Taking Stock 25 November, 2021

WHILE the Crown has been canvassing views on the future of litigation funding, unsurprisingly the fiercest opposition to the growth of the funding specialists has come from the Institute of Directors.

Often cynically referred to by investors as the Institute for the Old Boys Network, the IoD says it is fielding distressed calls from major companies which are protesting about the increasing cost of insuring directors and company officers (against their own failures).

A premium that used to provide, say, $20 million of cover might have risen in annual cost from a few hundred thousand dollars to a seven-figure sum.

Litigation funders have succeeded in High Courts, creating a new benchmark for director accountability, causing substantial payouts and leading to these premium increases.

The next step litigation funds will seek is to demand full financial accountability so that the penalties match the cost of the errors, resulting in full compensation for the victims.

A director might find, through ignorance, laziness or negligence, that he/she is bankrupted, even if insurance covers some of the costs. The former politician Jenny Shipley is appealing to the Supreme Court to avoid this possible outcome.

Even harsher would be accountability that provides access to a director's personal assets that otherwise would be hidden in family trusts and other such devices. Last week China's government fired five directors and instructed them to repay US $391 million for their errors.

Even harsher than financial accountability might be the advent of jail sentences for incompetent directors.

Thankfully, nobody has yet suggested the Chinese solution for abject business failure – a brief stay in front of a firing squad. (I expect most will recall how the Chinese man in charge of designing a rail bridge for fast trains was made accountable when the bridge failed. He received the death sentence and was duly despatched.)

Countering the litigation funders' solution, the IoD has hinted that the best directors would retaliate to any incoming unreasonable liability by simply declining to accept invitations to serve as a director. For poor directors, chosen cynically for the wrong reasons, this might be a great outcome for all.

My view is that our most skilled directors are not the problem. No court would penalise a director who had performed his task thoroughly. The problem, in the opinion of our best businessmen, is that barely one in ten directors has any skill in strategic thinking or in risk/return analysis.

Sadly, many are lazy, box-ticking, pompously over-estimating their credentials.

I spoke recently with a distinguished company chairman who recalled from years ago the unofficial gatherings of IoD directors where each director would talk freely about their experiences and about the processes which did and did not work out well. Such meetings were of real value.

Those regular meetings evolved into what he called ''woke'' meetings, where successful directors were expected to attend IoD meetings where so-called academics would lecture the directors. The skilled directors went to such fabricated meetings once, and thereafter were absent.

The value of such meetings had disappeared. Eventually, such IoD occasions were attended only by those who were most unlikely ever to achieve excellence in governance, those who wanted to believe that academia is a source of appropriate advice to governors.

I also spoke with another experienced leader in this area who had attended a course run over a few days. He asked other attendants why they were seeking a career in directorships.

Generally the answers focused on the belief that business success, wealth, or self-judgement of ''reputation'' had led them to offer themselves as directors, as a sort of reward for their self-assessed wonderfulness.

Not a single person answered that they wanted governance roles so they could add value to risk/return analysis and not a single person responded that analysis, strategy or specialised knowledge was the basis of their governance ambition. Not one.

The easy, perhaps some might say ''glib'', inference to draw is that directorships are seen by the least competent people as a status symbol, or as a means of achieving higher wealth, or a means of achieving power. The best directors take on the responsibility as a ''duty'' or as a service to others.

In today's world, many organisations, especially in the public sector, have introduced to the selection criteria issues not related to competence and experience, like race, gender lifestyle preferences or, simply, gender.

Perhaps this has opened the door to some excellent people but it also has allowed a range of new wannabes to exploit the opportunity.

A number of newcomers with utterly inadequate value-add have found their way onto Crown-funded boards, satisfying the new criteria of diversity but at a cost of any measurable value-add.

I was amused to hear how one gnarly, experienced chairman because so frustrated by the worthless twitterings of one such pretender that he cancelled the newcomer's speaking rights at the Crown entity meetings. Needless to say, that ''twit'' no longer is on that board, though still uses the so-called ''honour'' in self-promotion.

Directors must have potential to add value, should be competent to assess risk, and must be well enough informed and connected to provide input on strategy.

They are not there to ''represent'' any particular community. They are now required to represent all stakeholders.

Directors in NZ are adequately paid. They should meet high standards of transparency. They must ensure quite difficult disclosure laws are honoured.

The shareholders of the company pay the premium to cover directors for accidental errors.

Misdeeds like negligence, fraud and stupidity are not covered by any insurer, though there have been instances where insurers have been bullied into settling major claims for such blowfly-like behaviour.

The litigation funders are now there to represent the stakeholders to ensure accountability for all, especially executives and directors. In many ways, the litigation funder is doing ''God's work''.

The IoD, at best a mediocre organisation, has little status in the real world and has contributed a little, but only a little, to the improvement in standards of director behaviour.

We now know the High Court, the Court of Appeal and the Supreme Court are able to do their jobs, thanks to litigation funders. They cannot do their jobs unless a case is brought to the Court.

Weak directors, chosen for the wrong reasons, will respond wisely if they see the litigation funders as a dark threat and make the decision to find the status they seek in those areas that do not have control over other people's money.

Yet there is some reason to hope that the weak directors will be isolated.

We are well past the time when the fourth estate – the news media – had the credibility to influence retail investors or director behaviour.

Passive, index-following funds do not employ wise, experienced strategists or analysts so their influence is next to nil.

But we may still have a handful of active fund managers to tackle the issue of incompetent governance, the fund managers perhaps having the voting power to make them effective agitators. The NZ Shareholders Association also looks to be an effective handbrake on inept governors.

Investors in public companies, indeed the whole public sector, are going to need aggressive independent representation, if we are to constrain Crown activism based on ideology rather than democracy, decisions made by people clearly disconnected with the activities they seek to change..

