ryman, Summerset and Metlife – have all enjoyed rapidly rising profits, despite the worries of various analysts who query the reliance on rising house prices.

None have significant debt, all would have massive inflows of cash each year (from the exit ‘’taxes’’ when residents die) should they ever stop land banking and developing new villages.

The rest home provider, Arvida, is not comparable, it being predominately a price-taking care provider, though it aspires to develop its sites to pick up some real estate margin.

Synlait has grown significantly, its revenues and profits rising impressively.  It now plans a new North Island plant, following, one assumes, agreements to obtain milk.  Its link to A2 Milk, whose unique product Synlait supplies, has given Synlait growth in another area.

The power generators/retailers have mostly achieved high share prices by paying out all of their nett cash flow as dividends, knowing that the yield and relative certainty of revenues make them attractive to income investors.

They have had little need for capital expenditure, there being little growth in demand.  Contact Energy has used surpluses to rebuild its balance sheet and should now be able to increase normal dividends.  Trustpower’s split into two clearly suited its shareholder, Infratil. I am unaware of a benefit to shareholders that offsets the costs of the restructure.

Heartland Bank has had another year of progress, its profits and dividends (and share price) rising.  Its impressive growth to date may not be an annual event but it now has some scale and would clearly benefit from buying UDC Finance.  It raised $20m with a share placement this week and will raise $10m more in January from HBL’s retail shareholders.  Clearly it will continue to grow.

It seems obvious that Turners has now a strong position to exploit its holding in Motor Trade Finance, and may have discouraged Heartland’s interest in MTF.

Home equity release loans grew for HBL in the year.  This product may be seen as a new version of a pension for many whose homes have risen sharply in value.  Indeed we often hear of people who have a monthly payment from their house, more or less paid for by the growing value of the home.

HBL will be proud to have been nominated as ‘Best Specialist Lender’ in the Australian Lending Awards.

Takeover targets Airworks and Hellabys offer differing problems.

The Hellabys offer, now lifted to $3.60, is perhaps realistic now, but the Airworks offer from an unknown and apparently irrelevant Chinese bidder would leave shareholders with some cash but remaining shares in a company with no apparent skill in doing what Airworks has done so well, combining use of its maintenance and refurbishment work, with entrepreneurial success based on specific industry knowledge.  Shareholders will hope that the entrepreneurial existing management stay on for some years.

The investors who remember John Burns from the 1980s, or indeed Girvan, Chase/Farmers or James Smith, will shudder, wondering if a new controlling shareholder will align the interests of all parties.

I have offered all my Airworks shares to the Chinese and will quit the residual number when I know how many were not taken by them.  They want 75% of AWK.

The listed property trusts have all made progress, rewarded for reducing debt in earlier years, and now enjoying longer leases as well as low bank debt costs, and in some cases the low cost of long-term fixed rate retail funding.  Those who did not exploit this funding opportunity may wonder why.

The energetic young men running Augusta have wanted to shake up the National Property Trust, chaired by the highly experienced old timer John Anderson, who has witnessed many corporate activities in the 50 years he has had in the investment world.

Augusta wants to manage NPT’s portfolio and wants NPT to borrow and issue equity to buy more property, effectively gaining more scale.

NPT has three similar propositions and apparently may favour a proposal to link to Kiwi Property Group.  This may lead to NPT shareholder warfare, as Augusta (9%) has allies in two other major shareholders, including fund manager Salt and apparently, together, hold close to a majority of NPT’s shares.

In general property trusts/companies lose a little nett profit when interest rates rise but all of the listed entities are so well funded their dividends look robust, even if rates rise a little.

The highest-yielding LPT is the once-ugly Argosy, which grew out of the toxic Hodges/Waltus era, then Urbus, then merged with ING, finally renamed Argosy.

Rid of some ugly legacies, Argosy is now well-run and is a genuine option for LPT investors, along with Goodman, Kiwi, Property for Industry, Vital, Precinct and Stride, itself with legacy issues from its connections to the putrid Money Managers people.

From a stand-alone viewpoint, the NZX offerings look credible, the NZX itself being a genuine option for income investors, despite the loss of its outstanding mature leader Tim Bennett, who had to handle the expensive mistakes of his predecessor, Weldon.

Bennett has retired, leaving this month.  If his successor is Mark Peterson (who is acting CEO), the NZX would have as a new leader an experienced, decent man, of quiet but determined disposition.

Peterson might oversee our exchange losing some scale, as increasing numbers of companies dual list, and perhaps head for prime listing in Australia but his role might enjoy a rapid expansion of the NZDX, the debt market and the funds management division.

