Chris Lee & Partners Ltd

Taking Stock 28 July 2022

Chris Lee writes:

WHEN Ian McCrae, the founder of the admirable technology company Orion Health, announced his retirement last week he became the second of New Zealand's most creative and admired technology developers to call it quits this year.

Of course the earlier exit was of Steven Newman whose clever ideas have led to the growth and successes of Eroad (ERD).

McCrae retired for health reasons, while Newman's retirement has never been successfully explained to the market, though I understand he had reached a stage where his range of skills were not exactly what ERoad now needed most.

His poorly explained departure spooked the market, leading to a dramatic slump in ERD's share price. The price had soared to $6.70 after the merger with its rival Coretex, and an over-subscribed rights issue and placement to help fund the transaction. All looked well, with two major banks committing to long term funding.

But his unsignalled (to the market) walk-out led to ERD's share price slumping to around $1.50, before a recovery in recent days to around $2.15.

I was amongst a few market participants to query the communication skills of the ERD board.

Newman, like McCrae, was devoted to his craft but never paid much homage to the capital markets or to investors, whose support and skills were needed to propel his work into a shape that might encourage others to fund Newman's aspirations.

His departure, it seems, signalled his acceptance that ERD was not a one-man show but had grown to be dependent on more mundane matters like product development, product delivery, sales, market development and, tediously, dependent on liaison with state and federal regulators, big fleet operators and, most boringly of all, transient local councillors and politicians.

Armed with clever, well-developed technology, ERD needs, to be blunt, to be a transparent, smart company able to keep ahead of its competitors by being nimble, a great communicator, and a pursuer of excellence. Most of all, it needs to monetise its excellence. It needs to sell!

Last week I met with its replacement chief executive, Mark Heine, at ERD's headquarters in Albany.

Its unpretentious premises are on the roof of a small shopping centre, alongside car parking areas. Its premises more closely resemble a factory than a glitzy corporate office, having wasted minimal capital on visuals. The board room featured a few chairs, a screen, a cookie jar and a coffee warmer. 

I could not help but contrast such parsimony with failed companies, like Murray Bolton's Maine Investments, which had a few shekels as capital but borrowed from the public around $100 million and used precious funds to buy millions of dollars-worth of art works and a corporate hospitality yacht, revealing a mindset hardly appropriate to a highly leveraged start-up.

Investors received back a few cents in the dollar after the leverage toppled the company.

Newman, with his technical skillset, is no marketer and appears to have no interest in glitz, clearly respecting that cash is precious, especially when the company is striving to achieve scale, nett profit, and the wherewithal to service debt and equity investors. I admire his priorities.

Heine, recently anointed as CEO, is a lawyer, having specialised at Bell Gully in technology and intellectual property.

It is reasonable to disclose that during my career I have rarely watched lawyers convert into leadership roles in governance or corporate leadership. Perhaps only politicians have been less successful in converting to these roles.

The law, like tax, audit, foreign exchange and even accounting, is a subset of most business activities and attracts people quite different from those who develop a broad understanding of risk/return analysis, strategy, product development, customer needs, financial management, market development, and human development. 

Many lawyers seem to have been indoctrinated at universities and large law firms into believing their specialist subject should prevail in every conversation, accordingly making only the rare transition to a successful chairman or CEO. Indeed I can think of many companies ruined by such a narrow perspective.

As a globe we might be much better off if more scientists, engineers and multi-skilled people drove the progress of our businesses and public service entities.

Of course, there are exceptions and Heine looks like being such an exception.

Aged 40, married, father of two youngsters, quietly spoken and both courteous and thoughtful, Heine seems to have a clear view on how ERD must gain momentum. His ego is not visible. He lives just down the road, on the North Shore. 

He accepts that ERD has fallen behind with its product delivery, lagging in the competitive race to introduce clever, efficient, cost-effective technology to its market.

His focus is on faster production and faster delivery, exploiting excellent technology, using what he describes as an outstanding, growing team of competent, experienced salespeople to achieve market penetration in the USA, and perhaps Australia, in pursuit of scale. He seems highly enthusiastic about the skills of his technical people.

He has a time budget of two years to increase revenues by a third.

Heine left his law career with no thought of becoming the ERD CEO but was well familiar with the company's dependence on the sort of expertise he had developed.

In the front foyer of the office, ERD keeps an electronic scoreboard, displaying progress in areas like sales, margins, client retention rates and the market shares in NZ (remarkably high), Australia (still beginning) and the most important of all, the USA, where the potential is obvious.

Elsewhere there is a map of the three countries, with tiny lights tracking every area with ERD technology in the vehicles. The USA's East Coast is better lit up than the West Coast.

Newman's clever ideas began with triangulating vehicle positions on public roads, enabling road user charges to be calculated perfectly, without human intervention, grew to providing maintenance reports on each vehicle and more recently, cleverest of all, grew into road safety, using technology to live track each driver and vehicle, drawing attention to driver fatigue or error before it resulted in a road accident.