Litigation funders can take, and have taken, cases against the Crown, the most public being a case against the Ministry of Primary Industries, for allowing the importing of toxic pollen that ruined some kiwifruit orchards. MPI paid $40 million in compensation.

Expect many more such cases.

In my judgement, the growing power of litigation-funded cases, brought before our handful of skilled commercial judges, is bringing hope to a wide range of the public, especially retail investors.

The Institute of Directors and the Crown would be better to lift standards and welcome interventions that would ultimately remove those ''twits'' that believe directorships are a gravy train, or a status symbol, for people of modest achievement.

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Johnny Lee writes:

THE takeover of Z Energy, by Australian fuel retailer Ampol, took another step forward last week with the release of the Commerce Commission's ''Statement of Preliminary Issues''.

The Commerce Commission's concern, and ultimately what the January 18 decision will hinge upon, is whether Ampol will decrease competition and accrue too much market power in our fuel markets if the takeover is allowed to proceed.

Ampol ownership of Gull is the clear sticking point. Ampol will almost certainly not be allowed to retain control of both Gull and Z Energy. This would comfortably meet the definition of substantially lessening competition in the fuel retailing markets and be met with a rejection.

Ampol is not pleading for control of both. It has proposed either selling Gull to a third party (a Trade Sale) or to the public (an IPO of shares on the NZX). The Trade Sale solution would require a willing buyer - one that does not face the same constraints as Ampol - to take over Gull at relatively short notice.

Most major international players already have a presence within New Zealand or have recently exited. BP and Mobil are active competitors here. Shell's exit is well known, and the larger Asian retailers have yet to express any interest in competing on our shores. We are a country of 5 million people in the corner of the world; a world where the narrative – although not necessarily the reality - is shifting away from oil consumption.

A buyer may yet emerge. Ampol will not want to endure the uncertainty of an extended clearance process, nor will it be enthusiastic on finding itself under pressure to sell quickly at a poor price. Pricing tension will rely on Ampol keeping its options open.

The suggestion of an IPO was more detailed and saw far more discussion from the Commerce Commission.

It is clear that this solution would be unique for the Commerce Commission. It has never considered a proposal of this nature – where an IPO divestment was used to resolve competition concerns. Normally, the sale of Gull to a new buyer would allow the Commerce Commission to interview and discuss issues with the purchaser. With an IPO, the end buyer – potentially tens of thousands of retail investors – is unknown. How the new shareholders vote, therefore how the strategy of Gull evolves after the IPO, is unknown.

The major concerns surrounding the IPO solution relate to Ampol's shareholding in Gull following the IPO. Ampol has previously submitted that in the event of an IPO, it would retain a shareholding in Gull in order to ensure the success of the listing. This is normal – Vulcan's recent IPO saw the major shareholders retain a meaningful stake giving confidence to investors that all parties were ''on the same page'' and working towards the same objectives.

Retaining this holding would also add pricing tension to the offer, as Ampol could increase or decrease its stake to match demand. The issue with this, of course, is that Ampol would retain some control over Gull while acquiring Z Energy, defeating the purpose of the IPO in the first place.

Its proposed solution is to effectively forfeit the voting rights of its shareholding, as it slowly sells down its holding over time. Any major shareholder who emerges in the newly listed company would need to be disclosed to the Commerce Commission.

An IPO of a petrol distributor is not necessarily the most straightforward sell in 2021. Investors – particularly institutional investors - would need to be convinced that Gull's strategy addressed ESG concerns.

The second concern highlighted by the Commerce Commission was around Gull's supply chain. Gull, being owned by Ampol, uses Ampol for most of its refined fuel. Separating the entities without jeopardising Gull's ability to compete will require agreements to be put in place securing supply while Gull searches for new sources of fuel.

The takeover offer itself is an intriguing one. Many shareholders have already expressed to us a preference to retain their shareholding, rather than accept the offered price (which at this stage is technically unknown, due to adjustment clauses). The board of Z Energy has recommended the offer, subject to an independent valuation. The group with the best access to information believes it is a fair price.

At this stage, a successful takeover, followed by an IPO of Gull seems a probable route. A swap of assets – from control of Gull to control of Z Energy – should not substantially lessen competition if appropriate safeguards are in place, and concerns around supply chains can be resolved through contractual agreements.

However, the issues are complex, and the Commerce Commission has no precedent to draw upon. The easier decision may very well be to decline consent, maintaining the status quo. This would undoubtedly have flow on effects, that could be either positive or negative for competition.

The final decision will apparently be made on 18 January. It is not uncommon for these dates to be extended, especially for major transactions such as this.

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THE redemption of the ANZ Capital Notes – known as ANBHB – puts a final full-stop on the longer than expected story of these securities.

The $500 million issue will be repaid on New Year's Eve this year, in cash and at par. The accrued interest for the month period (25 November to 30 December) will be paid at the same time. This $500 million will then be searching for a home, in a market where demand remains comfortably ahead of supply.

As the timing of the repayment will coincide with the holiday period, we would encourage those seeking to reinvest this money to give consideration to the timing when electing to reinvest. The wild swings in the sharemarket early this year highlighted the dramatic decline in liquidity that occurs over the New Year period – swings that are best avoided.

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MY Food Bag's half-year result has been announced to market, including its first dividend since listing and affirming previously forecast earnings. Despite the ongoing lockdowns and business disruptions, the business is growing as expected.

My Food Bag's share price performance since listing has been almost entirely downhill. While the company cannot be blamed for changes in underlying interest rates, the 5.00% gross dividend yield proposed at the initial public offering now looks decidedly uncompetitive, partly explaining the decline in share price. At current prices the forecast yield is closer to 8.00%, which is much more realistic relative to the rest of the market today.

