Chris Lee & Partners Ltd

Taking Stock 28 October 2021

Johnny Lee writes:

A2 Milk has updated the market, hosting an online Investor Day to provide an extremely in-depth view of the environment it finds itself operating in, and its strategy moving forward.

The share price responded negatively, but has been very volatile in recent weeks, a time period that has included lawsuits, lockdowns and takeover rumours.

A2 Milk has been under fire in recent weeks in relation to disclosure, facing two lawsuits regarding an alleged failure to disclose relevant information during the height of Covid. This remains ongoing, but the Investor Day presentation certainly did not lack detail.

A2 Milk recently entered Australian regulator ASIC's list as one of the most short-sold shares on the ASX. As a reminder, short-selling is the practice of borrowing another shareholder's shares in order to sell them, effectively punting on the share price falling and facilitating a profit when repurchased. So far, the short-sellers have been rewarded, although this is not always the case. Short-sellers infamously sold shares in Tesla, which this week struck record highs as it became the 7th company worldwide to reach a market capitalisation of a trillion US dollars.

A2 Milk's presentation, which appears to be attempting the world record for number of acronyms in a document, is a very useful and timely document for current and potential shareholders. A2 Milk should be applauded for the breadth of topics discussed, as well as its honesty in dealing with several sore points for long-term shareholders.

The very detailed analysis of the Chinese consumer presents many interesting insights. The market – specifically, the Chinese Infant Milk Formula market – is changing very rapidly and A2 Milk is attempting to stay ''ahead of the curve'' as these trends develop and evolve.

New Zealand remains the second most trusted source of infant milk formula – behind China itself – but the trend is moving in the wrong direction. Chinese mothers, who typically use infant formula for a longer period of time than their Western peers, are increasingly moving towards Chinese-sourced products over international competitors. This is in contrast to barely a decade ago, where international products were being increasingly preferred due to perceived benefits in product quality.

A2 Milk, so far, has outrun this negative trend through expansion and marketing investment. It has also left itself some room to grow in what it calls ''lower tier cities'' – parts of China with a greater rural focus and lower costs of living. A2 Milk has typically targeted the ''ultra premium'' end of the sector - $85 NZD per kilogram - but the rapidly diverging paths in birth rates is prompting a renewed focus on this ''lower tier'', where birth rates are higher.

These two specific challenges are clearly the primary focus for the company's marketing strategy. Birth rates in expensive cities are falling, and new Chinese consumers are increasingly focused on products designed ''for Chinese people, by Chinese people''.

That being said, brand loyalty remains high within their existing customer base, moving the challenge towards recruiting new customers. One of the difficulties unique to infant formula is that your ''customers'' cease using the product after a year or two, and parents are increasingly only creating one ''customer'', despite the recently loosened government regulations regarding family size. This forces A2 Milk to actively search and lobby new parents to try their product, all while maintaining an image of premium quality.

In response to this, A2 Milk is looking to expand its portfolio into more milk-based products aimed at young children and families, seeking to leverage off its existing brand image. The company has seen some success from the recent launch of a UHT milk product, providing a proof of concept for this strategy.

The Daigou channel remains problematic, but is an industry-wide challenge caused by an issue beyond the company's control. A2 Milk's focus is instead to grow other distribution channels.

Outside of China, the company is still seeing growth and sees potential in several new markets, including Vietnam, Indonesia, Malaysia and Singapore.

Existing markets are something of a mixed bag.

In Australia, the growth of ''milk alternatives'' – almond, soy and oat being common examples – is contrasted by a decline in overall fresh milk volume. A2 Milk's market share is still growing in this shrinking market. Production capacity is struggling, which is leading the company to invest further into this space.

The US market is proving extremely competitive, and to make matters worse, the Covid lockdowns have hurt prospects further. New and unknown brands rely heavily on their visibility with promotions, as they cannot yet rely on brand loyalty. Furthermore, the ending of lockdowns prompted a flurry of demand towards restaurants and dining out, away from grocery shopping and home cooking. Overall revenue declined, although A2 Milk points out that unfavourable foreign exchange movements proved the difference between an increase and a decline.

The Mataura Valley Milk acquisition is still five years away from reaching profitability. Significant headwinds have emerged which are expected to reduce earnings, specifically issues around existing customer inventory oversupply.

Overall, the company is experiencing new challenges and attempting to expand into several areas simultaneously, each with their own set of unique issues and opportunities. Both manufacturing and marketing are likely to see significant investment, as the company fights to retain its market share in some markets, and grow it elsewhere. Early sales - for next year's report - have been disappointing, with challenges across most of the markets the company operates within. The balance sheet remains its saving grace, allowing the company ample room to weather the storm.

Conversations regarding shareholder return – either in the form of a buyback or dividends – remain a footnote in the face of the challenges in front of the company now.

Overall, the update is well timed and, while not particularly positive, provides an insight into the struggles the company is facing and its plan to tackle them.

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Chris Lee writes:

THE prospect of a new world-class gold find in New Zealand was discussed in Taking Stock two weeks ago, in very general terms. A little more detail is available and more will be available later in November.

ASX-listed Santana Minerals has a resource at Bendigo-Ophir in Central Otago. The resource is measured independently as having an inferred quantum of 640,000 ounces with an average of one gram of gold per tonne of rock, the lowest grades at 0.25 grams.

If the cut-off were a compelling 0.5 grams per tonne the resource would still be around 500,000 ounces and would encounter a lower mining cost, creating a generous margin.

The published results, and the geologists' ambitions, suggest that the next few drilled holes might soon be assessed as implying a million ounces, with a cut-off of 0.25 grams. Increasing the cut-off point to 0.50 grams might mean a reduction in the tonnes processed of nearly 50 per cent, for a loss of gold of only 16.5%.

The potential of the mine has enthused all who are involved in the project.

As an aside, one troy ounce of gold is 31.1035 grams. At $2500 per ounce, 1 gram/tonne is worth $56 against a mining cost expected to be around $28 per gram of gold produced.

Santana last week lifted its drilling programme to double shifts, burning cash resources in the interests of ensuring the market is fully informed. The results to date have justified optimism. Clearly Santana will need more cash to maintain double shifts, and has today signalled a capital raising.

Currently the market capitalisation of Santana (SMI) is around A$25 million, meaning the market is valuing its resource at around A$40 per ounce of inferred gold, amongst the lowest measurement of all Australasian explorers, measured by inferred resource to market capitalisation.

A re-rating to at least A$70 per ounce will now be SMI's goal, prompted by the higher yields and the growing resource. That figure (of $70) would be the median valuation for gold explorers, yet well below the ratings of lesser companies.

Were its planned corporate presentations in Australia to achieve the higher rating, SMI's market capitalisation would be nearer A$45 million (now $25m), on its inferred resource (640,000 oz), but would be $70m, if its drilling optimism were justified. The information on drilling released yesterday, explains the optimism.

A share price leap would have two obvious outcomes.

Firstly, it would encourage the original investors, as the share price would need to rise to around 65 cents from its current level in the twenties.