The technology works. ERD technology does improve road safety. What is there not to like about that!

ERD's merger with Coretex led to the aggregating of complementary products and market knowledge.

Ultimately ERD's success depends on continued refinement of clever ideas, and sales, with very high retention rates, when short-term leases of the ERD black box expire. Current retention rates are an impressive 94%.

To reward investors it must pursue greater scale. Its two-year target would be an important milestone, if achieved.

Investors now should be pressing for detailed, quarterly reports, underlining the importance of ERD becoming excellent at communicating with its clients, capital markets and retail investors.

Disclosure: My family holds ERD shares. 

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SANTANA Minerals last week raised around ten million dollars to progress its gold exploration project in Bendigo, near Cromwell, in Central Otago.

The Sydney share broker Bell Potter supervised an institutional placement restricted to ''wholesale'' clients as it was not accompanied by the type of information document that can be used by retail investors.

Santana is not yet ready to raise money with rights issues, though that day may arrive, should the funding for a mine be sought. 

Bell Potter sought to raise about six million but received substantial over-subscriptions. Those in Australian mining markets who look to invest in such placements would have been watching Santana's remarkable drilling successes, knowing that the company would want to raise large sums to keep the drilling rigs working.

Each hole drilled descends deep into the innards of the earth, seeking the rock formations that have trapped gold in the distant hundreds or thousands of years. Each hole is drilled by independent contractors. One hole costs around a hundred thousand dollars to drill. Scores of holes have been drilled and hundreds more will follow.

The Australians would have read Santana's stock exchange releases, disclosing that in recent weeks Santana has encountered rock tens of metres deep that released on average high levels of gold, more than ten times the grade needed to make a margin. The potential investors would have known that drilling must continue and would thus have had a real reason to invest.

The wholesale investors clearly would be advantaged if for each million they put into the placement, they received shares discounted cheaply, rather than priced fully. Their incentive prior to the price setting for the placement was to undermine the share price, a relatively easy task given the low numbers of existing investors who would want to sell. On very small daily volumes the daily price fell by as much as half in the days leading up to the placement. 

Finally, when the money was needed Santana priced the placement at A$0.625 cents. The share had been S1.02 only a few weeks ago. 

The placement was well over-subscribed. Santana now has all the funds it needs for most of the next year. Those who provided the money have cheap shares.

All this was inevitable. It is a rule in life that he who has the money makes the rules. Santana will hope to slightly alter that rule one day to read that he who has the gold, makes the rules.

Santana now progresses flat out, expecting that its drilling will greatly increase the estimated resource that it has discovered.

The directors expect the current resource estimate of two million ounces will become a multiple of that figure. The directors are greatly enthused by the high grade of the gold, some ''hot spots'' referred to as a ''jewellery box'', the gold visible and, importantly, able to be extracted cheaply, with much less energy that would be the case, 90kms away at Macraes, for example.

Drilling holes every 100 metres produces an ''inferred'' result, the rock between holes ''inferred'' as being consistent, but if the next step of infill drilling, every 30 metres or so, validates the findings at the greater distances, then the status of the gold moves from inferred to ''indicated'', the data becoming around twice as valuable, as the information becomes more certain. 

The current estimated figure of two million ounces of inferred resource would have a present gold sale value of around $5.5 billion, slightly absorbed by the cost of the mine, which could easily be $200 million, and by production costs, yet to be calculated but clearly related to the apparently high grade of gold and the indicated cheaper cost of extracted gold from the rock. Taxes and royalties and depreciation eat further money but even at two million ounces such a rich grade of gold can produce fairly handy surpluses translating into investor satisfaction.

It would seem to be a mathematical improbability that the discovery stage has ended.

One wonders at what point the project will interest Ngai Tahu, which already has impressive gold royalties from West Coast projects far smaller than the likely project at Bendigo.

Ngai Tahu, observing the progress on private land in the Dundas Ranges, might be attracted by the investment outcomes but would also surely be impressed by the employment created by a potential mine that would employ hundreds of well-paid people, in a wide range of jobs. 

Meanwhile private contractors employ a dozen or two hardy people who work day and night, seven days a week, operating the drilling rigs, probably, right now, in freezing conditions.  

Investors, meanwhile, watch the progress, studying the drilling results which are published on the ASX Santana's website.

In a pretty depressing world, this project remains a potential source of light.

Disclosure: My family is a minority shareholder in the project. 

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Johnny Lee writes:

VULCAN Steel has announced its first major acquisition since listing, purchasing Ullrich Aluminium for $165m. The transaction will be funded from borrowings.

The share price rose sharply after the announcement was made.

The purchase – eight months after listing – is in line with its previously stated goals of acquiring scale through industry consolidation, as well as diversifying its product range and therefore revenue streams. Indeed, its prospectus specifically stated that aluminium products were a market of interest and one it would be pursuing as a growth opportunity.

For context, Vulcan stated in its prospectus that it employed 842 staff as of June 2021 – Ullrich employs over 600 staff across Australasia.