New Zealand raises corporate debt from retail instruments rather more expertly than does Australia, where debt is seen as a poor cousin of equity.

The NZX will want to see some of our newer companies, perhaps like Hydroworks, grow into scalable businesses, and mature into iconic businesses.  Hamilton Jet would be an example of an inspiring business.

Failures and Disappointments

No one would be surprised by the collapse of Pumpkin Patch.

Its future was in doubt from the time its inexperienced and young chairman and directors decided to head to the USA and Europe ten years ago, opening dozens of outlets, and borrowing large sums to do so.

It lost tens of millions of borrowed money, having earlier had absurdly, childishly excessive, dividend policies.  Its governance determined its fate.

Those who succeeded the Greg Muir era have not been able to find sales successes that put right the outcome of the earlier errors.  Pumpkin Patch was doomed long before it collapsed, in my view.

Wynyard was a more disappointing failure as it appeared to have a chance of success, with its clever software used in security and crime solving.

Indeed as late as July 2016, Forsyth Barr had a neutral recommendation at 65c, and a target price of $1.23, according to a promotional newsletter FB produces.

Wynyard had wanted FB to arrange a rights issue earlier in the year, and at one stage wanted to raise capital at a price exceeding $2.00.

Ultimately they were persuaded to discount that price and raised money that Wynyard thought would meet working capital needs for two years.

Clearly the Wynyard people thought two Middle East contracts would convert to cash imminently.

The Middle East emirs never did produce a cheque book so the development work behind those contracts, costing tens of millions, were incinerated and the company was destroyed.

The slump in value of Veritas was signalled almost from its day of (backdoor) listing.  Veritas made various Mad Butcher owners rich with its purchase of the franchise but there never was any realistic hope that franchised meat packaging outlets would gain in market share, in my view.

It will do well to survive but even in that event its original listing price would seem to have been somewhere near Mars.

Intueri was also a huge loser and in my view is also likely to fail.  It is paid fees by a Crown education funder and was expected to grow in Australia and New Zealand.

In Australia it now may face huge repayment of fees that were wrongly paid following investigations that found that ‘’students’’ were actually immigrants more interested in citizenship and access to social services, than in higher education.

There is a strong suspicion that the same outcome might occur here.

On a different scale well beyond the threat of failure but still disappointing were Orion Healthcare and ERoad, both of which are dominant companies in New Zealand with their innovative software.

Orion Healthcare is a world leader in analytics and a genuine player in healthcare technology, ERoad a supplier of GPS-related technology that calculates road tax, and other technology that reports on issues like maintenance and driver behaviour to truck owners.

Both companies have seen their share price slashed, as, like Xero, they spend all available cash flow chasing a bigger share of the American market.

In both cases these companies will see 2017 as a crucial year, a time when sales momentum must increase.  In 2017, I suspect we will need every ‘’Trev’’ to ‘’get in behind’’.

Office News

We close our offices on Friday, December 16, until Monday, January 9.  In my case, this break is welcome.  Peter Jones in 1956 adequately described my current energy levels!

Penelope, Tania, Sue, Giovanna, Sonja, Brian, David, Kevin, Edward, Michael and I wish all our clients and readers a memorable, healthy and happy festive season, Happy Xmas, and hope that 2017 is a peaceful year with ample good fortune and good fun.

Chris Lee

Managing Director

Chris Lee & Partners Limited

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TAKING STOCK 8 DECEMBER 2016

 

ALL of our discussions on the banking sector, here in Taking Stock, in Michael Warrington’s Market News, and in Kevin Gloag’s research pieces, should by now have prepared investors for a new chapter in their relationships with their banks.

They should soon discover in New Zealand and Australia that:

- Banks badly need long-term deposits from retail investors and will recognise this by paying more for 2-5 year deposits.

- Banks are likely to lend less to those who are borrowing to buy houses, farms or businesses.

- Banks will lend less to established businesses, withdrawing rarely-used committed facilities to companies.

- Banks will pay out in dividends a lower percentage of profits.

- Banks will have higher write-offs, leading to lower profits and, as shown above, lower percentages of the lower profits as dividends.

- Italy might be the epicentre of more banking earthquakes.

Taking each item separately, I anticipate that to maintain their core funding ratios, the banks must raise more money from New Zealanders or issue more bonds internationally for longer terms.

In essence the banks will need to compete with all other options for savers and investors by offering better rates.

I can imagine a bank offering just 1% for a 30-day deposit but perhaps nearer 4.5%-5% for a two-year deposit.

Inevitably, housing lending will have tougher criteria and higher interest rates, to slow down demand.