Secondly, it would enable SMI to attempt larger wholesale placements at a better, discounted price, with the result being an injection of cash that would fund a prolonged double shift drilling programme over a much wider area of its licences. One of the drilled areas in what is named the Rise and Shine target, is displaying increasing grades, as the drilling widens and explores deeper.

The drilling programme aims to prove a much greater resource and would itself have two possible outcomes, if it continues to produce higher yields.

The growing resource might prompt larger mining companies to cast an eye at the project. A market cap rate of A$70m would seem undervalued if the inferred resource had a potential value of billions, gold price dependent.

A second outcome might be an accelerated programme to gain resource consent, then raise the capital needed to build a mine, and then begin mining. Building the mine would cost many tens of millions. A million ounces has a current value of $2.5 billion. The implied margins would at today's gold price be attractive.

Given progress to date, the Bendigo mine has the promise of being a world-class gold mine, just as the Macraes Mine has proved to be.

It is a truism that the best way for a miner to reduce risk is to produce the gold at the known price of today, rather than punt on the future gold price.

Only a brave mindset would defer production in the hope of a higher gold price, even when Canadian gold mining chief executives are gaining global attention with their brave gold price predictions, as Bloomberg reported last week.

Of course, gold prices can move quickly.

I recall the results of a mine which our clients helped to fund at the delightful farming/trout fishing village of Waikaia, in the South Island. The mine is now a completed project.

The mine was planned when gold was priced around NZ$2,100 an ounce. The project was impressively successful, producing around 80,000 ounces in five years but the gold price slumped, meaning the average gold sale price was around $1,620 an ounce, not $2,100.

Investors received a moderate return, though that return would convert to an excellent level if the company achieves its ambition with a second project, 40 kilometres away at Waikaka, where it holds an option that would be attractive at current gold prices.

To put the Waikaia project into perspective, if the gold had been sold at today's price, around NZ$2,500 an ounce, the dividends for Waikaia investors would have increased by a further $72 million, an average of two million dollars per investor.

The smallest of the 35 investors would have received an additional $300,000 in dividends. The Toyota ad's dog had an appropriate word for this missed opportunity.

The project at Bendigo-Ophir is being investigated at a time when gold prices are stronger. Yet no word from above is available on the next cycle of gold prices - up or down, Canadian gold prophets notwithstanding.

The geologists at Bendigo are conducting double shifts, hoping that rising average yields will lead to a growing seven-figure resource.

A wise NZ government should be cheering the project's success. Royalties and tax should be welcomed, by any government with any ambition to balance its budgets.

Footnote 1: Many of our clients, and the writer, hold shares in SMI, totalling perhaps 10 percent of the company.

Footnote 2: I plan a visit to Bendigo in two weeks and will discuss that in a future Taking Stock. Of course, my trip is COVID-dependent.

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ARDERN and her colleagues, hopefully, are cheering on Santana's progress but they should save energy to think more deeply about what is threatening sheep, beef, and dairy farmers.

New Zealand's ability to supply milk and meat to the world, thanks to our ability to grow grass, showcases one of our most important comparative advantages.

The world will continue to eat meat and drink cow's milk for many decades, wherever it is produced. Demand is rising, not falling. We need to be supplying.

Political intervention in the sector seems to be reducing our ability to supply, damaging our economy and rural communities. This would inevitably lead to other countries, with much harsher farming methods, increasing production to fill the gap, were we to continue to preach that our pastureland should be engulfed by pine forests.

By continuing to undermine our sheep and beef farming, and our dairy industry, we might produce marginal reductions in our contribution to the gasses that are measured to assess climate change, but the globe would not have any nett benefit. Globally carbon emissions would rise as the pasture-produced food was replaced by intensive farming methods in other countries. Surely the objective is to help reduce carbon, globally.

Our current obsession with replacing pasture with pine trees, to enable the accumulation of carbon credits, might increase returns for the landowners but the cost of such programmes is extreme. We should think more deeply about this new, toxic trend.

Years ago, our agriculture-based economy was governed in parliament by a fair number of people who had created the time and the money needed to give up their real jobs, working for decades on farms, learning first-hand the risks and returns of working on the land. They moved into parliament as community service for what were then meagre wages, to apply their knowledge to a rural-based economy.

Virtually every parliament had a healthy number of farmers who had helped create New Zealand's wealth. Those people contributed greatly to our country, on the land and then in governance. Keith Holyoake was just one example. He accepted the role of Prime Minister for a salary of less than $10,000 per year.

Today, I see dozens of people in parliament who have had sheltered careers, being paid to work in bureaucracy, writing policy, guided by pollsters. As the Government now enjoys a majority it can introduce doctrinaire policies, exploiting the ability to load the public sector with people chosen not for their knowledge and acumen but for their acquiescent, some might say their obsequious, unchallenging, relationship with the government. A weak, complicit public service feeding reports to doctrinaire politicians would hardly be the optimal route to robust policies.

I fear that without any voice from our productive sectors, especially our agricultural sectors, policies are being implemented that might have serious, if unintended, consequences.

We have had more than 30 pasture-based farms sold off this year to convert to pine forests; that is, thousands of hectares of great land, to be covered by pine needles.

One can hardly blame the farmers. The messages they are hearing are clear. Trees are welcome, ruminants are not.

It is true that there is more money to be made selling carbon credits to global polluters (in China or India) than there is to be made by everyday nourishment of the land and the animals.

Some leading advocates of our farming methods are being persuaded that this trend makes short-term monetary sense.

Short-termism is a disease. Pine trees are a short-term solution.

Carbon credits do not reduce carbon across the globe. They just enable polluters elsewhere to offset their carbon output.

It is getting dangerously close to the date when it might be very difficult to reverse this new political directive. It will have a wide range of unintended consequences.

NZ needs to produce food for the world while nurturing its natural resources, innovating to eliminate damage to waterways, soil and the atmosphere. Our farmers are great innovators.

Pine trees, in the minds of many, are an abomination.

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MICHAEL Warrington, who writes Market News every Monday for our clients (and outside readers) has long promoted the NZ Shareholders Association, largely on the basis of its willingness to vote proxies for investors who might otherwise not vote.

The NZSA is providing an excellent service in this respect. Another valuable service it provides is access to company executives on ''field'' trips, available to all NZSA members.

Given that by definition the NZSA caters solely for real investors, this service is invaluable, achieving information sharing and progress reports on matters that do not breach insider rules and are rarely reported in the media.

The service is crucial as the media today have little time or budgets to provide generic company information, and in many cases, are denied access to company executives, for valid reasons.

There are many such reasons justifying the decisions of chief executives to decline to engage with reporters. These include:

- Lack of time. CEOs are absurdly busy, even more so during Covid when they are addressing additional issues that were never in their strategic plan. They do not earn their rewards by chatting to reporters.

- Confidentiality. Insider trading rules, when breached, are career-ending. Reporters are always looking to promote themselves by gaining tips on what might happen next. Reporters gain promotion and inter-industry respect for their publishing of ''tips''. Executives, who provide ''tips'', are sacked.