There appears to be a growing trend, both globally and indeed locally, where large players prefer growth through acquisition, securing staff and market share immediately rather than growing organically. Labour supply issues exacerbate this, as companies find themselves struggling to find the staff to fuel growth. The ANZ Bank's acquisition of Suncorp is one recent example of this, while the New Zealand funds management industry is also experiencing the same patterns.

For Vulcan investors, this acquisition will immediately add to its bottom line, although the true benefits may not be seen until economic conditions improve and the company is properly integrated into its overarching business.

Further acquisitions seem likely. When it first listed, Vulcan had already made something of a list of sectors it wished to enter, including aluminium and roofing. As these acquisitions take place, shareholders will be careful to monitor the balance between debt and equity, ensuring the company is properly capitalised and does not stretch itself beyond sane levels.

No concerns were raised regarding competition constraints.

Vulcan has enjoyed a string of positive earnings upgrades since listing and has seen this rewarded with a rising share price. There has been significant volatility, but shareholders clearly feel the company is on the right track.

As with all acquisitions of this size, Vulcan's next challenge will be to properly integrate an entirely different culture into its own, without compromising the values it stands for. A family-owned business is quite different to a publicly-listed company, which sees itself questioned by shareholders and subject to shareholder votes.

Vulcan will update the market, including its long-term plans for this new acquisition, on August 24.

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TRAVEL

Johnny Lee will be in Christchurch on Wednesday 24 August (Russley Golf Club).

Edward Lee is in Auckland Central tomorrow, Friday 29 July (Jarden House, 21 Queen Street) and has some spaces available. Please phone or email us for an appointment.

Edward will also be in Wellington on Thursday 25 August (Featherston Street); and in Auckland again on 31 August (Ellerslie), 1 September (North Shore) and 2 September (City).

In September, he will be in Blenheim on Thursday 8 and Nelson on Friday 9 and in Napier on Thursday 22.

Chris will be in Christchurch on September 5 and 6 (morning), in Ashburton on September 6 (pm) and in Timaru on September 7, keen to meet clients to discuss investment portfolios. 

David Colman will be in Lower Hutt on Friday 26 August and is planning trips to Whanganui and Palmerston North.

Please let us know if you would like an appointment.

Chris Lee & Partners Ltd

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Taking Stock 21 July 2022

Johnny Lee writes:

INFRATIL has announced the details of the sale of its towers business, to Canadian investment group Northleaf Capital and UK-based investment group InfraRed Capital.

It comes a week after Spark announced the sale of its own TowerCo business, at the same multiple (33.8 times EBITDA) as the Infratil sale.

The sale values Infratil's tower business at $1.7 billion, which in turn values Infratil's stake in the tower business at about $850 million, two years after Infratil purchased its 49.95% stake in the overall Vodafone NZ business for $1.03 billion.

Infratil has agreed to re-invest $340 million of this $850 million back into the towers business, becoming a 20% shareholder. Brookfield Asset Management, the other major shareholder of Vodafone, did not make the same investment.

The announcement from Infratil specifically mentions the new tower business targeting growth, both in terms of new towers and future co-tenancy. Co-tenancy refers to inviting other groups to access its network of towers, taking advantage of its existing assets and locations to maximise returns. Global competitors in the telecommunications industry, deterred from entering our market due to these barriers, may have reason to reconsider this decision going forward, as our towers industry more closely aligns to global trends.

2022 has been a busy year for Infratil's subsidiaries, with Manawa, RetireAustralia, Vodafone and Kao Data all making changes to their businesses. RetireAustralia will likely report back soon with the conclusion of its strategic review, detailing its next step forward.

Infratil next reports in November, with its half-year results.

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THE ANZ Bank is raising $3.5 billion (Australian dollars) at $18.90 a share, four months after spending $1.5 billion buying back its own shares at $27.70, as part of its 2021/22 buyback scheme.

ANZ, following a decade of pursuing asset sales and a ''return to core'', is now looking to purchase Suncorp Bank for $4.9 billion, allowing it to sharply increase its scale in Australia, back in line with its competitors.

ANZ shareholders, both in New Zealand and Australia, will be given the opportunity to buy an additional one ANZ share at the pre-determined price of $18.90 for every 15 shares already held. A shareholder owning 1,000 shares, for example, would be entitled to buy an additional 67 shares.

ANZ does deserve some plaudits for conducting the capital raising in this way. A simple pro-rata issue gives every shareholder equal opportunity to participate, while conveying the risk of non-acceptance back on the issuer and its underwriters. A rights issue also ensures that those unable or unwilling to participate are fairly compensated for that decision.

As the new rights offer is fully underwritten, the ANZ bank does not carry any risk - outside of extreme circumstances - of the offer failing. Shareholders, of course, carry some risk of the price falling below the $18.90 price closer to the closing date. This occurred recently with the capital raising by NZX Limited. This can be partially mitigated by shareholders delaying their acceptances until nearer that date.