The bumper period observed in the first half of last year has led to some metrics declining – for example, revenue is down year on year – but remains strongly ahead on longer-term comparisons. Importantly, margins are improving, and escalating costs from inflation are successfully being passed through to customers.

Major fund managers continue to disclose increasing shareholders, with close to 20% of the company held by two particular fund managers. Clearly, conviction in the story remains high.

My Food Bag's share price performance has left it as one of our worst IPOs in recent history. It would be natural to assume that the company had failed to meet its forecasts, and perhaps its full-year result in May will prove this correct. However, the investment environment has seen some change over the past 12 months, and today's lower share price is clearly tempting some of the larger shareholders to top up.

My Food Bag's focus moving forward will be to explore avenues for growth, embedding itself more firmly into its customers day to day routines and finding ways to better control costs.

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Edward will be in Wellington on 2 December.

David Colman will be in Lower Hutt on 1 December.

Johnny will be in Christchurch on 7 December – this will be the final trip to Christchurch for the year.

Any client wishing to arrange a meeting is welcome to contact the office.

Chris Lee & Partners Ltd

Taking Stock 18 November 2021


MANY old-timers will tell you that they enjoy their vocation so much they would find complete retirement a status not unlike a death sentence.

Some sharebrokers, merchant bankers or investment bankers understandably find it hard to ''go fishing'' permanently. I am in that group.

A field trip I enjoyed with some clients last week reminded me of this job enjoyment, resulting, some might say, from the ''privileges'' of a career in capital markets.

One week you may have a superb dairy farmer explaining the logic of farming the ''pasture curve'', or discussing work in genetics, that lead to dairy cattle producing more milk, even in unfavourable weather.

Next week it might be a wonderful business leader discussing the research that precedes philanthropy or it might be a public sector leader explaining the dynamics between public service leadership and political parties.

Last week it was a field trip into the Dunstan ranges at Bendigo, near Cromwell, that energised me as I listened to a veteran geologist explaining his work and observing his passion for the science and his tolerance of a lifestyle that today's younger geologists might find ''old fashioned''.

Bendigo is a huge station a few kilometres north of Cromwell, tens of thousands of acres, owned by John Perriam and his family.

Perriam, in his 70s, was the genius involved in differentiating the qualities of merino wool. Now a widower, he lives near Arrowtown and shares his Bendigo Station work with his family. They are adding great value to the area, dividing the land into parcels that are appropriate for different activities.

I think Perriam bought Bendigo after the Crown flooded other land he owned around Cromwell, in the course of building the Clyde Dam, a Birch/Muldoon Think Big project, the dam built in the 1980s.

The Bendigo Station Perriam bought comprises terraces with topsoil and gentle hills near the highway, suitable for lifestyle blocks, pinot noir grape vines and soon a 40-acre cherry orchard.

It also comprises thousands of hectares of rocky, steeply undulating land in the Dunstan range, much of the land covered only in tussocks and scrub. The wind has long dried out the

land and redistributed any topsoil to some place many miles away. It was in this barren land that gold was found more than 100 years ago.

Inhabiting the land today are a few rabbits, the odd small flock of sheep and a precious few cattle. The most famous of the sheep was Shrek, who escaped the shearers by hiding in a cave, eventually shedding 27 kilograms of merino wool when he was captured.

Also in the hills is a tiny drilling machine that might be three or four metres tall. It drives diamond cutters into the bowels of the valleys, looking for the deep veins of gold-bearing rocks that 150 years ago first attracted gold miners. After completing each extraction site, the tiny hole is capped, leaving a visible remnant, roughly the size of a top hat.

On Bendigo Station are the remnants of mining huts and pubs, a reminder of a gold rush that over time has produced many millions of ounces of gold, throughout Central Otago.

The early miners scraped away, sometimes creating mines that went down several metres. At one stage hundreds of miners scratched out a living at Bendigo.

They retrieved some gold but did not have the equipment to reach into the gold-bearing rocks that are 150 to 250 metres below the surface. A little gold reached the surface but most of the resource remain buried.

The geologists today have drilling equipment that drives a tiny cylinder - circumference not much bigger than a zucchini - into those rocks.

The drill drags up beautiful shiny blue/grey rock, with veins that look like capillaries, often sprinkled with gold flecks, smaller than a grain of salt.

These samples are laboriously cut by a diamond saw, bagged and labelled, with one part sent for assaying locally, one for assessment in Waihi, and one to a laboratory in Australia.

The assayed results form the intellectual property that determines whether the gold resource is worth pursuing and, if so, which areas and at what depths gold is present at commercially-viable levels.

The exploration licence is now owned by the listed Australian mining company Santana Minerals. It has raised the money to explore, each hole drilled costing around $100,000. The current monthly sum spent is nearly $500,000.

Last week, Santana's geologists had one diamond drill working 24 hours, seven days, as the company seeks to build its understanding of the potential of the project.

To date the results of its work imply a resource with a current market value of perhaps $1.7 billion. The drilling has barely started. The goal is much more ambitious.

The Santana directors have told the ASX that they expect the continued drilling will increase the inferred resource to a million ounces within a month or two.

They have not speculated on what figure another year of drilling might imply.

One of Santana’s directors, Warren Batt, has vast experience, having led many successful gold producers, as a geologist and as a director.

Another director is geologist Kim Bunting, whose tenacity and belief in the project is the reason the project is now advancing at a rapid speed.

Batt and Bunting combined would have around 80 years of experience in the sector.

The projects they pursue must have the potential to produce gold for less than half the value of the gold, they must be able to repay all costs within three years of mining, and they must be projects that last for many years.

They want to see Santana increase the Bendigo resource to a million ounces in December, creating access to new capital that would enable three drilling operations to be working double shifts, expanding the resource to a level that might one day rival Macraes (Oceana Gold), which has mined five million ounces over 30 years and has five million more resource to extract. As the crow flies, the Macraes base is just 40 miles away.