- Trust. The silly billy reporters, the Felicity Ferrets of the world (as Metro magazine readers might recall) find it satisfying to report salacious or irrelevant tripe, such as which famous businessman had a nephew who promotes anti-vaxxing, or gets parking tickets, or fell over in the mud at an agricultural field day. Silly reporters will access only those chief executives who are undiscerning, or those who grab every opportunity for a ''click'', enjoying their moments of public exposure. These peacocks are of little relevance. Wellington once had a voodoo priest who captivated gullible reporters.

- Respect. The CEOs with whom I engage are disinclined to talk to those reporters who have not developed knowledge of the subject and are looking for a benevolent educator. We have far too few reporters with genuine ability to analyse and explain. Clicks seem more important than analysis.

For all, or some, of these reasons, many skilled chief executives find it easier to be unavailable to the media. It is not discourteous to be unavailable to reporters.

The NZSA, however, does have informed leadership, its people welcomed by companies and chief executives as an opportunity to engage with people about whom they care – sincere, interested investors.

My view is that those investors with time on their hands, and an understanding of business far deeper than any Felicity Ferret will ever achieve, should join the NZSA and join the field trips.

They will not receive ''tips'' or learn whose nephew gets parking tickets, but they will get knowledgeable insight into company progress.

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TRAVEL

Kevin Gloag will be in Timaru on the afternoon of Tuesday 2 November and the morning of Wednesday 3 November.

COVID has made our planned seminars impossible. We hope to hold them in early 2022.

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

Chris Lee & Partners Ltd

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Taking Stock 21 October 2021

AT a time when several structural changes are disrupting the world economy and financial markets, finding a gem in the NZ market is challenging.

The retirement village sector seems to be overcoming disruptions, still finding eager demand, and still shrugging off the distractions of dopey resource consent laws, skilled labour shortages, and incompetent regulators. Perhaps it remains a promising opportunity.

The items of news last week highlighted the sector's dismissal of such irritants.

The newcomer to the NZX listings, Arvida, confirmed its firepower and its pursuit of a sustainable, profitable future by buying some high-quality villages around Tauranga and Auckland, reaching agreement with a deep-pocketed seller, Blackstone, a huge American private equity company.

I am impressed by two aspects of this purchase.

Firstly, it demonstrates that Arvida has seen the limits of remaining a small, provincial retirement village operator, with a focus on small towns and outdated villages.

Arvida started its life as a listed company rather like Metlife did in the 1990s, lumping together privately-owned villages, in effect putting a corporate structure on top of some amateurish but kind business operators. Its listing was inauspicious, quietly followed by further capital raising at prices that may have annoyed the investors in the initial offer.

Its villages then received most of their income from the fees paid by full-care patients. Margins were tight. Arvida had little opportunity to subsidise this marginal business with property development margins and real estate value growth. It was mostly a backwater company with a glum business model.

Soon after listing it was greatly helped by a change in the government policy that dictated the maximum cost it could charge for care. That change allowed rest homes and private hospitals to charge unlimited weekly fees for ''premium'' rooms, loosely defined as rooms with a view, or with modern facilities like kitchenettes or ensuite bathrooms. The government's dictated pricing was redefined as being for ''standard'' rooms, not ''premium'' rooms.

The retirement villages immediately focused on redefining the better rooms, enabling the companies to charge more than what the government would pay for the tenants eligible for government subsidy.

Previously the government-declared rate was the one and only rate, whether the room was superior or not.

That fee was grossly insufficient for those operators who provided superior care and facilities and meant that those in the business of providing care in areas where property values were less exuberant would never have offered the same growth in value as those with an Auckland focus.

The law change literally rescued the Arvida investors, a handful of which had been All Blacks. Without the unexpected boost of the premium room revenue, Arvida would have been a marginal operation.

To put the new law into context, a facility with twenty ''premium'' rooms could lift its annual fee – and probably did lift its fee – by $20,000 per room, per year, meaning the village owner had $400,000 of additional, unexpected revenue.

Arvida has around 20 villages so its revenues would have increased by several million.

Since then Arvida had diversified its debt with bond issues, locking in long-term low interest rate cost, and now, with its new purchases, it is raising capital, perhaps around $300 million through institutional placements and a good old-fashioned rights issue. It will soon have a much better base, centred around Tauranga and Auckland, with room for value increases, via land prices.

I applaud Arvida. I suspect the company is getting sharper advice and is developing confidence in its ability to attract support from the capital markets.

This new confidence is the second aspect of its purchase that impresses me.

Arvida will never be a Ryman, a Summerset, or an Oceania, but it does not need to have that ambition.

It must simply be a reliable provider of good services at a price that has a natural demand for a market segment that might be more price sensitive than the market Ryman identifies.

The other item of significance last week was that the highest-end of the sector is also gaining access to capital markets. Winton aims to find demand for a high-spec product, its villages built in attractive destinations, its building standards at the top end, luxury being its promise. It may also tap the capital markets for support.

Its villas and apartments will cost up to $3 million, so its market segment is different even from Rymans.

I do not yet know the details of Winton's exit formula, but I assume those who buy will be signing an agreement to pay a lump sum deferred management fee when they sell (or die) and return the dwelling to Winton.

Announcing its top-dollar product now should not necessarily be likened to raising a middle finger to the unnecessary and poorly-conceived campaign of the Labour government and its agency, Commission for Financial Capability, which want to prevent people from signing up any licences to occupy which feature unregulated financial conditions.

This silly plan seems to be based on the assumption that ''senior'' people should be protected from themselves, a notion many will find offensive.

The uncommercial, I would say inexperienced, people who want to intervene in the current model believe that there are three stages of retirement village life, two of which they wish to regulate.

The first stage is the purchase decision, currently required by law to provide clear, transparent conditions that must be discussed, and are required to be addressed by independent legal advice as a pre-condition of any sale and purchase agreement.

The conditions spell out the fee structures, what service and facilities are provided and signal the exit (deferred maintenance) charges. When a ''senior'' person signs up, they know and accept the financial commitment they are making.

The second stage is life in the village. This stage may involve high levels of nursing care, drug administration, and palliative care.

The interventionists do not propose to address this, it seems.

The third stage is the exit, usually involving an estate.

Conditions, signed upon purchasing, will spell out this formula for calculating the return of some of the purchase price. The agreement might define who pays to restore the dwelling to a saleable condition and would identify any other obligations, like continued monthly charges until a re-sale occurs. Nobody entering the village would be unaware of these processes. They must be disclosed and discussed before signing an agreement to buy.

These conditions are set by private treaty, not by some regulatory interventions, and are agreed when the purchase documents are signed. In effect they enable villages to provide low-cost living to residents, gaining their profit from the residents when the residents exit.

The person currently in charge of the Commission for Financial Capability is Jane Wrightson, herself a ''senior'' of around 60, whose career has been in Crown or Council funded organisations, including once being Chief Censor on the Broadcasting Standards Authority and as Chief Executive of a funded organisation that promoted arts and crafts in Wellington. Her role is stylised as the Retirement Commissioner.