The offer is accelerated, opening next Tuesday (26 July) and closing on 15 August. Shareholders will receive information directly from Computershare, and will be able to apply online through a dedicated website. Those who do not accept the offer will receive a small payment for the difference in value, if one exists, shortly after the offer closes.

The ANZ also took the opportunity to reaffirm its intention to pay a 72 cent dividend at the end of the year, bringing the annual dividend to $1.44, or 7.6% on the capital raise price. Being an Australian company, the dividend is unlikely to be fully imputed in New Zealand.

The ANZ has also found itself the topic of discussion in the news media recently, following its confirmation that it was looking to purchase accounting and business software company MYOB. The early response to this potential acquisition was one of bewilderment, as major shareholders queried the rationale for such a move. A week later, it has confirmed that takeover discussions had ended with no transaction taking place.

Any clients who wish to discuss this rights offer are welcome to contact us.

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ANOTHER update for Santana Minerals shareholders has been announced to market, marking its strongest results yet. The share price rose again after the announcement.

The results from the drilling at the Rise and Shine deposit open up the possibility of continued drilling east, after the success of the northern exploration earlier this year.

The update follows its recent Mineral Resource Estimate and marks another piece of good news for shareholders, who have watched the share price fluctuate wildly amid the global upheaval of the past year.

While it remains a long-term project, it is a clear step in the right direction.

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IT may be too early in the year to be awarding annual brickbats, but one company has boldly stepped forward to stake an early claim.

New Zealand Automotive, which listed in early 2021, has given an absolute masterclass on how not to conduct oneself in the corporate arena, as the company's leadership disintegrates amid a bafflingly public spat amongst its directors and two major shareholders.

New Zealand Automotive, best known for its subsidiaries ''2CheapCars'' and ''New Zealand Motor Finance'', listed at a time when motor vehicle retailers were queueing en masse to publicly list, prompting caution from some that interpreted this as a warning signal surrounding market valuations of such assets.

After listing with a reference price of $1.30 last year, the shares have gradually declined, and last traded at $0.45.

The public statement, released to the stock exchange, states that four directors have resigned, effective immediately. One of the four directors has an interest of 34% of the shares in the company, the second largest shareholding (behind the remaining director at 59%). This round of resignations follows those of the two independent directors in April.

The statement details ''a fundamental breakdown of trust and confidence'' between the directors, and ''irreconcilable differences . . . regarding the way in which a publicly listed entity should be managed and governed''.

The statement also states that the remaining director had intended to put forward a motion to remove the board and replace it with three new directors. One of the three nominated has since rescinded this nomination.

The remaining director has since spoken publicly to media, blaming his fellow directors for the company's performance.

Board resignations are not in themselves unusual. Directors may leave to pursue another role, or at another location or simply to move onto another stage of life. Typically, these resignations are accompanied with best wishes and a generally unresponsive share price.

In this instance, the share price has dropped significantly and the small number of retail shareholders remaining in the company are left wondering why this unusually public display of board incoherency was ever publicised in this way.

One thing this bizarre affair highlights is the risk of investing in companies controlled by single entities. Earlier this year, we observed the meltdown of DGL Group, the chemical logistics company controlled by Simon Henry, following his unprompted outburst regarding Nadia Lim. DGL Group delisted from the NZX almost immediately following this event.

Having strong and committed shareholders has value, as it ensures those making decisions have ''skin in the game''. Indeed, no one has lost more throughout this affair than the majority shareholder and remaining director of New Zealand Automotive. However, it appears even this was insufficient incentive to ensure both groups operate collegiately.

Any remaining NZA shareholders will be nervously anticipating the next leadership update and hoping for a dramatic improvement in the company's professional conduct.

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NEXT month marks the beginning of reporting season, when companies announce the results of the previous six months, any strategic changes and, of course, the declaration of dividends.

The global staff shortage is affecting most companies, and will be a theme across many of these full year reports. The likes of the aged care sector is experiencing well known shortages across their nursing and construction arms, as the country experiences labour shortages across all major industries.

Auckland Airport's intention to host a jobs fair, with over 2,000 positions across a range of invited employers, highlights the methods employers are resorting to in order to secure labour. Indeed, the ''Position Vacant'' sign is becoming increasingly commonplace around Wellington. Some of our country's most important sectors – such as midwifery – have almost daily warnings of risks it faces without assistance.

New Zealand's listed companies generally try hard to keep markets informed of any substantial changes to outlook, in accordance with continuous disclosure requirements. A2 Milk, in particular, will be careful to ensure that its results remain in line with its most recent forecast.

The likes of Sky City and Sky TV will also be of interest to shareholders and observers alike. Sky City has already given some guidance, expecting profit to be in the low millions. More important to shareholders will be an update on the situation in Adelaide, as well as guidance going forward.

For Sky TV, long-suffering shareholders will be feeling cautiously optimistic, as the light at the end of this long, long tunnel slowly comes into view. A strategy update will also be welcomed, perhaps shedding light on the recent overtures towards a move into radio station ownership.