At today’s prices a million ounces of gold has a market value of around NZ$2.6 billion. The Macraes mine has been an outstanding success despite the years when gold prices were less than half of today's price, and despite the relatively low grades of gold at Macraes. Santana seems to be accessing better grades.

A fully operational mine at Bendigo might require capital of more than $100 million and would first need approval, after an expensive resource consent programme.

Such a mine would employ hundreds of Central Otago people and provide them with an average wage comfortably exceeding $100,000 per year. New Zealand needs projects that build wealth, especially after the use of debt to combat Covid costs.

Royalties and taxes would bring the Crown hundreds of millions while gold prices were at current levels.

New Zealand's annual gold exports would reach well into the billions, per annum. Our wine exports exceed two billion dollars per annum.

For the people of Central Otago, the attraction of the project is obvious, especially at a time when tourism faces headwinds.

Field trips have great value for those who invest at the early stage of new projects.

One sees the scale of the project, the value to be extracted from land – private land – that has little other economic value, and for those who want to keep learning, there is great value in listening to experienced people, and watching them practise their skills.

One sees the passion of the geologists, and all involved in the project.

We watched one geologist stroke the blue/grey shiny rock that emerged from a cylinder, the rock extracted from 170 metres below ground level. He noted that handling such rock was what motivated him each day to put his boots on. He treated the sample as admiringly as a grandparent may treat a grandchild.

''The rock is beautiful,'' he said.

Santana has every right to believe it has acquired a licence that might lead to a mine of world-class scale, perhaps tens of years of production.

Obviously the future drilling will confirm or deny that, but to date the holes drilled imply that the amount of gold in the rock is significant. The risk of there being no gold has passed.

Resource consent will need to prove that the project is compelling. Whilst the mining site would be visible only after travelling for many miles into the ranges, the consent process demands evidence of high environmental protection. The consent process may take a year or more, assembling experts to explain the protections that would be needed.

If all went smoothly it would be four to six years before the valleys in the Dunstan range could be a source of wealth for New Zealand. The gold price itself is unpredictable and is a further risk for investors.

Whatever the outcome, Bendigo will remain home to vineyards, lifestyle blocks, and at least one cherry orchard. It will have gravel roads leading up the private land in rocky ranges unsuited for any other productive use.

But in Central Otago there will be many hoping that a new gold mining venture at Bendigo will create billions of dollars of value for the area, increasing the nation's wealth, increasing productivity, and providing long-term employment.

Disclosure: Our clients and my family own shares in the ASX company Santana.

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Johnny Lee writes:

CONTACT Energy has released a ''thought piece'', discussing the future of our electricity market as we slowly move towards fully renewable generation, and the most efficient way to incentivise and create that future.

Electricity generators have formed a large part of investor portfolios since the introduction of the Mixed Ownership Model in 2013.  Investors have enjoyed reliable dividends and, broadly speaking, a stable share price relatively insulated from the swings of global markets.

Electricity generation is responsible for about 5% of New Zealand's carbon emissions and accordingly forms a part of any discussion regarding decarbonisation.  New Zealand's electricity is considerably ''greener'' than that of most countries, but making the move from 85% renewable to 100% renewable is proving significantly harder than the push from 75% to 85%.

Contact should be applauded for taking the initiative and opening the discussion – regardless of its own stake in the solution – despite not being Government-owned.

Genesis, which is majority owned by the Crown and is the owner of most of our non-renewable generation, has not yet responded.  Its engagement will be essential for this idea to proceed further, as Genesis is the owner and operator of the Huntly power station.

This is an issue that will face almost every New Zealander.  Even ignoring the environmental impact, most Kiwisaver investors will own shares in the electricity generators, and a significant amount of government revenue and tax revenue is derived from the profits produced by these companies.  This affects us all.

The problem that needs to be solved revolves around this push towards 100% renewable generation, and the consequences of such a push.

There are three specific concerns that are considered when examining our electricity market.  These are defined as the ''Trilemma'' – environmental sustainability, energy security and energy equity.  Moving to 100% renewable by phasing out our gas and coal generation will affect all these issues in different ways.

Environmental sustainability will be the biggest beneficiary from this push.  Our current system offers incentives to maximise low-cost power – wind, solar and hydro – to increase margins between the cost and sale price of the electricity generated.  While coal and gas have a cost, the wind and sun do not.

Energy security will likely be negatively impacted.  We currently rely on our fossil fuel generators to act as our backup during periods of low wind or rain.  Phasing these out will necessitate a solution to this problem.

Some solutions have been discussed in regards to this, including batteries, green hydrogen and pumped storage.  These solutions take considerable time to evolve from idea to reality and carry significant risks themselves.  The Lake Onslow pumped hydro solution, for example, was estimated to somehow cost four billion dollars, take six years to open, and would be located in the ''wrong'' island in terms of demand.

Another solution suggested was a ''demand response'', meaning agreements in place with large-scale users to shut down operations during times of stress.

The third tenet is energy equity, or affordability, and will become a greater concern over time.  The Huntly station costs a significant amount of money to maintain.  As we introduce more and cheaper supply, our use of the station will continue to fall, and the price required to provide electricity will need to rise to cover its fixed costs.  Our current auction system prices electricity at the highest marginal cost for all generation, meaning that if Huntly needs to increase pricing to cover its fixed costs for the few times it is utilised, the cost of all electricity rises with it, creating a volatile pricing environment.

Independent ownership of each asset has, broadly speaking, addressed all three of these issues so far.

Our auction system – where generators offer electricity at gradually increasing prices until demand meets supply - is theoretically efficient and effective at ensuring supply of power.

In practice, there are some unintended consequences of operating this system.  The issue of ''spillage'' – deliberate wastage of water from our hydro stations – is one such example.  In theory, generators could deliberately undersupply the market to achieve a higher auction price, an act Meridian was accused of last year.