Her career has not stemmed from the private sector. This might explain her thinking. She says she wants to concentrate on the first and third aspects of the private treaty, the treaty accepted by those who choose to buy into a village and accept the conditions.

It is not relevant to consider whether or not this patronising approach is insulting to seniors, implying they know not what they are doing.

She is simply wrong to make the cost of buying and exiting a signature project for an agency whose value has always been debatable.

If there is a stage of village life that should be carefully monitored, it would surely be the middle stage, where too often small villages do not provide the services they promised, and where care levels vary, often because of inadequate revenues and margins, or poor management.

Perhaps there is a case to review the minimum standards of care.

Wrightson and her policy wonks clearly see the sector as being a worthy project to justify the commission's budget, but display little nous in aiming their energy at retirement village profits, rather than their standards of care.

The start point for Wrightson should be the perpetual, stupid Crown under-funding of care services, the Crown declared cost being unforgivably lean, paying for a level of service at rates much lower than prison costs.

An independent, competent, knowledgeable Commissioner would tackle this underfunding by confronting the Government, demonstrating that the Crown's budget-saving model is forcing subsidised care residents to be at the mercy of the village owners. Does she have the stomach to raise this real issue? Her agency is dependent upon the Crown for its budget.

It is the level of care that could be standardised and monitored, if indeed there is a need to interfere with a sector that records very high resident satisfaction.

The purchase and sale arrangements should be the business of the two willing parties involved and be no more the focus of a commission for seniors than a senior person's purchase of travel, a car, or a table-tennis bat. Frankly I would be insulted if Wrightson and her policy people sought to ''protect'' me from my decision to sign a purchase agreement.

If Winton sells hundreds of $3 million high quality units and the buyers agree to accept fifty cents as the repayment on exit that would be none of the business of a government, or an arguably silly agency of government.

If the government does wish to intervene it should build villages to its own idea of fair value, let the tax-payer take the risk, and let it find a market for its product.

I suspect the queue of people wanting to enter a government village would look rather different from the queue who choose the Oceania, Ryman, Summerset or Winton model.

Images of Silverstream Hospital, closed in the 1970s, might come to mind.

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Johnny Lee writes:

MONDAY'S inflation data, showing our strongest annualised price increase in years, has put the Reserve Bank on notice. Expectations have shifted, and the OCR will need to move to accommodate this.

Swap rate markets were quick to respond, with rates lifting across the board. Mortgage rates followed. Interest rates on deposit accounts were somewhat slower to respond.

Looking deeper into the data, the main items under pressure were vegetables (highly seasonal), meat and dairy, council rates, international travel, petrol, toys and hobbies and, of course, new housing.

It would shock absolutely no one to observe that petrol prices have roared upwards. Petrol is the most visible contributor for most New Zealanders. The huge leaps in the price of crude - WTI is up 60% this year and almost 20% in the last month alone – suggest our next inflation data point, in January, will show another leap. Gas prices have further flow-on effects, especially in the transport sector.

The causes of this are multi-faceted, but part of the rise has been caused by the slow pace of re-engagement from supply – both from OPEC and US shale producers – and a sudden spike in demand following the lifts in lockdowns around the world. Petrol is not unique in in this regard – coal prices, natural gas prices and even fertiliser prices have all surged.

Some have also argued that the push towards renewables and away from fossil fuels, fuelled in part by the growing importance of ''ESG'' standards in the investing community, has led to underinvestment in energy security and a general misallocation of resources.

Ultimately, if demand for oil remains strong, the world will supply it – at the right price.

House prices, which are subject now to almost weekly articles in the media, lifted further. The construction sector has been vocal in lamenting the difficulties in securing both labour and materials, and recent efforts from central Government have been largely aimed at other pressure points for the sector.

The question now is whether these price increases are transitory or part of a fundamental shift towards higher pricing. A quarterly spike in pricing will not be of concern to the RBNZ, but a gradual shift towards higher pricing – perhaps fuelled by an increasingly expensive labour force, will prompt the committee to take steps to curtail those rising prices.

Internationally, labour force costs are a rising concern (for central banks – not for workers!). The spread of Covid has led to a huge increase in ''excess mortality'', or the number of deaths beyond the expected value. Fewer workers, combined with a dramatic shift in migration, has led to squeezes in the economy.

Reserve Banks, including our own, have broadly adopted a ''wait and see'' approach, believing that prices either stabilise or will gradually ease over time. Recent commentary around the world regarding supply chain issues suggests this may come to pass. However, in a world still ruled by Covid lockdowns, there are ample reasons to expect Reserve Banks to be cautious when it comes to forecasting.

Ultimately, market expectations have shifted. Swap rates are now sharply higher than they were a week ago, and the voices demanding interest rates rise will only grow louder if data points come to pass as expected. Rising interest rates will devalue most investments, and investors will need to ensure they factor in these expectations when considering their next moves.

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2021 will be a year remembered for many different reasons, but for the investment community, it will likely be remembered as a year which saw a stunning resurgence in M&A activity.

Mergers and acquisitions have been seen in almost every sector, even in New Zealand. The likes of Tilt, E-Road, Trustpower/Mercury, Arvida, Radius, EBOS, Vital Healthcare, Z Energy and Infratil have all been involved in various deals throughout the year. Arvida, the most recent to approach capital markets to fund an acquisition, raised about 30% of its market capitalisation, equivalent to Ryman raising $2.5 billion dollars.

I suspect we have not seen the end of this. Companies are increasingly looking externally to achieve growth or scale. The potential tie-up between 2 Degrees and Orcon is one such example of the latter, with two smaller competitors joining forces to tackle much larger and more established competitors. The merger of BHP's oil and gas assets with competitors Woodside Petroleum is another such example.

Both EBOS and Infratil have been particularly willing to open their chequebooks, searching for businesses that complement existing operations while providing an avenue for growth. Both companies are well known for their respect of company funds, while acknowledging that investors do not pay their board members to put money on term deposit. A2 Milk, despite all its recent difficulties, is another with a large cash balance and a stated intention to use it.

With this shift towards M&A, it is important we observe the lessons from abroad. Some companies, with share prices at elevated levels, will seek to capitalise on this by raising money from investors while the price is high. This makes perfect sense from the company's perspective. However, the M&A boom in the United States has shown that investors must be careful not to mistake hype (and an excess of investible capital) for genuine product.

Last week saw approximately $500 million announced in capital raising between Vital Healthcare and Arvida. Another major IPO is expected to be announced by the end of the month, while the debt market continues to churn out new deals for investors to consider. Clearly, there is money looking for a home, and companies willing to use it.

Clients are welcome to contact us to discuss these transactions as they occur.

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TRAVEL 

David Colman will be in New Plymouth on November 1.

Edward Lee will be in Wellington on November 12.

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

Chris Lee & Partners Ltd

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Taking Stock 14 October 2021

IT may have escaped the attention of our media and most investors but last week New Zealand received some great news.