Chorus may also find itself in a position to firm up its intentions for shareholder distributions. Its recent share buyback scheme has been met, largely, with success, and it has previously stated an intention to accompany this with gradually increasing dividends.

With consumer confidence falling, and interest rates rising, shareholders will be looking to company leadership to skilfully navigate these troubled waters. Next month's reporting season will be important, as companies particularly exposed to tourism, supply chain constrictions and labour shortages will be careful to position themselves to endure the period ahead.

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Travel

Edward will be in Auckland on Wednesday, 27 July (Devonport), 28 July (Ellerslie International), and 29 July (Jarden House, Queen Street,CBD).

He will also be in Wellington on Thursday 25 August (Featherston Street).

He is also planning a few trips for September (Nelson, Blenheim and Napier).

David Colman is planning trips to Lower Hutt, Whanganui and Palmerston North. Please let us know if you would like an appointment.

Chris Lee & Partners Ltd

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Taking Stock 14 July, 2022

Johnny Lee writes:

SPARK has completed the partial sale of its towers business, establishing and selling 70% of the new TowerCo business to the Ontario Teachers' Pension Plan Board, in Canada.

The sale will realise about $900 million in cash, with Spark agreeing to act as a tenant of TowerCo for the next 15 years, with multiple decades of renewal rights.

Infratil – a part-owner of Vodafone – will likely be announcing the results of its own tower sale soon. One imagines that the metrics will be similar.

The question for Spark shareholders now becomes exactly how the company intends to utilise the proceeds from the sale. Spark has outlined three possibilities for discussion – repaying debt, investing in future growth, or returning the funds to shareholders, likely by way of a dividend or share buyback.

A combination of the three seems most likely.

Spark intends to notify shareholders of its intentions during its full year results on August 24. In making this decision, Spark will consider a range of factors, including its debt levels and credit rating, its imputation credit balance, its share price relative to historical levels, and its future growth prospects.

Previous discussion on this topic has elicited feedback from some shareholders who would prefer Spark to retain ownership of these assets, retaining control and internalising the costs and benefits of ownership. The Warehouse Group's decision to sell its ''Red Sheds'', and Seeka's decision to sell its orchards, elicited a similar response.

Regardless of one's stance on the asset sales, a valuation of $1.175 billion (34 times earnings) and Spark's decision to retain 30% control should strike a reasonable balance between the two viewpoints. Spark's share price rose in response to the announcement and is now at levels not seen since it was known as Telecom.

Utilising asset sales to fund buybacks is an increasingly common theme in this environment, as companies find themselves holding assets that have inflated in value, producing a below-acceptable return, and witnessing a share price decline.

The likes of Property for Industry and Investore Property are both actively engaged in share buybacks, as both find themselves trading at a steep discount to their underlying current property values. Both, incidentally, will struggle to fulfil these buybacks, as market liquidity dries up and major shareholders express reluctance to part with their holdings at current levels.

The partial sale of TowerCo by Spark will see the company move away from tower ownership and maintenance and towards telecommunications and service delivery, its expertise.

Management must now consider how best to spend its windfall. Judging by the market's early share price reaction, Spark is on the right track.

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TWO developments out of China emerged this week, one with immediate and one with long-term ramifications for investors to consider.

The first saw the developments in Henan, where thousands of Chinese protestors gathered to complain that their banks were freezing deposits, pleading for the government to intervene and restore withdrawals. The protests were later ''dispersed''. The Chinese Government has since pledged to repay some of the frozen deposits. Many governments guarantee bank deposits to a defined maximum.

The New Zealand Government's plan to guarantee bank deposits has not yet been implemented, with the initial timeline suggesting this will happen next year. An update will surely be forthcoming over the next few months. The indicated level of the Crown guarantee was previously defined as $100,000 per investor, per bank, a relatively generous amount.

While the scale of the events in China was relatively small, it marks another stress point for the world to monitor and highlights the need for such deposit guarantee schemes to be ironclad in their design, maximising depositor and investor confidence, while minimising the moral hazard of a taxpayer backstop. Such a backstop is not, and should never be, an open invitation to increase risk, as we observed during the financial company collapse in 2008.

The other development came from the United Nations, which published its World Population Prospects research paper.

We have known for some time there is a trend developing, particularly in the OECD, of decreasing long-term birth rates and increasing life expectancy. Fewer people are choosing to marry and have children, while those who do, tend to have fewer children overall. Two thirds of the world's population now live in a country where the birth rate is below the level needed for zero growth, including New Zealand. Countries still experiencing population growth include Nigeria, India and The Philippines, all of which are already among the most populous countries in the world.

However, the UN report highlighted just how quickly these trends are accelerating, particularly in China. The Chinese population may have already peaked, with India set to overtake it as the most populous country as early as next year. 

The outcome of an aging, declining population on a global manufacturing powerhouse is already observable on the other side of the East China Sea, where the Japanese population has been shrinking for over a decade. The ratio of workers to non-workers – called the Dependency Ratio – also becomes highly relevant, as those contributing to government coffers instead begin to withdraw from the pot as they reach retirement age.