Contact is not proposing a shift in the overall approach.  However, it notes that the current structure is not providing the correct incentives to encourage this final move to a completely renewable system without compromising our energy security and affordability.

But Contact has provided three solutions it believes could represent a step forward.

The first two solutions revolve around the establishment of either a Capacity market – where a third party would auction annual demand, in excess of true demand – or a Strategic Reserve, a system where the Government would pay the owners of strategic assets (for example, the Huntly station) to be available to supply the market, solving the issue of expensive assets sitting unused.

Contact's preferred solution, however, is to separate out all non-renewable assets into a new company, called ThermalCo in its paper.  It envisages all market participants – including Genesis and Nova – combining assets into this new entity, which would then have a monopoly over all non-renewable generation.

This solution solves several problems, while allowing a market solution within the existing regulatory environment.  ThermalCo would offer supply agreements, priced in a way to incentivise more low-cost production from renewables.  This certainty gives all providers the opportunity to consider long-term renewable projects to replace our fossil fuel generators, and ThermalCo would be able to stage a controlled exit from its assets as it watched demand diminish in place of new renewables coming online.

Of course, this thought piece and the research and analysis that went into it, will be for nought if others do not engage.  Genesis, in particular, will have a role to play moving forward.

The electricity market has changed and faces another period of change.  If we are to accept that our non-renewable generation must eventually shut down, the industry must have a plan to avoid brown-outs and wild fluctuations in pricing.  Adding more renewables – we have several geothermal and wind stations at various stages of development – will not solve the issue of energy security during unfavourable weather.  If we are to have expensive reserve generation for these periods, we must accept that this comes at a huge cost.

Contact’s solution addresses both of these points and warrants further discussion.  There are a number of major factors – Tiwai being one – which will threaten any long-term plan.  However, the industry requires certainty in order to properly function, and this discussion will be an important part of developing this certainty.

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Investment Opportunities


Vector – has closed its offer, successfully issuing $225 million senior bonds (VCT100) with a 6-year term (maturing 26 November 2027).

The interest rate was set at 3.69%.

Thank you to those who participated through Chris Lee and Partners. Anyone wishing to invest in this issue is welcome to contact us to arrange an on-market trade.




Edward will be in the Wairarapa on 24 November.

Johnny will be in Christchurch on 7 December – this will be the final trip to Christchurch for the year.

Any client wishing to arrange a meeting is welcome to contact the office.

Chris Lee & Partners Ltd

Taking Stock 11 November 2021

NOT all investors will recognise the names of Arthur Grimes and Bryce Wilkinson but the message these two scholarly financial analysts offered last week should be sobering to all investors.

Working within the think-tank NZ Initiative, Grimes and Wilkinson signalled that global and domestic financial conditions are closing in on midnight, to use the climate change description.

Continued printing of money, burgeoning fiscal deficits, and poor-quality government spending would have an inevitable outcome, they wrote.

High inflation, low productivity, absurd asset prices (housing in particular), and clumsy government were a recipe from which no investor would benefit.

Grimes is an economist and former Chairman of the Reserve Bank, a position he held for ten years.

Wilkinson has had a most distinguished career as a financial market analyst, economic commentator and, many years ago, a senior research manager at the country’s high-brow investment bank, Jarden. They are two diamonds in our economist sector.

Neither are the risible plastic products of egomaniacal American banking, nor are they the type who preen themselves each day, counting the success of their clickbait ramblings that stem from rearranging, without insight, the thoughts of others, in an attempt to sound learned.

Grimes and Wilkinson are both insightful, afraid neither of political unpopularity nor peer criticism. They do not seek popularity.

While they were warning of the consequence of a dreadfully weak public sector, aligning with a social but uncommercial government, they were also producing a slogan that all investors should recite.

This time is NOT different, they noted. Well said!

What we will soon observe is simply cause and effect.

The global creation of trillions of funny money, of which more than $100 billion was created in New Zealand, coupled with low productivity and supply chain blockages that look to be semi-permanent, might not produce an outcome any different from previous mad-science experiments. This time is indeed unlikely to produce an outcome different from every other burst of printing money. The consequence is inevitable: - inflation.

High inflation results from consumer demand grossly exceeding supply, and becomes embedded when high wage demands follow, employers unable to control costs, skilled and semi-skilled labour shortages preventing pricing tension. Falsely low interest rates encourage borrowing and spending.

A birds-eye view of the biggest USA ports today would reveal more than 100 huge container ships waiting to reach the dock and unload. Shipping blockages do not look to be temporary.

Dozens of other ships at the docks around the world wait with little patience to be unloaded, one of the main causes of the delay being the shortage of trucks on which to load the containers.

Trucking is knee-capped by a lack of truck drivers.

The USA has around half a million vacancies for truck drivers, resulting in much higher wages, and a current recruitment plan aimed at single women.

The trucking companies offer women a well-paid job PLUS a home (kitchen, bathroom, bedroom), between the driver’s cabin and the cargo. So far the campaign has been successful at only the most modest rates. There remains a chronic shortage of trucks to decongest American ports.

In the UK the shortage of drivers has led to wage offers reaching a level three times the wage of school teachers. Will New Zealand respond by realigning its education system to teach skills that lead to jobs?

China, enjoying such fabulous demand that it is able to ramp up price increases, reported this week that its October trade surplus was at record levels, despite its manufacturing sector facing electricity brown-outs that restrict production.

Wilkinson and Grimes are clear that lower supply during periods of high demand leads to prices that undermine economic stability.

China is the beneficiary of higher Western consumption. The result can be only an extension of the accelerating trend of wealth moving from the West to the East.

With wealth comes power.

From all this change, some resulting from the global response to Covid, come puzzles for NZ retail investors to solve, as they plan to invest their capital.