When my wife and I bought our first home just on 40 years ago, we could borrow on first mortgage two thirds of the value of the house, providing the implied repayment per year was less than 30% of my take-home pay.

Those sort of ratios might return.  Housing prices might stabilise or fall a little.

Today banks must provide capital for every dollar of committed (even unused) loan facilities to corporates.

If they have a facility in place to a big company which is not currently using that facility, the banks would have charged fees, taken the fees to profit, and calculated the capital requirements of the future lending.

Right now banks will be reducing or cancelling some or all of such facilities (will they rebate the original fee?  Just kidding), enabling them to shrink their commitments, effectively reducing their capital obligations.

Bank dividends will perhaps soon be reduced to say 40-60 per cent of tax paid profits.

If a bank makes $8 billion, and used to pay $6 billion in dividends, it might have found that its share price was a multiple of, say, 18 times the dividend, say $30 a share.

If it reduces its profit and dividend pool, because of write-offs from Australian property development lending, to say $4 billion, even if the multiple remains 18, the share price might drop to a figure much below $30, simply reflecting yield.

There will be differences in performance between the banks.  Heartland for example can probably retain or even slightly increase its current profitability and dividends because of its lower levels of lending in the problem areas, and because it does not need to shore up its capital.

Of course I do not signal that Australasian banks are vulnerable to destruction but I do see there might be a new era when banks are forced to adopt lower risk strategies to survive profitably.  They are collectively selling off assets they should never have bought.

I see that as great development.

It does bring into focus my harping criticism for decades about banks who set strategies to increase dividends and bonuses, rather than survive stylishly in more difficult years.

Many times I have written about the lunacy of buying back one’s own capital with unsustainable profits.  How many more times will banks have to issue new capital at much lower prices than those at which they bought their own shares back?

We are heading for an era of more modest dividends, more modest executive aspiration and, hopefully, for an era when bonuses are no longer necessary to attract and retain the sensible sort of executives I want to have in charge of my call accounts!

When bank executives are made redundant, and seek a new position in the sector, bonuses might not be on the agenda for discussion.

Of course none of this commentary takes account of the pachyderm in the pantry.

The potential Italian change of government might so dent confidence that the planned multi-billion recapitalisation of its bankrupt bank system becomes impossible.

Currently the Italian banks’ problem loans far exceed their total capital.

The Italian government cannot prop up the banks.  The EU rules prevent this.

If the market will not refinance the banks, and the government cannot remain within the EU while underwriting the banks, then the troubled Italians must decide on one of two options.

They either let the banks hit the dust, or they leave the EU.

Italy has 11% unemployment, no social welfare worthy of the description, and 35% youth unemployment.

Its sovereign debt is 130% of GDP.  Its total debt is closer to 300% of GDP.

It is the third largest economy in Europe, the 10th largest in the world.  It is in one almighty mess.

The Christmas Grinch might spend Xmas thinking about what Italy is doing to our digestive systems!

 _ _ _ _ _ _ _ _ _ _ _ _

ANY day soon we should hear from Mark Berry, the head of the Commerce Commission, on the CC’s verdict, after considering the country’s major newspaper groups’ case for a merger.

The CC’s initial response has been that if the two groups, Fairfax and NZME, merged there would be a virtual monopoly created, comparable to communist China.

In the vernacular, the editorial content of our newspapers would lose the ’’plurality’’ that should offer readers variety of opinion.

In favour of the merger is the voice that claims our newspapers would fail if forced to compete for advertising and readership.

In opposition to the merger is the idealistic claim that readers must have access to more than one view.  (Personally I have never put much energy into reading the political ideology of newspaper or television reporters/ editors.)

The Dominion, the Christchurch Press and the NZ Herald would become one paper if the merger were allowed.

Those in favour of the merger argue that the costs of a newspaper would exceed revenue, if competition were required.

Many have voiced their opinions, including old newspaper hacks, town drunks, current newspaper editors, eleven retired newspaper editors and various others.

Mark Berry is not without advice!  (He might feel like an All Black selector.)

To me the only issue is whether there is still today any sustainable audience for any daily newspaper, given the reality that very few people under 50 ever buy a newspaper.

They prefer to pick up news and views via their smart phones, iPads or computers.

They seem to have faith that the ‘’news’’ is factual, that views are balanced, and that all the important issues are covered by those who exploit the internet option to circulate the ‘’news’’.  They seem to believe in the reader forums that ‘’democratise’’ or lampoon the so-called ‘’news’’.

Perhaps young people believe that the internet news services are no worse than the newspapers.