The cause of these changing birth rates is open to debate, with some experts blaming the cost of living, while others suggest the rising accessibility of education among women is a major contributor. Regardless of the cause, more and more data is emerging that shows this trend is becoming entrenched.

This will have an impact on a number of global exporters, including the likes of A2 Milk, which hopes to sell an increasing amount of infant formula around the world. Fewer births means fewer customers, necessitating a pivot in strategy from A2 as it looks to other avenues for growth.

Warning signs continue to flash around the globe, as both short and long-term problems continue to search for a solution.

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THE Reserve Bank of New Zealand has lifted rates again, moving the Official Cash Rate from 2.00% to 2.50% yesterday, as it re-iterated its primary focus on inflation.

The Reserve Bank published its usual commentary at the same time. The commentary was broadly in line with previous statements, although a greater focus was made on the rising risk of further escalating inflation and the rising risk of recession.

One statement in particular is worth highlighting. The Reserve Bank specifically states that ''Once aggregate supply and demand are more in balance, the OCR can then return to a lower, more neutral, level.''

This quote should give confidence to those anticipating an ''n'' shaped move in interest rates, where rates rise and then recede as inflation concerns abate. Such an investor will be carefully monitoring opportunities, particularly in the fixed interest and term deposit space, to lock in long-term rates alongside these peaking interest rates.

The statement should also serve to highlight the Reserve Bank's belief that supply is the primary cause of the inflation pressures currently being observed. Supply chain issues continue to plague the globe, while the crisis in Ukraine exacerbates these concerns.

Much was made of the reference to ''medium-term downside risks to economic activity'', although this is unlikely to be new information to regular readers. The world is experiencing a high level of stress at the moment, with the developments in Sri Lanka the latest headlines to emerge.

Overall, the statement reads as though the bank is finding it increasingly difficult to juggle three priorities – inflation, employment, financial stability – while the ground shifts beneath its feet.

It is not a role I envy.

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LIKE many listed companies, Kingfish Limited, the listed Fisher Funds vehicle, has had a disappointing start to the year, as the New Zealand sharemarket stutters and investors move from growth stocks towards defensive stocks.

Kingfish is a useful product for some, giving investors access to a diversified array of New Zealand growth stocks, while being structured to provide a relatively high-dividend stream for its investors.

Kingfish's portfolio is made up of 15 stocks and cash, with the majority of the portfolio consisting of Mainfreight, Infratil, Fisher and Paykel Healthcare, Summerset and Auckland Airport. These five stocks make up about 70% of the portfolio, meaning Kingfish's fortunes are largely tied to the performance of these individual companies. Dividends received from these five largest investments will not be meaningful.

Yet the company commits to spending about 2% of its Net Asset Value each quarter by way of dividends. Its NAV has fallen about 20% this year, which logically means its dividends will see a corresponding decline, assuming prices do not recover, perhaps nearer 10 cents than 15 cents on a per share basis. Quoted dividend yields - which look at historical dividend levels - are unlikely to be relevant in the face of such a decline.

Coupled with this is the unlikelihood of its Warrants issue coming to fruition later this year. Kingfish utilises warrant issues as part of its capital management programme, allowing shareholders to purchase more shares at pre-determined prices as a way of injecting capital (and cash) into the fund. This year's issue is priced at $2.03 (minus dividends) and is dated November 18. Barring a sharp rise in equity values, this warrant issue may conclude with no participation.

The poor start to the year is seeing most portfolios, whether shares, bonds or property, decline. The trio of Kingfish, Barramundi and Marlin are no exception. Investors should anticipate these declines to be reflected in the dividend distributions in due course.

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Santana Minerals has announced its latest Mineral Resource Estimate (MRE). The result is a tripling of its inferred resource to 2.09 million ounces.

As early as March this year, Santana had highlighted a company objective of becoming a multi-million-ounce gold resource. The company's new objectives are to continue adding to this and to raise the classification of the gold with continued drilling.

The share price rose 20% following the announcement, but continues to be volatile.

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Investment Opportunities

ANZ Bank – The ANZ has allocated its offer of perpetual preference shares, issuing $550 million and setting the distribution rate at 6.95% for the first 6-year period.

Any investor who would like an allocation can contact us by tomorrow.

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Travel

Chris will be in Auckland and has times available in Ellerslie (Ellerslie International) on Tuesday, 19 July.

Edward Lee will be in Auckland on Wednesday, 27 July (NorthShore - venue TBC), 28 July (Ellerslie International), and 29 July (Jarden House, Queen Street, CBD).

Please let us know if you would like an appointment.

Chris Lee & Partners Ltd

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Taking Stock 7 July 2022

Chris Lee writes:

IF there were a few words from ABOVE that could bring certainty to the questions troubling investors like me, any clue on the outcome and duration of the European war would claim my full attention.

So, too, would some certainty about interest rates, with a heads-up on where and when they will peak.

For equity investors, the interest rate question is of similar importance to the imminence (or certainty) of recession. Arguably one might cause the other.