Which one asset class will produce income, on which to live, and grow in value, to offset inflation?

Price rises may well already far exceed an annual rate of 5%, especially if the rate is calculated on the goods and services on which retired people spend money. Long gone are the days when the Reserve Bank ran a separate basket to reflect the prices of the goods and services on which the retired sector spends. The basket of goods and services that is measured to calculate inflation is based on the spending of people aged around 36. The prices of goods and services purchased by most investors (predominantly ‘’seniors’’) rise far more than the official rate of inflation.

Clearly, cash rates will not protect buying power, nor will bond rates, though every investor needs a core sum invested in assets whose nominal value is relatively predictable. Capital preservation always has a fan base with our senior citizens.

Historically, property often has risen in value at above inflation rates, but it faces challenges as a sector.

Unlike residential property, which has a captured market, retail property faces a future in which tenants adapt to a market with fewer tourists. Rental holidays have become more common than rental increases, the major listed trusts, like Precinct, noting that rental holidays have already cost more than $10 million. Once the employment subsidies come to an end, there may be multiple closures in the retail, hospitality, entertainment, and tourism sectors, affecting tenancy rates.

Industrial or medical property might find that tenants can pay higher rents, but Wellington office property is surely not going to be buoyed by the public sector for an indefinite period. No government can continue forever to create more of the equivalents of the ‘’Commission for Financial Capability’’, to create jobs of doubtful value, requiring office space at premium levels.

The listed property trust sector has locked up some of its long-term funding at low costs but will not benefit from the rising bank swap rates on which term loans will be re-set, in the years ahead. Investing in selected listed property trusts will continue, with emphasis on careful selection.

The equity market has often supplied some hope for investors in periods of inflation.

Some companies have costs that are controllable, and others have goods and services so crucial that consumers lose their pricing sensitivity. The prices of their shares might rise, even in a difficult market.

One imagines that the technology, health, and food sectors will be robust. Specialty areas, like data security, might not find its market is constrained.

Many other sectors will face rising costs, skilled labour shortages, and price resistance.

Will the retirement village sector enjoy such high premium prices if the housing market retreats, rather than stalls?

The commodities sector often has not been hurt by inflation.

Magnesia, whose supplier is mainly China (85%), is essential to the auto industry (needed in aluminium), lithium is still key to battery efficiency, gold is used in electronics as well as jewellery, oil shows no sign of a falling price and even the current enemy of everyone, coal, has enjoyed record prices.

Perhaps the commodities sector may benefit from higher inflation. Certainly milk powder is in strong demand, as are meat, fruit, fish and vegetables.

Meanwhile investors are being fooled if they do not see through the stupidity of those companies which use their surpluses to buy back their own shares.

In doing so, such companies signal that they have no fear of a future when capital might be the key to survival.

I recall how the ANZ, about a decade ago, bought back its own shares at more than A$30 per share, then, facing headwinds, issued new shares at around A$15, a disgraceful transfer of wealth from long-term investors to those who bought later at a discount.

Given its tendency to make popular, short-term decisions, I expect ANZ will repeat this sort of behaviour, as might the other Australian banks. Regrettably Australian banks are more impressed by short-term American strategies than by arithmetic.

The ageing US investment sage, Warren Buffett, says his Berkshire Hathaway group has $150 billion in surplus cash. Will it succumb to buying back (reducing) its capital? Probably.

Clearly, any financial advisers worth their annual fees will be reading and thinking deeply, as we head towards a future that Grimes and Wilkinson see as ‘’troubled’’.

If there is one suggestion that one can offer at such a complicated time, it is that investors use the advice sector, if they can find an adviser not humming their employers’ tunes.

The year of 2022 might pose new problems after a decade of flattering returns. One hopes that retail investors will set their investment policies to align with their personal risk profiles.

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Johnny Lee writes:

ONE likely consequence of this rising inflation will be a flurry of companies seeking to raise funds before the cost of money rises further.

Contact Energy, Kiwibank, Auckland Airport and Vector have all announced plans to raise money in the past month on the debt market, with Kiwibank’s offer closing substantially oversubscribed, and early indications suggesting a similar fate for the others. The likes of Vital Healthcare and Arvida have raised capital via rights issues on the equity market, Vulcan Steel has successfully listed on the exchange, and several other smaller companies are said to be wanting to list in the near future, including the car dealer, Armstrong’s.

This outcome is entirely logical. When asset prices rise, it is inevitable that asset owners will seek to capitalise on this, especially when they fear the tide is turning.

In conjunction with this, many long-dated bonds have begun trading at modest discounts, reflecting the changing environment. The steepest discount is reserved for the 30-year Auckland Council bond, whose coupon rate of 2.95% suggests excellent timing for the Council (with the benefit of hindsight).

The surplus of retail capital has been common theme for many years now, pushing asset prices higher and interest rates lower. As the conversation shifts towards inflationary pressures and rising interest rates, expect to see more opportunities arising, as companies seek to ‘’lock in’’ low rates.

The challenge for investors (and their advisers) will be to ensure that upcoming issues are not priced opportunistically. The imbalance between investors wanting to invest, and companies seeking additional capital, is beginning to show signs of a moderation, with rates offered rising.

The other trend investors will see alongside this is a continuation of sale and leasebacks agreements of company buildings and land.

These occur when companies sell high value assets to a third party and immediately sign long-term leases – say, 15 years - agreeing to lease the property back. This has been a popular strategy in the agriculture and retail sectors in particular.

For example, Seeka has been among those to adopt this strategy in recent years. Seeka views its expertise in the growing, handling and marketing of its products – not investing in local land prices. The sale of the land frees up huge amounts of capital, reducing debt and allowing the company to employ that capital in more effective ways and, presumably, earning greater returns than the cost of the land lease.