Our country has discovered a major resource, probably worth billions of dollars, and within months may be able to announce a world-class resource that in subsequent years should make a significant contribution to the country.

If the resource grows in line with statistical probability, the great outcome would be: -

- 350 permanent, new, well-paying jobs, in Central Otago, none dependent on tourism.

- An annual revenue base for the Crown of tens of millions.

- An increase in exports to Australia of more than a billion each year.

The project to which I refer is at Bendigo-Ophir, less than an hour north of Cromwell.

The area has a tiny population- a few grapevines, and a few farms – and currently is on land some distance from any sealed road, accessible via Crown land, but probably needing a new road to make entry easy.

The resource is gold.

Last week, the news release advised investors that an independent agency in Australia had assessed recent diamond drilling test results and calculated that the area drilled was likely to contain 640,000 ounces. The area drilled was a tiny fraction of the land that will be drilled.

Drilling continues. It would be a statistical oddity if within months that number of inferred resource was less than a million ounces.

A million ounce gold mine meets most definitions of a world-class mine.

To put this into perspective, when the discovery was made that led to Macraes Mine, in a similar geographic area, the estimates of resource had reached a million ounces.

More drilling at Macraes led to mine extension. Some thirty years later, Macraes, now owned by OceanaGold, has smelted more than five million ounces of gold, and believes it has some further millions of ounces to extract in coming years. The land has released gold worth more than ten billion dollars.

The land at Bendigo-Ophir was identified years ago by veteran geologists, Kim Bunting and Warren Batt, as being similar to the land where Macraes started.

Batt had been the principal geologist in the discovery of the Macraes find. Bunting believed Bendigo has similar characteristics.

He has made Bendigo a personal project and currently wears the smile of someone whose instincts and training have been rewarded by independent confirmation that Bendigo-Ophir might soon be classified as world-class mine, as Macraes certainly is.

Getting to this point has been an adventure.

Raising the millions needed to access and begin drilling is no simple feat in New Zealand.

Bunting and Batt achieved that, and then scaled up their drilling after agreeing to merge with a small Australian mineral explorer, Santana Minerals, listed on the ASX.

With the help of Australian broker Bell Potter, new money was raised enabling Bunting and Batt to have certainty about funding a three-year drilling programme, in the hope of proving that a world-class mine could be planned. Last week's announcement suggests the programme is on track.

Every diamond drilled hole costs around NZ $100,000, the work performed by a Southland company with expertise and the access to the drilling gear.

Last week's news provided the breakthrough, albeit being the first major step of what should be a long-term project.

As well as confirming a resource that grows as the drilling continues, the independent analysis confirmed that the gold-bearing rock has been oxidated in the last 800 years and thus should release its gold with a process known as heap leaching.

This process reduces the energy required by eliminating the need to ''grind'' the rock, a method commonly used that is expensive, and energy intensive.

Furthermore, the new analysis revealed higher grades of gold than anyone had anticipated, implying that the attraction of the find will not just be the savings caused by heap leaching.

Bunting and Batt will be expecting the size of the resource to be recalculated in coming months, perhaps allowing Santana to raise further capital with placements or rights issues, enabling the mine to enter its next stage.

While all this is futuristic, some things are undeniable:

1. 640,000 ounces, recoverable at, say, 90%, equates to a resource worth $1.4 billion at today's gold price.

2. The government receives royalties on all gold that is smelted. Three percent of $1.4 billion would be $42 million.

3. Gold sold at a margin over cost of $500, would produce profits per year of $50m. Tax at 28% would accrue at $14m per year. (Figure calculated on 100,000 ounces of production per year.)

4. Dividend income would ultimately be attractive.

Without room for argument one can conclude that the news release (to the ASX) by Santana Minerals should have been welcomed by the government, investors, the media, and the many businesses in the area that would benefit from a major, long-term (10 years plus) project generating wealth and well-paid employment.

Of course, there are caveats.

The gold price could sink. (It could also rise.)

The tiny area drilled might not be representative of the many hectares yet to be drilled.

And let us not talk about the consenting process. Even when the land itself is not Crown-owned, there will always be those who prefer to leave gold in the ground. For the Crown to take this view would be odd, given that it authorised the exploration of the land.

Currently those who have read the Santana ASX release clearly understand that there are caveats. The Santana share price doubled, from 10 cents to 20 cents, when the news was digested.

If the news had been that the quantum of gold had been confirmed, that consent was certain, and that the gold price would be stable, the Santana shares should be worth a high multiple of its current level. There are uncertainties, the consent process being the most obvious.

Yet, we should be celebrating.

A large mine, producing hundreds of millions of revenue each year, indefinitely employing hundreds of well-paid staff, generating annually tens of millions for the Crown, ought to be an item of good news welcomed by a cash-depleted government, having to cope daily with gloomy news and rising debt, requiring servicing with what looks like rising interest rate cost.

Meanwhile, investors should keep an eye on the next ASX release.

Another major increase in the inferred resource would surely brighten everyone's day!

Disclosure: Our family trust holds shares in Santana, as does a group of our clients.

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WE all know the law can be an ass, especially when it is created off the hoof by people with neither an understanding of the principle of unintended consequences, nor the practicalities of executing a plan.

Law is for many a boring subject, especially commercial law, but investors might be wise to follow an imminent case in the highest courts, relating to the innocent subject of holiday pay.

Currently, the Holiday Pay law is designed to protect vulnerable workers, and it ensures workers are fairly compensated for any unused leave when they retire from a job.

This aspect of the law was hardly drafted to protect the privileged or the highly paid. Yet in recent times a well-paid executive resigned from a public company, was paid out for his unused leave, but was unhappy about the formula for calculating his entitlement for his unused holiday entitlement.

The executive had regularly qualified for a discretionary bonus, paid on top of his salary. He is now taking the company to court, claiming his unused holiday pay should have included his (potential) bonus, as a component of his actual salary, despite the bonus being payable only at the discretion of the company.

(As an aside, one anomaly in unused holiday payouts is that the payments are based on the final year's salary, so if an executive begins work on $50,000 a year, never uses his leave, and retires after twenty years on a salary of $500,000 p.a., he might claim his unused leave (80 weeks) and expect to be paid out at the rate of $500,000p.a.)

The new court case tests the claim that the potential, discretionary bonuses are an entitlement.

If the court finds the claim has merit his holiday pay-out would need to adjust somehow, to some assumed entitlement to a discretionary bonus.

As it is now big companies accrue the expense of unpaid leave, display the number in the accounts but never include undeclared, discretionary bonuses.

A large company may have tens of millions of accruals to meet the claim, but no company has ever imagined that the final payout for unused leave must include undeclared, or unawarded, discretionary bonuses.

A sanguine employer might well reason that a departing employee does not require incentivizing with a bonus.

The biggest losers if the law found against the company would be the trading banks, which habitually allow senior staff to accrue leave, assessing the urgency of their daily work to outweigh the need for holidays. It is not uncommon for banks to ''owe'' staff tens of weeks, for the leave never used.