To me, the interesting topic never discussed is whether there is any audience for a real newspaper, any talent to produce such a paper, and any advertising budget willing to support such a venture.

We ceased to have ‘’real’’ daily newspapers in New Zealand about eight years ago.

I think I know the tipping point.

It was probably when Jones sued the Sunday Star Times over an article which was enflamed by the incorrect inclusion of a photograph of Jones, alongside others who he naturally would resent as being comparable with him.

He argued the article and the accompanying photograph defamed him and sued for a huge sum - millions.

The SST and its legal team, after a quite short period of contemplation and research, decided not to contest his claim and settled out of court for a figure that was significant, unlike any previous defamation award, if media scuttlebutt is correct.

I think that from that day on, Fairfax, the owner of SST, altered its editorial instructions and ever since, it and its stable of papers have avoided controversy, avoided all but the most superficial coverage of business or capital market content . . . and discarded its right to be regarded as the Fourth Estate, a guardian of public standards.  There are journalists who still try, but they are the exception, and they have no access to funding to perform meaningful research.

I absolutely guarantee that the ratbags who rorted the investing public causing the non-bank lending collapse will re-emerge to do it again if the news media remains blind, deaf and dumb.

The media continues to engage uninsightful columnists whose content is fit, at best, for school curricula, rather than for adult consumption.  Just read the Saturday Dominion Post to understand my point.

The Sunday Times ‘’business’’ section now is run by a British woman, Jayne Atherton, whose knowledge of, and connection with, real business is similar to my connection to the practice of galaxy navigation, and whose connection with the New Zealand investment population, who require real news and analysis, is similarly non-existent.  (Investors are usually from the generation that would buy a useful newspaper.)

In my view she is the least impressive ‘’business’’ editor I have observed, though she may be a pleasant manager of staff and an obedient servant of her employer.

The daily newspapers also seem to have taken their lead from that allegedly huge settlement, reverting to the most pitifully bland and superficial coverage of any subject that was potentially awkward.

Sadly, this coincided with the demise of the business papers, The Independent, ruined by a gauche young editor, and the National Business Review, now a ‘’magazine’’ in the words of one of its few remaining skilled journalists.

The NBR, like the daily papers, focusses on ‘’clickbait’’, the insulting term assigned to describe the practice of assessing what the ‘’public’’ finds interesting by how many ‘’visits’’ the item gets.

The Sun in Britain would have made its unimpressive readers happy by having 60 ‘’Page Threes’’, had it pursued the ‘’clickbait’’ doctrine.

The NBR engages dreary, tired columnists, with the exception of Tim Hunter, a Scotsman still prepared to wade into controversy.  Ironically Hunter was the SST Business Editor at the time of the Jones defamation case.

In its printed form the NBR is to a business paper what Trump is to real business leadership.

The modern task facing the media and the NBR is how to earn revenue from its digital presentations.

An obvious solution would be to load up on gutsy, expert reporting and analysis, I would have thought.  Perhaps the practice of interviewing the business leaders might be part of that strategy.  Maybe we might then have access to knowledge.

Instead, the NBR closes down sections if they do not appeal to advertisers, and seeks to sell a ‘’news’’ service that cannot compete with Bloomberg, the NBR not having the budget to employ sufficient journalists, nor access to sufficient expertise to ensure the content is insightful.

It focusses on radio, where its audience does not seem obvious, and on an internet ‘’flash news’’ service, where the audience is also tiny, and insight is rarely obvious.

One wonders whether the man who vendor-financed the sale of the NBR is monitoring its nett revenues, needed to pay him out.

Columnists, some of whom are many years past the date when they were fresh and insightful, produce much of the content.  Views are not ‘’news’’.

So I believe the real argument – content - has been lost by default and that there now is no chance of any newspaper in New Zealand gaining a growing, sustainable audience, given the bland, irrelevant, lowest common denominator content.

The CC decision does not matter.  We are watching a corpse twitch.

By contrast National Radio still produces interesting journalism.

Perhaps it should print off its best documentaries and items, rather than force its audience to listen to podcasts.

Conventional wisdom says that newspaper advertisers go where there is an audience.

This is a different thought process from that which says that an audience is not achievable without revenue from advertising.

No one seems game to try to produce a real newspaper, with articles by curious, energetic journalists, with a background in the subjects on which they write.

Given how appallingly the likes of NZME, Fairfax and MediaWorks have been governed, it might be too late to imagine that there might be a new focus on content.

The dailies will live out their last days with front pages dominated by family tragedies and car accidents, and business pages devoted to minority group conferences sponsored by Ecoya, the maker of scented candles.