There are several ways investors can choose to effectively take the reverse position. Both the New Zealand Rural Land Company (NZL) and the Private Land and Property Fund (PLP) are examples of listed companies that operate on the other side, buying land and signing very long lease terms to tenants operating the land. Horticultural risks – commodity prices, weather, environmental regulations – remain with the operator, while the vagaries of property price fluctuations and interest rate movements become the domain of the landowner.

Another sector witnessing this trend is in telecommunications, with companies selling off physical assets, such as mobile towers, to a separate entity, freeing up capital to be used elsewhere.

In an environment of rising interest rates, investors can expect more instances of asset owners looking to capitalise on high prices. This is a global trend. While investment opportunities are always welcome, investors will need to continue to be discerning.

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EROAD’s acquisition of Coretex inched closer to a conclusion this week, with Overseas Investment Office approval granted for the transaction.

OIO assent was one of several such approvals required, with Commerce Commission approval the final one required before the deal can proceed.

The acquisition, which intends to broaden ERoad’s product offering into entirely new sectors, will allow the combined company to target new customers with new products. It expands the company’s reach and gives it a greater array of options for growth.

Commerce Commission approval has not yet been granted. The Commerce Commission has raised several issues – specifically surrounding the market for electronic road-user charges software – that must be addressed before approval is granted. Both Coretex and ERoad have made submissions in response to this.

These submissions are always something of a back-and-forth. The Commerce Commission is not, and does not pretend to be, an expert in the field of telematics and the service providers in this sector. It has raised concerns that ERoad and Coretex combined would have insufficient competition to restrain its market power. ERoad effectively needs to argue that its competitors are strong and that the barriers to entry are low enough that future competitors are likely to appear.

The Commerce Commission argues that if the transaction was disallowed, Coretex could eventually grow to become a major competitor to ERoad, either through a separate company acquiring its technology, or Coretex developing new technology to directly compete with ERoad. Arguing against such hypotheticals is difficult, although Coretex’s heavily redacted response focused on this point.

Ultimately, ERoad makes the point that its major competitor in this space – Navman – will ensure the company has some competition to help restrain costs for consumers.

The arguments seem compelling and ERoad is confident the deal will complete by the end of this year. From there, the much larger business will begin the process of marketing its full suite of products to new customers, as it seeks to continue its long history of growth.

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Kevin will be in Christchurch on 24 November.

Edward will be in The Wairarapa on 24 November.

Johnny will be in Christchurch on 7 December – this will be the final trip to Christchurch for the year.

Please contact our office to make an appointment.


Chris Lee & Partners

Taking Stock 4 November 2021

Johnny Lee writes:

THE listing today of a profitable, dividend-paying company has been music to the ears of both retail and institutional investors alike on both sides of the Tasman, as we welcome another billion-dollar company on to our exchange.

The IPO of Vulcan Steel, a 26-year-old Australasian steel distributor, has been ''in the pipeline'' for many months. It will give investors exposure to the construction and engineering sectors at a time when governments globally are contemplating using their extensive balance sheets to invest in national infrastructure.

Steel distribution is not a sector that would fill New Zealand investors with many happy memories. The poor long-term share price performance of Vulcan competitor Steel and Tube will have led many to feel unfavourably towards the sector, although Steel and Tube happens to be one of the best performers of 2021 after some bleak years of indifferent leadership.

Vulcan acts, effectively, as a middleman. It purchases very large quantities of steel from producers, then distributes smaller quantities to customers, either as is or with modifications made at one of its processing plants.

Middlemen are necessary in this sector, as steel mills operate with ''MOQs'', or Minimum Order Quantities. Steel mills produce steel in far greater quantities than an individual project would require, necessitating the middleman to procure and manage inventories for end users. Steel mills also take considerable time – months - to fill orders, while the end user may need its steel within days. End users may also require specific modifications (an etching of a silver fern, for example) on its steel before use.

This requires some skill. Steel procurement operates on a replacement cost basis – meaning that sale price is dictated by the prevailing price at the time of sale. Ordering in bulk locks in a cost price for Vulcan, but sales may come weeks later, when the price may be unfavourable.

The Initial Public Offering is for approximately 40% of the company – existing shareholders have retained the other 60% - which will give comfort to investors concerned about unaligned interests or short-term shareholders cutting and running. The board of directors themselves will have close to 25% of the company between them after listing, including founder Peter Wells, who will end up remaining one of the largest shareholders after the float.

Steel distribution is, largely, a sector which relies on scale to be competitive. Scale allows distributors to order in greater quantities, giving them greater power to negotiate larger discounts from suppliers. It also allows them to hold larger inventories, which better equips them to service their customer base. As such, mergers and acquisitions are frequent throughout the history of the sector.

Vulcan is not the largest competitor in the sector, but it is established and has a diverse range of customers. Its largest customer provides only 2% of its revenues, and its top 20 customers provide only 13% of its revenue.

The steel sector at large has seen fairly modest growth in recent years, but hopes are high that projects in the rail, alternative energy and healthcare sectors will contribute to a short-term boost for the industry. Similarly, non-residential construction demand in Christchurch is expected to lift overall demand for steel in New Zealand.

The story does have some lowlights. The diminishing scale of the automobile industry in Australia has been a headwind for steel. This seems unlikely to be a reversible trend.

However, for Vulcan, several growth opportunities still exist.

The first and most obvious will be geographic expansion – extending its reach into new areas, particularly in Australia. From there, the focus will turn to expanding its product range, enhancing cross-selling between different product lines. Vulcan was specific in highlighting the potential of roofing steel and reinforcing steel as products that would complement its existing range.

Another avenue was growth via acquisition. Vulcan noted in its Product Disclosure Statement that acquisitions will become a key part of its growth strategy, and access to capital markets will be important to fund this long-term. The steel distribution market remains fractured, and Vulcan is well placed to capitalise on this.