The banks will be up for at least tens of millions, and possibly hundreds of millions in Australasia, if the law rules in favour of the claim.

For that reason, I assume that the banks are funding the public company's defence against this claim. ANZ is certain to be funding the defence. The banks will see this cost as money spent to clarify an issue without any public focus on the banks.

Without such funding the public company itself might have just settled confidentially, assuming that the cost, say $50,000, was cheaper than paying the legal bill of a case.

A more cynical view might stem from the counter argument, that should the claim fail, the cost to the claimant might be catastrophic. A large organisation, at least potentially, might simply invite the discontented, departing employee to back off, given the cost of a court case, should the claim fail.

Whatever, this case will be in focus for all public companies, indeed all companies that offer discretionary bonuses.

Might this be the case that puts an end to the practice of discretionary bonuses, or leads to a redefinition of entitlement? Might such bonuses be deferred and dependent on future years of employment, perhaps recoverable if an employee leaves before an escrow period is reached?

 _ _ _ _ _ _ _ _ _ _ _ _

THE law society has welcomed the concept of litigation funding, arguing the merits of access to justice outweigh the risk of frivolous claims. I applaud that response.

In focus will be the current planned case against A2 Milk, where existing investors in ATM will be pondering the extent of potential payout to those ATM investors who bought shares last year, at a time when ATM had not signalled the extent of its falling revenue.

Investors would want to know who would foot the bill if the litigation funder succeeds.

I bought some of my holding during that period. If I were compensated, the money might effectively be paid to me by those who had owned the shares prior to the alleged ATM disclosure failure. I have owned ATM for many years. Effectively I would be paying myself, if ATM itself simply paid me, from its company funds.

Yet, if there were a real error by the ATM directors, might the directors be the target of the claim, their professional insurance providing the pool from which I might be compensated?

This question must surely be considered.

Litigation funding has already served one great purpose.

It has brought to attention lazy, incompetent directors, forcing them to retire or adopt new levels of thoroughness, and to accept that their behaviour affects other people's money.

When the court defines how much Mainzeal's inept directors must pay (personally), investors will have proof that incompetence has a cost.

One extrapolates from this mindset the future arguments of those who will ponder why fund managers, KiwiSaver managers, as an example, charge fees for expertise, even claim massive bonuses in good years, yet are seldom asked, for example, why they mis-used other people's money by buying canines (such as TV3 many years ago, as an obvious example).

The case against fund managers is not far away. Out of court settlements will be a device used to avoid publicity.

Litigation funders are bringing change to behaviour. They are levelling the playing fields, but there will be unintended consequences.

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Johnny Lee writes:

THE takeover of Z Energy, by Australian fuel retailer Ampol, has cleared its first major hurdle – board support.

The board of Z Energy has thrown its weight behind the takeover, negotiating what is effectively an extra 5 cents to bring the total offer price to $3.83. The eventual price paid will likely be lower, reflecting dividends extracted from the company during the takeover process.

There are several more hurdles to overcome.

Commerce Commission approval is one such hurdle. Ampol currently has a presence in our market due to its ownership of Z Energy rival Gull. Combining the two assets would likely fail the ''substantial lessening of competition'' test. To get ahead of this issue, Ampol has committed to eventually selling Gull – either to another owner, or into public ownership via a share market listing – if the takeover proceeds. This solution seems likely to satisfy competition concerns, as this ultimately results in a scenario where there is no change in market power – simply a change in ownership.

A public listing of Gull would certainly be intriguing to investors, particularly current Z Energy shareholders, who have grown accustomed to the risks and rewards associated with fuel retailing over the past 18 months.

Ampol has also indicated that it intends to dual list its own stock on our exchange following the takeover. Overseas-based dual listings tend to suffer from extremely low liquidity on our exchange, and the trend has in fact been for Australian companies to delist from our board, rather than join it. Nevertheless, the NZX will no doubt be more than happy to see more companies list on our exchange.

If Z Energy’s departure heralds the arrival of both Gull and Ampol onto our exchange, investors may even find themselves better positioned long-term.

Overseas Investment Office approval must also occur. The scheme of arrangement makes the preliminary case that Ampol's significant infrastructure – including trading and shipping operations – will see benefits down the line to Z Energy beyond just scale.

The shareholder vote will be another key milestone in the process.

Previous discussion regarding this takeover generated a strong response from some shareholders that viewed the price on offer ($3.78 at that time) as being unacceptably low. The offer is well below the price many long-term shareholders paid for their shares, and the 5 cents per share increase is unlikely to make a material difference to those shareholders. The previously indicated dividends attracted many to buy the stock in the first place, and the prospect of a payout at these levels will feel opportunistic to some of these shareholders.

The board of Z Energy will be aware of this. Ultimately, the offer does not require 100% support, and the company will already have an idea from its major shareholders as to whether the offer can get across the line.

The independent valuation from Calibre Partners (formerly KordaMentha NZ) will be crucial. These reports have, in the past, been shown to carry some influence in swaying shareholder support, and nudging bidders higher to fall within a valuation range.

The first step is complete – the board, elected by its shareholders, has put forward its recommendation. It believes the offer is fair and should be accepted by shareholders. Shareholders will soon be presented with an independent view and asked to vote for or against the proposal.

This is expected to occur early next year, assuming no rival bid emerges.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _

TWO IPO's were placed on hold last week, as telecommunication companies 2 Degrees and Orcon (formerly Vocus) consider whether a merger of the two companies is feasible and could produce a better outcome than either company individually competing.

2 Degrees operates predominantly within the mobile sector, with approximately 20% market share. Orcon instead has a focus on the broadband market, where it has a market share of around 13%, almost twice that of 2 Degrees' 7% broadband share. In both markets, Vodafone and Spark remain the main competitors.

These numbers are important. Mergers within the telecommunications sector are notoriously tricky, due to a Commerce Commission that seems very reluctant to allow scenarios which could reduce consumer choice.

2 Degrees and Orcon will undoubtedly argue that ''joining forces'' is necessary to create an entity able to aggressively compete with Spark and Vodafone. The rollout of 5G, deemed necessary to compete in the mobile sector, is a burden that 2 Degrees majority owner Trilogy International Partners would much rather share than carry alone.

In turn, Orcon will know that bundling mobile and broadband – like Spark and Vodafone - is a much more appetising offer for consumers than either one alone. There is a logic for both sides to pursue this path.

Conversely, both owners will be cognisant that such a process may take far longer to resolve than the proposed floats – which were originally mooted for completion this calendar year. In the case of the failed transaction between Vodafone and Sky TV, it took almost a full 12 months for that matter to reach its conclusion. I imagine both Trilogy and Orcon-owner Macquarie Asset Management (joint owners with Aware Super) will be reluctant to waste too much time on merger discussions unless there is a genuine chance of a successful transaction.

The merger discussions are a very late twist in the tale and are by no means guaranteed to result in an actual transaction. Indeed, there are many impediments that could make such a merger unlikely. For now, investors can wait, as a raft of other opportunities begin to appear on the horizon for consideration.