Dishonest, misleading and potentially disastrous behaviour by government and business leaders will remain hidden, other than on brave and probably unwise digital sites, accessible only to the handful who care.  Ratbags will get free access to investor pockets again.

The newspaper owners do not care, it seems.  There is no ink in their blood.

They have created their own future, irrespective of what Mark Berry and the Commerce Commission might dictate.

 _ _ _ _ _ _ _ _ _ _ _ _

THE market reaction to Orion Healthcare’s six-month result will have surprised some.  In essence Orion reported slow but steady progress, repeated its belief that it would be profitable in 2018, and confirmed its determination to achieve scale in the USA.

It burnt a little more cash than it had forecast, chasing growth in its aspirational analytics software, but it is in line to achieve revenue of $210m for the full year, and seems confident that figure will grow the following year.

If it stopped spending on analytics it could be cash flow positive but it prefers to spend, even if it must draw down on an unused debt facility to do it.

The market reacted almost as though Orion was the next Wynyard, slaughtering its share price, reducing its market capitalisation to a little more than its current gross revenue.

So how does Orion compare with Wynyard?

Orion has an extremely bright, ambitious and committed founder as its CEO, Ian McCrae, a maths supremo who is genial, has family values and obviously has a real business model, but who is at best ‘’homely’’ in terms of his capital market presentation skills.

He is in his early 50s, has five children, pays himself a sensibly modest salary (around $300,000 p.a), has no other wealth, and has not extracted a dollar by selling down his 51% controlling interest in the business.

He has attracted other clever people and is driven by the need to provide better health solutions at a cheaper price, largely by getting health sector participants to share data and solutions and by developing information technology that helps individuals behave in a way that does not cause expensive health problems.

For example an over-zealous fitness freak would get warnings from his wrist watch if he were pushing his body harder than his genetic reference points might approve.  A drunk might get a message to catch the bus home.

If in a few years Orion has increased its annual revenue to $350 million plus, the company’s value ought to reflect significant profits and dividends.

My guess is that it might reach those levels.

Wynyard’s CEO was paid $800,000 p.a, had virtually no financial interest in the company, but was optimistic that two Middle East countries would begin paying tens of millions per year for software that Wynyard had developed and was still improving, at great cost.

Wynyard had a little sustainable revenue, good staff, experienced directors and good intentions but it put itself in a position where its future required sales aspirations that converted to revenue.  That did not happen.

The company collapsed, unable to raise more capital, unable to justify debt usage.

The CEO will move on to another IT job, in all probability, and will probably not want to feature a Wynyard chapter should he ever write a book.

The shareholders, who at different times included some of the most media-acclaimed investment gurus in the country, have lost their money, and 200 or more people have lost their jobs.

The market reaction to Orion Healthcare, which does have significant recurring income, seems to me to suggest that there is little faith in Orion’s ability to execute its plans.

There is no set of scales that weighs the chances of its success.

I hold Orion shares and will retain faith that Ian McCrae will deliver some health solutions that the world needs but I absolutely understand that, less so than ever, there are no guarantees about global investment success in coming years.

I can confidently say that if Orion achieves what it seeks to achieve, its market value would be many, many times greater than the value currently ascribed to the company.  I guess time needs to pass.

 _ _ _ _ _ _ _ _ _ _ _ _

TRAVEL

 

Chris is in Auckland and the North Shore tomorrow and on Monday.

Edward is in Wellington next Tuesday.

Our travel programme then ends until January, as our office closes on Friday, December 16.

Accordingly the final Market News and Taking Stock for the year will appear next week, unless there is something that arises of critical importance.  (Don’t discount the possibility – the Italian banking sector might deliver catastrophic news).

Meanwhile, we wish all clients and readers a memorable and happy Xmas/New Year celebration.

Chris Lee

Managing Director

Chris Lee & Partners Ltd

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TAKING STOCK 1 December 2016

THE changing horizon for city office buildings and city dwellings, both here and in Australia, has been dramatic.

Several weeks ago, Taking Stock observed the extreme over-supply of new apartments to the Sydney, Melbourne and Brisbane markets.

Cranes were dominating the skyline as property developers sought to meet the apparently perpetual and almost insatiable demand for apartments created to meet the Chinese government and Australian housing rules, effectively forcing Chinese investors to buy new apartments only.

These rules encouraged developers to build tens of thousands of new apartments.  The Australian banks funded the developments, providing a buyer with a 10% or 20% deposit had contracted to buy the finished product.

As I observed some weeks ago, many Chinese buyers were speculators, not investors, with a plan to sell the apartment on completion and with no intention of living in the apartment or finding a tenant!