However, there are risks to consider.

An economic downturn – alongside a slowing in construction activity – undeniably hurts Vulcan's bottom line. There is no escaping this. Vulcan profits from the distribution of steel and relies on economic activity more than most.

There is also disintermediation risk. Major steel producers – mills owned by the likes of BlueScope and InfraBuild – use distributors as part of their sale network. Were these companies to adopt a strategy to exclude Vulcan from this network – ''cutting out the middleman'' – Vulcan would need to locate alternative sources of steel to compete directly with them. Vulcan already has these supplier relationships in place, and is aware of this risk. Ultimately, it maintains strong, loyal relationships with both its suppliers and customers, and believes it can operate in a way that is mutually beneficial to all three – suppliers, itself, and end users.

Competition is another risk to be considered. The failed 2018 takeover bid from Fletcher Building for Steel and Tube is only one example of an industry that has seen considerable corporate activity in the past decade. If Vulcan allows itself to be left behind, other market participants could capture market share.

Other risks exist – industries moving away from steel towards other products, suppliers closing down, tighter regulatory requirements surrounding the quality of steel, Covid lockdowns hindering the ability to distribute product and other, normal risks that exist when investing in a listed company.

Vulcan lists today across both the NZX and the ASX. It forecasts a dividend yield of between 4.5% and 6% based on its prescribed pay-out ratio, with imputation and franking credits alternating each half, reflecting the diversity of its revenue streams.

It is already a profitable, growing company, which uses its skill in inventory management, focus on customer service and internal staff culture to help drive its company performance. The next step will be to take advantage of the expected growth in infrastructure investment, while staying one step ahead of its competitors.

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Chris Lee writes:

THE above item, prepared by Johnny, describes the Vulcan Steel company, listed in Australia and New Zealand today, after raising new capital, largely in Australia.

Those NZ investment bankers with an ability to separate wheat from chaff describe Vulcan as a company with experienced, competent governance and an excellent chief executive.

As is the case with New Zealand's most lauded company, Mainfreight, Vulcan is judged to have a modern culture that embraces all stakeholders.

It disregards the flim-flam of university and political doctrine, selecting its executive solely on the basis of knowledge, relevant experience, and excellence.

Its directors know the business thoroughly, they seem to understand the sector, and they seem to have unusual insight into the possible direction of the steel industry. The board and the executives do not rotate every few years, a philosophy shared by great companies like Fisher & Paykel Healthcare, Ryman, Mainfreight and the fund manager Infratil.

My guess is that Vulcan Steel will attract the attention of long-term investors and those fund managers who disregard the sharemarket index weightings when they invest other people’s money.

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LAST week I speculated in Taking Stock that the ASX-listed mining explorer, Santana Minerals, would raise new capital to fund an accelerated drilling programme at its Bendigo gold exploration site.

On Friday it raised A$4 million from largely Australian institutions, after an interesting capital market presentation, now displayed on its website.

Its objective will be to lift its independently-verified inferred resource to a million ounces or more, before Christmas, and then conduct infill drilling to convert the find from ''inferred'' to ''indicated''.

It will continue to raise cash as needed, hoping its ability to do so is enhanced by the evidence of its drilling programme.

I visit the site and meet with some of its executive next week and will record here what I learn.

It remains a project of potentially genuine scale for NZ, its fate not determined by threats like inflation, climate change, Covid, or doctrinaire policies, though I guess one can say that confidently only if it obtains consent after submitting a mining application, at some future date.

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THE lament expressed last week over the Ardern government’s preference to convert pastureland into forestry predictably led to a variety of replies.

Sheep and beef farmers want forestry to be planted only where pasture does not grow well. They argue that the world cannot eat trees. They argue vociferously. I admire our farmers.

An advocate with considerable expertise in forestry argued that what was now happening was a return to forestry of land previously converted to dairy farms.

He also posed the rhetorical question - if sheep and beef farming were an optimal use of pastureland, why would farmers not value land at the prices that horticulture and forestry advocates were prepared to pay?

He believed that carbon sinks, and carbon credits, offer a return on land that exceeds that of red meat producers.

Ironically, the same day we were all hearing news from climate change people on the fuel that forestry supplies to natural bush fires. Climate change activity causes fires that devour trees. Carbon sinks do not help much after fires devour the wood.

(How pleasing to hear Brazil pledge that it will cease destruction of rain forests.)

Those who plaintively point out that the growing world population cannot eat wood, no doubt are really highlighting that countries with suitable soil, air temperature, and rainfall consistency are the world’s food basket. NZ is up the top of that list, or would be, if we treasured our farmers.

If the outcome of the modern NZ ideology – to convert farmland to forestry – becomes entrenched, then the consequence might be much higher red meat and dairy prices.

At that point, the future ambitions for prime land might attract the farmers, as well as the tree advocates.

Do we need price increases in food before we reach a logical outcome?

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THOSE with an interest in gold have pointed out that the strange Troy ounce, of which just 12 make a pound, is quite different from the avoirdupois scale, where 16 ounces makes a pound.

We certainly have a world laden with bizarre anomalies.

An American gallon is not the same as a British gallon.

Gold is priced in ounces not grammes.

The depth of the sea is measured in chains, or fathoms, not metres.

Horses run furlongs, not 200 metres.

For my grandchildren this will all seem a mystery, especially now the astronomists believe they have found a star in another galaxy that is thousands of ''light years'' away, given a light year is measured at 365 (or sometimes 366) days x 24 hours x 60 minutes x 60 seconds x 186,000.

Light travels at 186,000 miles per second. The new star discovery is exciting but an unfathomable distance away.

Could we please start quoting gold in one-kilogram bars?

Troy ounces confuse everyone.

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Edward will be in the Wairarapa on the 24 November..

Any client wishing to arrange a meeting is welcome to contact the office.

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