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TRAVEL 

Johnny intends to be in Tauranga on October 21.

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

Chris Lee & Partners Ltd

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Taking Stock 7 October 2021

AT a time when many investors are enjoying the dividend returns of the NZX, a tiny number of conflicted fund managers are seeking to undermine the NZX's success.

It is tempting to disregard such campaigners as peacocks seeking an audience, rather than offering insight for the consumption of investors, but the mainstream media is elevating their concern, leading to investor concern.

Their argument focuses on the NZX decision some years ago to offer a range of exchange traded funds, which replicate the various indices that come from market platforms like the NZX.

These ETFs are run by a machine without any attempt to analyse the value of the securities within the index.

The machine every day buys and sells securities so that the ETFs, invested in, say, NZX top 50 shares, has a closing portfolio that exactly replicates the weightings of those 50 shares, the weightings changing as prices vary minute by minute.

Given that the NZX is the platform for trading, and is creating this data in NZ, it might be entirely logical for the NZX to be the dominant provider of index funds. You could argue that the product most naturally fits the NZX.

Those who compete with the NZX's Smartshares are now calling for the NZX to stop competing and sell its Smartshares business.

Active fund managers, who do use analysis and research as a means of establishing merit, create share price value. ETF machines effectively bludge on the process. If there were no active managers buying and selling on the basis of value, then share prices would simply move with ETF inflows, a dangerous determinant of underlying value, as we saw when ETFs pushed the prices of A2 Milk, Synlait, Meridian and Contact Energy.

So now we have the NZX running a successful stable of what it markets as ''Smartshares'' whose units are bought and sold like shares, the machine that calculates the weightings owned by the NZX.

There are now hundreds of millions invested in these smart ETFS, creating profits for the NZX, whose fees seem to me to be no more excessive than those of all the other NZ managers of ETFs, and for that matter the fees and bonuses of all fund managers.

The reality is that the ''manager'' of an ETF should receive fees related to intellectual property – virtually nil. That figure internationally is just a tenth or a twentieth of one percent, indeed nothing in some funds in places like New York.

The ETF manager may gain insight into markets, perhaps of value to him or her, and in NZ the ETF manager routinely lends the ETF-owned stocks for a fee to short sellers, rarely sharing the fee with the ETF investors whose shares are being lent.

Indeed one could argue that as short sellers by definition undermine share prices, no ETF fund manager with a ''long'' portfolio should be facilitating those who gain by causing prices to fall.

I conclude that the NZX is now managed in a mature way by its excellent chief executive, Mark Peterson, and is wise to seek to dominate the investing in an index that the NZX itself creates. Perhaps it should be the only ETF manager.

The agitators tend to be a mix of ambitious fund managers and some fairly hollow, relatively new salesmen, who some would say find it hard to gain attention behind the doors of power, so revert to rent-a-headline tactics, exploiting the media's hunger for controversy (and, thus, sales).

This week one such newcomer, Sam Stubbs, self-describes himself as a ''peacock'' who craves centre stage, and has taken on jobs for the money, rather than for the opportunity to build value. He says that he enters a room to take away its oxygen and will fight for centre-stage attention.

He wrote this of himself in an autobiographic description he submitted to the Business Desk news service. Business Desk published it. I am not sure that BD was being kind to Stubbs in publishing his self-description.

Stubbs' track record is unimpressive in my view. Perhaps the market leaders share this view. Index fund managers have very little access to the people whose knowledge helps to shape markets, and even less so if they choose to chase silly headlines with our struggling media, rather than present useful thoughts aimed at improving outcomes.

The ''peacock'' Stubbs, has had short, unmemorable roles at Hanover and Tower, neither of which organisation seemed to address their failings during his terms there. Stubbs now manages the tiny fund manager Simplicity (with around 2% of the market). It markets itself by chasing newspaper attention with supplied articles, often poorly thought out, in my view.

The genuine market leaders submit their views carefully, and make their points with an analytical mindset.

Stubbs attacked the NZX saying his little fund would reallocate its funds away from the NZX because of his dissatisfaction with the NZX. He seemed to blame the NZX for a lack of new issues, as though it had the power to demand that companies list on its platform. For obvious reasons (much wider capital access), many firms these days dual list with Australia, and some start-ups exclusively list with the ASX. It is simply a matter of fact that Australia's financial markets are larger than ours, and offer more and faster financial support than New Zealand offers.

The voices that condemn the NZX must think the NZX is discouraging businesses from listing. Those voices might also believe the NZX broking fraternity is too narrow, too few broking firms with any great ambition to help NZ capital markets to grow. Their views are blinkered.

They might look at Jarden, which has allocated time and substantial resources to Australia, employing hundreds of staff, handpicking what Australians believe were people who have established reputations for excellence.

Very few New Zealand organisations succeed in Australia, yet I doubt many would bet against Jarden.

Competing in Australia would not be an option for mediocre New Zealand ETF managers.

Instead, they explain their slow progress here by attacking the NZX, or so it seems.

In my view NZX shareholders should ignore such sad peacocks and should encourage the NZX to build its Smartshares to a dominant level, even if it caused feathers to fly.

The discontents might get more traction if they argued that the NZX should not have the dual role of market regulator, effectively the regulator of itself. The dual role is dangerous as was seen during Mark Weldon's unhappy tenure as CEO of the NZX, a Fawlty Tower era that must never be repeated.

In that era, the NZX regulator had to name the NZX as being in default of various reporting deadlines, a certain signal of leadership failure, and no one will forget the governance failures relating to continuous disclosure, or the audit failures with NZX members.

Currently the NZX delegates the regulatory function to NZ RegCo (NZR), which appoints independent people to act as regulators.

The choices of NZR's governors have not won universal approval, one such person, Annabel Cotton, being an ambitious Waikato accountant, who seems to have targeted governance roles, a directorship with Fonterra being one of her recent (unsuccessful) aspirations.

Cotton was head of the Securities Commission during a period when its reputation went south from an already southern location, after Jane Diplock's failures there.

Cotton chaired the meeting of the Securities Commission that led to the inexcusable decision to place Allan Hubbard and his wife Jean, and various of their companies, into statutory management, leading to political decisions that were as cruel and stupid as any that have occurred in my lifetime.

Cotton, if she were to be a regulator, would have double-checked the information on which her commission made its error. Had this happened, the billion-dollar error by John Key and his government might never have transpired. Key's legacy might have been a little cleaner.

The NZR's function might be best handed to the Financial Markets Authority if it cannot attract a level of talent that satisfies all. This might remove an area of conflicted interest that seems easy to fix.

Perhaps the critics of the NZX should start by analysing this second function, rather than argue about who can use the NZX indices, an argument that sounds like the grizzles of a runner-up.

 _ _ _ _ _ _ _ _ _ _ _ _

THE NZX indices themselves have a slightly controversial history.

There was no meaningful index until the late philanderer and opportunist, Frank Renouf, founded his fledgling merchant bank NZ United Corporation (NZUC) some 60 years ago and published daily the NZUC index.