The absurd result is that Melbourne has built 10 years’ supply for real demand, so that the market will be distorted, swamped with unwanted apartments, no bank willing to extend the development loan or convert into a mortgage loan for long-term repayment by the Chinese buyers.  (Indeed banks are fairly busy in downsizing their lending, though that is another story unlikely to be discussed yet by banks.)

In the past 12 months, Sydney apartment prices fell by 9.1% while Melbourne CBD units fell in value by 8.4%.

Both these falls have occurred before the massive over-supply becomes available. 

The Australian newspaper cites a recent one-bedroom Melbourne apartment as selling at $161,000, the vendor taking a loss of close to $400,000.  He must have been a motivated seller!

How will banks cope with this?

I calculated that the tens of thousands of surplus apartments being built across Sydney, Melbourne, Brisbane and Perth will result in forced sales, empty buildings and bank losses of perhaps $10-15 billion over the next two years.  My figure assumes 30,000 apartments worth $50,000 less than cost.  Others have gloomier imaginations.

Without those write-offs, the main Australian banks might have collected profits of perhaps $60 billion, over two years.

You must expect dividends to be cut, and as Basel IV arrives with tighter decrees about banking gearing, you would expect banks to then raise more capital, perhaps while they are still allowed, with hybrid securities (Tier I and Tier II).  The alternative to raising more capital is to downsize.

There is a mess to address in Australia’s main cities, as so often happens when greed overwhelms developers and growth-chasing (and bonus-chasing) bankers.

While Australia faces in its apartment market a ridiculous over-supply problem, Auckland continues to face an under-supply.  Prices in Auckland are rising!

Even retirement village apartments of modest size now sell for more than $1 million, affordable because the retired occupant of the new apartment has just sold a suburban home for rather more than a million.

In Wellington, supply also is less than demand.  The new Erskine 96 townhouse and apartment development in Island Bay is predicted to sell quickly.  Twenty four of the 96 planned dwellings sold on the first day, 31 within five days.

Inner-city Wellington apartment blocks are essentially full and may be over-full after the massive earthquake left dozens of apartment dwellers peering at a red sticker, and needing a new residence.  These refugees also include some retired folk from the Ryman’s building in Johnsonville.

But the dramatic change in Wellington is the demand for high-cost, central business district office space, the earthquake damage having created a new demand.

Just a month ago, we observed many Wellington property owners and brokers scuttling around tenants promising freebies, like free gymnasium access, in an attempt to keep tenants from moving to the significant surplus of good quality office space in desirable locations.

About 90 seconds of seismic activity has changed all of that.  There are now buildings that are red-stickered, there are buildings like the BNZ building on the CentrePort land that many staff do not want to re-enter, and the Statistics building may yet be red-stickered.

As a result, many thousands of public service office dwellers, all requiring 6.95 square metres of office space (as dictated by the Crown) are competing for what was previously excess space.

Quality premises that have not been structurally damaged by the November 14 earthquake are now being sought, the landlords in the extraordinary and unpredicted position of being able to select applicants for the unused floors.

Tenants wanting a three-month temporary area will be required to sign 12 or even 24-month agreements.  Previously empty space is now being let at $300 per square metre.

The best buildings, ironically, will have gone UP in value as blue chip tenants line up.

Company directors employing staff will know that the new Health and Safety regulations require directors to prioritise staff safety, and to supply facilities that are ‘’fit for purpose’’.

A building that reacted badly to the huge quake might no longer meet ‘’fit for purpose’’ standards.

So we have the extraordinary situation today of landlords being in the box seat, whereas just three weeks ago you had dire predictions that banks would be forced to further reduce the amount of lending they would perform in the sector, because of the excess supply.

My guess is that banks might still take a dark look at lending in Wellington and those who seek to borrow 60-65% of the value of their buildings there may soon find out whose umbrellas are available when the skies darken.

The Tasman Sea is the definition of a big divide, in the apartment building market.

In Melbourne, 18,000 new apartments will be completed within 18 months, whereas normal demand for new apartments in that period would be for 2000 new apartments.

The imbalance is certain to affect prices, perhaps by far more than the 8.4% that apartment prices fell in Melbourne last year.

In Wellington, post-earthquake, demand for new apartments is much greater than supply, leading to high rentals and 100% occupancy rates, though I do wonder if the top storeys will always attract the greatest price.  (Might low-rise, wooden buildings come back into vogue?)

Wellington is building a small number of new apartment blocks, some of which look to be cheap and little better than the disastrous Soho block in Taranaki Street, where resale values are well below original cost.

Prices will also reflect earthquake ratings.