Interest rates will be of much less concern to most listed companies. Generally, the listed companies have made arrangements to offset the coming era of higher rates.

Bank covenants have been negotiated. Credit margins are agreed. Term loans and overdraft limits have been resolved.

Many companies have locked in long-term funding at acceptable rates, grabbing an opportunity when the somewhat challenged Minister of Finance, and indeed the Reserve Bank, were talking about negative interest rates not much more than 18 months ago.

Many of the fund managers had bought government bonds yielding less than 1% to mark-to-market each year. The paper losses will penalise investors who need to exit managed bond funds but, in summary, the corporate debt levels look unlikely to threaten stability when rates are re-set.

Yet higher interest rates do lead to changes in capitalisation rates and must impact significantly on the annual valuation rounds for property trusts and retirement villages.

Instead of property valuation gains, think property valuation losses, further extended if tenancy woes, or lower sales volumes, add to the problem.

Having said all that, one large problem comes from the $160 billion of banking housing mortgages which are to be re-set in 2023.

Nearly half of all bank mortgages were priced until 2023, when rates are to be re-set. Total bank mortgage lending is around $340 billion.

A lift in rates from 3.5% to 5.5% on the average interest-only mortgage of $560,000 would mean an increase in interest payments of nearly a thousand dollars a month.

Will this threaten house price stability, banking repayment arrears, household sustainability, and social harmony?

One would have to hope that the word from ABOVE gives us comfort that rate rises do not bite too heavily into share prices.

A stock yielding a dividend of 5% would be worth twenty times the dividend, if 5% is a clearly better return than bond rates or bank rates.

But if bond and bank rates are 5%, the share dividend yield might need to be 7% to be attractive to income investors.

The price would then be a little over 14 times the dividend, not twenty, implying a lower share value of perhaps 30%.

From such changes do bear markets gain momentum.

Bond investors seeking to stabilise their wealth in a highly vulnerable market also pay close attention to interest rates.

Two banks (BNZ, ASB) recently issued five-year bonds at rates around, or more than, 5%.

Those rates attracted many, including me, but if the next round of bank bonds pay 6%, some (not me) will be grumpy. They might feel they would have been better to guess that rates would rise and wait for the 6% bond. My view is that 5% is likely to remain a fair return for bank securities.

And there is no word from ABOVE, at least no word audible to me.

So I will offer a guess, as a hint to investors.

Traditionally the banks have been close to hopeless at forecasting interest rates, except for the very short term.

Just last November the ANZ opined that the Overnight Cash Rate (OCR) would peak at 2.5%. The ANZ's economists are probably the best in the banking market, Sharon Zoeller proving a comfortable replacement for Cameron Bagrie.

Yet the ANZ's pick last November looks well astray if you judge its forecast against the current predictions of most banks, which is for the OCR to exceed 4% next year.

An OCR of 4% or more would in theory imply term deposit rates of more than 5%, perhaps 6%, and mortgage interest rates of at least 6%.

This sort of rate would be awful for capitalisation rates and equity prices.

Many businesses would be paying 9% to 10% for debt that a year ago was costing less than half of that rate.

Governments would be paying 4% to 5% for 10-year debt.

Indebted households would be under extreme distress.

My opinion is that none of this will happen. I hope I am right.

My guess is that the depth of pain, the certainty of recession, the rapid effect on unemployment, and, said somewhat cynically, the imminence of the 2023 election will put at least a temporary hold on interest rates.

My guess is that the Reserve Bank will be bullied into focusing on unemployment and the Treaty, ahead of facing up to inflation. I know the RB is ''independent''. However, one needs to look at its changed charter and the political appointments to its board to gain a real picture of political ideology.

I expect the OCR to be unnaturally constrained and instead government will feed such absurd contrivances as the scheme for the Crown to fund banks.

Perhaps this might be called ABOCR. Anything But OCR increases.

Would such political intervention curb inflation? No.

Might it be a distraction that muffles the inflation issue? Maybe.

Most in capital markets believe such Crown loans to banks and Quantitative Easing were contrivances, cynically delaying the inevitability of facing up to the required adjustments to spending.

We spend more than we earn. We have long spent our depreciation reserves on consuming more today, rather than maintaining assets like hospitals, schools, pipes, and road.

All political parties have found it easier to obfuscate rather than face the reality that spending more than you earn is a short-term strategy that passes the problem on to future generations.

So to summarise my view, it is that interest rates will not rise to a level that contains and then reduces demand, and thus inflation.

My bet is that voters will be wooed by money that comes from more debt in the hope of averting a knee-jerk call for change.

I doubt that whichever of the two electable political parties was in power would have played this self-focused game, in any of the last several elections.

Investors seeing through this might consider the long-dated inflation-adjusted bonds as one instrument that hedges against shallow, political chicanery.

I know the RB is set up to be independent. I believe my eyes, rather than my ears.

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TWO groups that will not appreciate rising interest rates are the listed property trusts (indeed all landlords) and the retirement villages.