When he succeeded in selling NZUC to Britain's Barclay Bank, NZUC became Barclays, and for some while the New Zealand Stock Exchange, with its trading branches in Dunedin, Wellington and Auckland, named its index the ''Barclays'' index.

Only in recent decades, did the NZSX become the NZX.

Renouf, a controversial fellow, later formed Renouf Corporation, and later still Renouf Properties, then abandoned his sharebroking firm Renouf Partners, after a period of hiring some fairly average staff, with whom Renouf did not work happily. He formed FH Renouf & Co, which itself never really gained traction, even in the heady days of that era.

Like many other high-profile business leaders in the 1980s, Renouf made astute donations to politicians and to the community, including forming the Renouf Tennis Centre, the money skilfully raised by selling Renouf Property shares at a huge price, just before the property company collapsed.

A towering presence with British mannerisms, Renouf had been a long-term prisoner in war years and learned to speak German while imprisoned. He was a gifted tennis player and part of the puerile group of business ''leaders'' whose fondness for other people's wives, and younger women, characterised the less seemly aspects of business in the 1980s.

Yet he was knighted for his donations to tennis and politics, some politicians glibly claiming in his citation that he had been an admired contributor to ''business''.

What was odd about this claim was that the business group which comprised the influential Wellington Club, and the social group which ran the Wellington Golf Club, declined his applications for membership on more than one occasion, blackballing him, hardly a signal of respect.

Perhaps some wives had been wise enough to offer a ''heads up''.

Today the NZX is, by comparison, staid and unstained by such imposters.

_ _ _ _ _ _ _ _ _ _ _ _

Johnny Lee writes:

THE class action against A2 Milk, filed this week by ASX-listed Australian law firm Slater and Gordon, sent A2 Milk’s share price lower and has once against highlighted a key risk associated with a public listing.

The filing alleges two specific and separate matters – that A2 engaged in misleading or deceptive conduct, and that the company breached its obligations surrounding continuous disclosure.

Anyone who purchased shares between 19August last year, and 7 May this year, will be automatically included in the claim. Such a long time period will include thousands of individuals – including myself - across the two countries in which A2 Milk has a sharemarket listing.

Eligible parties do not yet need to take any action.  They will be included during the preliminary stages with no financial obligation, and an opportunity to withdraw from the action in due course.  Eventually, affected parties will need to formally register their claims if they wish to receive any compensation.

The allegations primarily relate to the statements made by A2 Milk in its announcements to the stock exchange. Its 2020 full-year results, as part of its ''Outlook'', included the sentence: - ''Notwithstanding these uncertainties, overall for FY21, we anticipate continued strong revenue growth supported by our continued investment in marketing and organisational capability.''  The uncertainties refer to an earlier comment regarding Covid-19.

Obviously, this outlook did not come to pass. Revenue fell 30% in Full Year 2021.  The 12-month period between reportings saw the share price decline from approximately $20 a share to barely $7 a share, as the market became progressively more pessimistic that its forecast would be met.

There are four other updates that are being referenced in the claim, all of which were increasingly negative downgrades.

The first question is whether A2 Milk was, or ought to have been, aware that its initial outlook statement was inaccurate. The next question is whether the company contravened its continuous disclosure obligations by failing to adequately update the market.

There is no doubt that many of the purchasers of A2 Milk shares bought on the assumption that the forecasted outlook was credible and to be accepted in good faith. There is also no doubt that the company made considered efforts to update the market as time passed and more information came to light regarding the impact of Covid-19 on the industry.

If the claim does proceed, it is expected to take some time to resolve to a point of settlement.  Slater and Gordon itself states that the process may take up to three years to resolve.  Previous class actions have resulted in settlement in the tens of millions of dollars, with Slater and Gordon taking a portion of this as a fee on behalf of shareholders.  Typically, the company goes unpaid if the claim is unsuccessful, giving Slater and Gordon an incentive to choose its targets carefully.

A2 Milk has already indicated that it intends to ''vigorously'' defend itself from the claims.  There will be no party (other than Slater and Gordon) that wishes to see A2 Milk devote time, energy and shareholder funds to defending a court action from its own shareholders over the next three years.

Although it is very early in this process, there are two points that are worth raising at this stage.

The first is the value and importance of formally indicating an outlook, or guidance.

Since the outbreak of Covid, it has become increasingly commonplace for companies to decline to provide a financial outlook, citing market uncertainty and the value of historical models in these times.  Those that have, such as A2 Milk, have been careful to fill their statements with caveats.

Outlooks are undeniably useful.  No analyst or financial adviser has greater access to information than the company itself.  Indeed, A2 Milk's share price volatility after these announcements proves that.

However, if Slater and Gordon succeeds and A2 Milk's 2020 outlook is deemed to have misled investors, intentionally or otherwise, surely the response would be to decline to provide a company outlook in future? If shareholder resources are being dedicated to spending years justifying one paragraph in a financial statement, it seems the ''Delete'' key would be a far simpler way to avoid any future headaches.

The second point is in regard to continuous disclosure.

Continuous disclosure has been a problem, worldwide, since the dawn of capital markets.

Listed companies are expected (and required) to notify all of their shareholders whenever they come into possession of material information – with some exceptions.  This requirement is a legal one and part of the listing rules all companies agree to honour when they apply to list on our stock exchange.

The rule exists to ensure a level playing field, and prevent a situation where some shareholders – like those attending analyst briefings or with subscriptions to specific news sites – might be advantaged over others.

The exceptions – broadly speaking – are specific enough to remove any risk of grey areas emerging. A company does not have to disclose information that is irrelevant to its share price. It does not have to announce information that would breach the law, nor does it release information that is not material to its financial results.

Two other exceptions relate to confidentiality and incompleteness. A company is not required to breach confidentiality for the sake of disclosure, although there is some room for interpretation if this confidentiality is breached already – say a leak to a media outlet. Incompleteness is also a justifiable reason to withhold disclosure. If the disclosure relates to a matter that has significant uncertainty as to whether it will in fact come to pass, companies have a defence when choosing not to disclose. Indeed, disclosing it may in itself be misleading.

The NZX has committed significant resources in assisting companies to identify when a matter requires disclosure. Guidance notes, flow charts and highly specific examples have been published to aid in this process. Ultimately, I suspect it will always remain an area of contention.

A2 Milk, once our largest listed company by market capitalisation, will have specific procedures and policies for dealing with continuous disclosure. It will not have published its outlook without specific modelling and forecasting to justify its stance.

If this matter eventually concludes with penalties awarded against A2 Milk, resulting in compensation awarded to the current and former shareholders who purchased in the time period involved, the effects could be widespread.

Companies will need to consider whether signing off an outlook, and the risk of that outlook being incorrect, is justified in the face of potential loss of shareholder funds.

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TRAVEL

 

Please note that the spread of the Delta virus may halt our plans to travel and to hold seminars. We will communicate changes should there be a need.

Edward will be in Wellington on Friday, 15 October

Johnny will be in Tauranga on Thursday, October 21.

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

Chris Lee & Partners Ltd

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