The evacuated Tennyson apartments had an earthquake code rating of little more than 30%.  Its residents will have voted in the past to accept that rating, rather than spend to increase the compliance rating.

There will be many such buildings that have to be repaired or even demolished.

One imagines that the new buildings will be priced more on the compliance percentage than on the amount of sun they receive, or the thickness of the carpet!

Those whose apartments have suffered no structural damage ought not to be too smug.

As I have often said, the past is not a definite portent of the future!  I have yet to hear of any building that was strengthened by a large earthquake.

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THE chances of an American academic and a New Zealand market participant agreeing on what is wrong with American, indeed global, banking culture would be low, but the US author and academic Anat Admati may have narrowed the gap.

Admati was in Wellington last week, strongly advocating change in banking regulations and culture.

She points out that slack regulation, probably the result of the Washington banking lobby, has bred greedy bankers and a highly fallible model based on leverage and risk taking that are not sustainable.

She argues that while regulations might define the desired behaviour, the real problem is the greed and lack of integrity of global bankers, who find ways around regulations.

She and I are in accord!

She will have watched the ugly greed of Merrill Lynch executives who requested a bailout in 2008 and simultaneously paid themselves $2 billion in bonuses.

She will have watched the crassness of the Lehman Bros bankers, whose arrogance and breathtaking greed knew no boundaries.

She will have watched Goldman Sachs infiltrating the US regulators and power bloc, then using their new authority to feather the nests of the modern-day ugly face of capitalistic excesses.

If you want to change the American and global banking scene (and to be fair, Britain is as rotten as America), you need to align risk and return.

If you allow bankers to pursue any serious return, let alone extreme returns (including personal bonuses), then there must be an inflexible risk that jail, confiscation of family assets and expulsion from the sector will follow inevitably any serious breach of law, protocol or morality.

In New Zealand we have seen at least once a front-runner – thief in my lexicon - be fired from one organisation yet carry on to multi-million rewards in another.

We have seen people who have ripped the heart out of small investors with greedy, self-focussed corporate behaviour (think St Laurence, Strategic, Hanover, Bridgecorp, Lombard, Nathans, Money Managers etc.) go unpunished, allowed to carry on some years later as though they were suitable people to have control of other people’s money.

So it is not just America, Britain and the likes.

At least you can say that China, in some cases, has ensured risk accompanies the pursuit of high returns.

Anyone in China whose bankruptcies have occurred several times, and stripped creditors and investors of billions, would not be free to promote himself as a ‘’successful’’ businessman, suitable for public office.  Indeed, many such cheats just ‘’disappear’’.

In China, an engineer who messed up some signalling on a railway line, leading to a fatal smash, was shot dead in public.

That sort of ‘’risk’’ might concentrate the mind!

Heaven help a banker who helped himself.

What Admati said resonated with me.

You must get the right people into leadership roles and you must expunge the culture of greed and self-service that describes investors as ‘’flies’’ or seeks excessive reward while imperilling other people’s money.

Leopards can be cloaked in smart uniforms but they do not lose their spots.  To change the culture, you absolutely must change the chief executive.

The biggest single failure in capital markets or banking has been to identify correctly those people who are not ‘’fit and proper’’ people to hold leadership roles.

Leaders do not need laws to define a suitable culture.

They need morality.  Front-runners have already displayed their pathetic weakness.

There were many great leaders in New Zealand long before we ever started creating laws around insider trading, front-running, client first behaviour etc.

But we have all observed little Wallies, Liz, Megs and the likes chasing triple commission to sell things they did not understand, and worse, made no effort to understand.

If I were to ask a dozen real leaders in capital markets, of roughly my own vintage, they would name to a man those who are weak, greedy, selfish, exploitative and totally unfit and improper people yet retain leadership roles.

How come the ‘’fit and proper’’ conditions are so readily ignored?

Do we really need laws to define fairness?

Admati, I think is exactly right.

Change the people, monitor closely behaviour, and deal to those who do not have a real spine.

Admati has written an academic book on banking, with a German co-author Martin Hellwig, with the typically academic title: ‘’The Bankers’ New Clothes – What’s Wrong with Banking and What To Do About It.’’

I will read it over Christmas.  I expect it might also address the subject of gearing.  (Imagine if banks could accept deposits equal in quantum only to their paid capital!  That would very quickly sort out the housing price problem.)

_ _ _ _ _ _ _ _ _ _ _

SOUTHERN Cross Finance has announced a P2P platform enabling people to lend directly to others, with a mortgage security over property.