Rising interest rates drive down capitalisation rates. Lower cap rates lead to lower valuations. Property trusts and retirement villages have to report changes in the annual valuation of their properties.

When interest rates fall, cap rates rise, so valuations rise. The property trusts and retirement villages report the ''profits'' that arise from higher valuations.

Here's how it works.

Property Trust A has a property producing $5 million of rent. If interest rates are 3%, the valuer each year may value the building at, say, 20 times the rent, a ''cap rate'' of 5%, two per cent more than bank rates. The valuer multiplies the $5k rent by 20 and ''values'' the building at $100 million.

If interest rates fell the next year to 2%, the ''cap rate'' might go to 25, effectively calculating that a buyer might buy the building at a yield of 4%. The valuer would argue that the building is worth 25 times the rent - $125m.

Triumphantly, Property Trust A claims a revaluation profit of $25m.

But if rates rise from 3% to 4%, the ''cap rate'' must fall as the mythical buyer would want a 6% yield from the rent. The new cap rate would not be 25, not 20, but 16.67% (16.67 x 6 = 100).

The new valuation would thus be 16.67 x 5m (rent), or $83.55m, a fall of $16.65m. Property Trust A then announces the effect of falling cap rates has decimated its profits.

In recent years, all property trusts and retirement villages have scored huge revaluation gains based on rising cap rates.

We may now be in an era, for some years that highlight the wisdom of knowing when to sell.

If we do reach that point in 2022 and 2023, we may see a replay of the 1980s. That was when all sorts of charlatans claimed to be property gurus and engaged in a race to buy more buildings than their competitors by borrowing gaily from badly-managed banks.

When interest rates were in double figures, and when one could buy government stock at yields of 17%, various dopes were buying properties at yields of as low as 6%, exploiting particularly the BNZ's braindead willingness to achieve growth by lending to property ''gurus''.

I recall a building on Thorndon Quay, bought for $5m, with bank debt of $4m, selling two years later for $1.5m, the new buyer funded by the same bank which was writing off $2.5m of its original loan.

The Westpac building on Lambton Quay sold for $35m, and a few years later sold for little more than half that.

Tough times and rising rates, leading to lower cap rates, will sort out the skilled property people from the wide boys. There may be some areas where demand exceeds supply – like Wellington – but there will be other areas like lower Queen Street, where demand is low.

My guess is that, right now, the banks are pressuring the weaker of their big-time commercial property clients into cancelling dividends and reducing debts.

Some will see this, to use the cliché, as banks removing the umbrellas as rain clouds appear.

I would see such a response as a sane corrective action to previously foolish banking practices – over-lending to over-confident people when markets were over-priced.

Those who have cash, and modest debt, might be mopping up some bargains.

Retail investors, in my opinion, should be attentive, ensuring their portfolios will continue to match their risk tolerance.

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ONE set of investors who were attentive and were quick to react to silly pricing were those high-risk punters who were early to join the frenzied crypto-currency market.

Many, especially in the US, used their cash as security to borrow, leveraging some dangerous positions in tokens like Bitcoin.

Some, having made paper gains of tens of thousands, or even more, apparently were wise enough to capture some profit by selling some of their tokens.

I read that the next step for a group of these punters was to enter the trading platform that sells second-hand Rolex watches. Various second-hand Rolex watches soared in value by tens of thousands.

Those who swapped their tokens in Bitcoin (or whatever their crypto flavour) for second-hand Rolexes were much smarter than those who kept all their tokens.

Bitcoin has fallen in a few months by more than 60%.

According to the newsfeed Bloomberg, second-hand Rolexes have fallen in value by only 20%.

However, the good-old string-powered spinning tops, that so entertained generations of boys in the 1950s, are now selling on secondary markets at ever-higher prices.

One wonders what the market is like for second-hand knucklebones.

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IF the ANZ perpetual preference shares, paying around 7% quarterly interest, was wrongly timed for some investors, they should not be dismayed.

It would be uncharacteristic of corporates facing an unknown period of perhaps rising interest rates, were the corporates to simply revert to bank lending. Surely there will be many new bond issues.

Bankers, in tough times, have the upper hand and can screw down tougher covenants, demand higher up-front fees, fatter margins and shorter review periods.

Wise corporates will sidestep the banks and offer bonds to retail investors at rates that might not be cheaper than bank debt, but will be with covenants more flexible than banks can offer.

Providing the corporate offerings to retail investors are fairly priced relative to the covenants, investors will have many attractive issues to consider in coming months.

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Travel

Chris will be in Auckland (Takapuna) on Monday, July 18, and has times available after 3pm. He is in Ellerslie's Best Western on Tuesday 19 (afternoon) and Wednesday 20 (morning).

Edward Lee will be in Auckland on Wednesday, 27 July (NorthShore - venue TBC), 28 July (Ellerslie International), 29 July (Jarden House, Queen Street, CBD).

Please let us know if you would like an appointment.

Chris Lee & Partners Limited

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