I guess the market for borrowers will be those who are not able to access bank mortgages, perhaps because they are unemployed, self-employed, have only the smallest of deposits, or perhaps because their need is for bridging finance only.

I will not be looking to lend on those platforms and I do hope Southern Cross Finance changes its name to Southern Cross Mortgages.

If it does not, its initials, SCF, may create the same sort of noise that fingernails do, when scratched across a blackboard.

In fact I would recommend Southern Cross change its name to something like Boiled Eggs Ltd or Sawdust Gravy Ltd to disassociate itself from the disgraceful behaviour of a company called Southern Cross in the 1980s and 90s.

That company, hopefully unrelated in ownership to the current P2P lender, used to lend money on one-year interest-only mortgages to help cheap building companies sell houses. 

It would lend at low rates tiny or nil deposits, for one year, but on the 366th day it would require repayment, or would move its interest rate to 24% or higher, under a penalty provision.

Many a struggling couple would find that after just one year they could not refinance their 100% mortgage with a mainstream lender and would struggle to meet each monthly repayment to Southern Cross, at the increased instalment level.

On any occasion they would miss a payment, an unlovable law firm had been granted fishing rights to send ugly, threatening letters to the terrified couple, charging, from memory, $300 as an ’’admin’’ cost for each letter.

The ‘’admin’’ fee would be added to the mortgage, thus attracting 24% interest.

I challenged the law firm and published details of the legal but ugly behaviour.  I was pleased when the practice died.

I recall an exchange of letters with the ugly Auckland law firm, which behaved unconscionably in my opinion.  I think they regarded me as mildly belligerent.  (Who me? – Ed)

One assumes the people behind Southern Cross are now of a different ilk but in case anyone else recalls that era, they might be wise to change their name now.

 _ _ _ _ _ _ _ _ _ _ _ _

IF Wellington Ltd was a listed public company today, the smart suits would be shorting its shares and preparing to buy back in a few weeks.

The huge Culverden and Seddon earthquakes created havoc in the South Island and have caused considerable damage to Wellington’s reclaimed land, damaging dozens of office buildings, some fatally, and damaging some apartment buildings, especially in areas not built on rock.

It has created real damage to Wellington’s port, which is the entry point for cruise ship tourists, inter-island travellers and plays a role in container shipping and particularly logging exports.

Cancellations of planned visits have been growing, hotel occupancy rates have changed, especially in the five-day stay area, where out-of-town commuting helps fill the rooms, and there have been many corporate leaders wrestling with the conflicting objectives of keeping the company operational, but meeting Health and Safety obligations.  Should they simply move to another city?

No one is helped by the wide-eyed talk of earthquake forecasters, where there are two schools of wild thoughts.

One set of soothsayers circulates the white-knuckle idea that the quake on November 14 opens a passage for more such powerful events.

The other equally unwise school has pupils claiming that the once-every-200-year event has passed, and our only task now is to ensure our great-great-grandchildren are prepared for the next event.

Earthquakes are random, according to the best science, like Lotto numbers.

I did know a fellow who twice won first prize at Lotto.  He died young, having proved the point about random events, but not living long enough to enjoy his luck.

It is undeniable that Wellington has suffered a huge blow, made the worse if the lack of an insurance cover at the Port is reality rather than urban myth.

One imagines one inevitable outcome is that insurance will rise in price.

The summary of the events to date that I most respect came from a property owner of several large buildings.

He said that if a 7.8 quake was going to rattle any NZ city, the best outcome was that it struck near Wellington, whose earthquake building codes were a least twice as demanding as any other NZ city.

A quake of that dimension would flatten Auckland, whose code was about 40% of the Wellington code.

To date buildings have done their job.  No lives were lost.

It is a sobering thought that no building on Planet Earth is strengthened by a 7.8 quake.

Wellington is indeed a great city, ranked in the top dozen of the world.

It will need a long period of restoration to get back to its best.  Its people will need some of the stoicism exhibited in Christchurch, which lost 187 people, 1290 commercial buildings and 30,000 houses in a quake of less severity but centred beside the city.

The spirit is there, in Wellington.

As noted above, 24 planned new townhouses in Erskine, Island Bay, sold on Day One of its sales drive (10 days after the quake).

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TRAVEL

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherstone St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington - by appointment please.

Edward plans to be in Blenheim on 5 December.

David Colman will be in Palmerston North and Wanganui on 7 December and New Plymouth on 8 December.

Chris will be in Auckland and Albany on Friday, 9 December and Monday, 12 December.

Investors wishing to make an appointment are welcome to contact us.  There is no charge for these meetings.

Chris Lee

Managing Director

Chris Lee & Partners Ltd

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