nz farming systems Uruguay

[Snoopy]

But my question is, what happens if a significant capital raising is completed?

This week a very important vote takes place. And I am not talking about the general election on Saturday! On Thursday 24th November at 3pm, the future investor direction of New Zealand Farming Systems Uruguay (NZS) will be decided at the NZS AGM. The vote is on the adoption of an extended loan package from majority shareholder Olam, and the associated downsteam consequences of that. Olam itself is not allowed to vote. So it will be up to we small shareholders to decide. Providing an evaluation of the proposal is an independent report issued by Grant Samuel (the GSR) dated October 2011. The revised funding package will allow the completion of infrastructure to support a total of 49 dairy sheds, up from 32 already operating at the end of June 2011, and 37 completed by October 2011.

SNOOPY

[Snoopy]

In the recent past Olam have adopted a somewhat combative attitude to the remaining 571 small shareholders. On November 9th 2011 there were newspaper reports of NZS small shareholders holding the company to ransom and possibly forcing their company into liquidation. As a small shareholder I resented that editorial tone. I didn’t even see potential liquidation of the current company structure of NZS as a great threat. NZS is EBIT positive already. With the company’s share price below net asset backing, an orderly sale of farm assets could be positive for small shareholders in the medium term. Nevertheless I believe that the investors left in NZS want to see this farm development project through to completion. My sincere hope is that Olam will now start to work co-operatively with the remaining small shareholders. Perhaps the acceptance of a director nomination from the small shareholder ginger group, the second largest shareholder by partnership and dairy farm owner Rob Poole, is an indicator of an olive branch being extended in this direction?

SNOOPY

[Snoopy]

Some on this forum keep posing the question, when will NZS ever be profitable? The answer depends ultimately on how much new capital shareholders are prepared to put into it.

The FY2012 projection is for an EBIT of $US8.541m. There will be no tax payable as NZS have reputably eight years worth of tax credits in the bank with the Uruguayan tax authorities. This consists of $US42m in tax credits and $US42m of additional ‘Project of National Importance’ tax credits (GSR p16). With no tax to pay for many years, whether there will be a real profit or not depends very largely on the company’s interest bill. That interest bill into the future in turn depends on how much capital the company raises over the next twelve months to pay down debt.

For illustrative purposes, I think it makes sense to look at three capital raising options (to be continued).

SNOOPY

[Snoopy]

If no additional capital is raised (lets call this capital raising option 1), the debt profile of the company is forecast to look something like this as at 30th June 2012 (GSR p9):

$US110.0m in 8.9% bonds payable to Olam (+$US40m over EOFY2011)
$US25.7m in 9-11% NZS Uruguayan bonds
$US20.0m in a 7.25% Banco Republica loan (+$US15m over EOFY2011)
$US7.0m in a bank syndicated loan. (-$US1m over EOFY2011)
$US1.5m to HSBC.

A total of $US164.2m in loans at an indicative interest rate of 8.9% means an interest charge of $14.61m and underlying profitability for FY2012 of:

$US8.541m-$US14.614m= a $US6.073m loss.

This is not a sustainable position for the company, in my opinion. The best way to reduce this loss would be to curtail spending on developing the farms, thus slowing up the improved cashflow resulting from farm development. I conclude that Option 1, inject no new capital, is not optimal.

SNOOPY

[Snoopy]

The highest cost of NZS company funding looks to be the NZS Uruguayan bonds set up under the previous management regime. However these cannot be fully redeemed until 2024. So the best medium term way to reduce the interest component of expenditure of NZS is to reduce the loan to Olam.

The projected net interest paid for FY2012 will be $US6.842m (GSR p18). With an end of year loan balance of $US164m, that gives an indicative gross interest rate of 4.2%. Even allowing for the fact that not all of these loans will be demanding interest for all of the year, this doesn’t add up. Declared interest loan rates that NZS is paying indicate something nearer to a $14.6m interest bill. Reading the last line of GSR p18 solves this incongruity:

“The cash flow statement has been prepared on the assumption that interest on the Olam loan will not be paid until the loan is repaid.”

So NZS is harbouring a hidden and compounding debt to Olam! Be careful about reading those cashflow statements superficially.

Olam’s preferred capital raising proposal was for $US120m. That would probably have wiped out Olam’s loan and any accrued interest. With the Olam loan repaid, NZS would have ongoing debt of $US54.2m as previously detailed. At an estimated overall interest rate of 8.9%, this means an interest bill of $US4.824m per year. So using our projected EBIT figure of for FY2012, we can work out an underlying FY2012 net profit of:

$US8.541m-$US4.824m= $US3.717m.

Assuming 172m new shares were issues at NZ70c (172m/0.75 x 0.70= $US), based on $NZ1=US75c this would produces earnings per shares on the enlarged share capital of:

$US3.717m/(244m+230m) = US0.8cps.

With net cashflow from operations forecast to improve to $US26m by FY2014, we could by then be looking at a much higher indicative distributable profit of.

$US26-$US4.824m= $US21.18m. $21.18m/(244m+230m)= US4.5cps

This capital raising proposal was rejected by most minority shareholders, partly because some shareholders felt that while some injection of capital was required, $US120m was more than necessary- i.e. the proposal was capital inefficient. The second reason for this proposal rejection was that the capital raising was structured so that minority shareholders were unable to trade their capital raising rights while Olam unilaterally put themselves forward as sole underwriter. Thus it was felt that Olam had specifically designed the capital raising to fail so that they could jump to the 90% compulsory acquisition threshold and delist NZS. In so doing small shareholders would be forced out.

SNOOPY

[Snoopy]

A third capital raising proposal has been floated in the GSR (p8). Here the GSR proposes a capital raising as small as $US80m, accompanied by a $40m shareholder interest earning bond. Such a bond would probably be at similar interest rates to the current Olam loan, because of similar risk. So 8.9% on $US40m equates to an incremental interest bill, post the Olam loan being repaid, of:

0.089x$US40m= $US3.560m

An extra 115m/0.75 shares issued at 70c would raise $US80m of new capital

So we can now calculate the projected net earnings for FY2012 under this third proposal:

($US8.541m-$US4.824m-$US3.560)= $US0.157m.
$US0.157m/(244+153)= US0.04cps

As farm cashflow improves, by 2014 we could be looking at a profit as high as:

($US26-$US4.824m-$US3.560m)= $US17.62m.
$17.62m/(244+153)= US4.4cps

Under this third proposal, income per share is lower than option 2, but shareholders would also have interest income from the co-proposed shareholder bond. With 244m NZS shares around pre issue, shareholders might expect $US40m worth of bonds to be issued at a rate of US16.39cents per share that exists now. This bond money would provide ongoing shareholders/bondholders with bond income of US1.46 cents per bond unit (of US16.39c) per year. Note that US16.39c for each of the 244m NZS shares that now exist will raise the bond’s required $US40m.

Furthermore if any shareholders did not have enough cash to fund this bond, because the bond has an income stream, they could even use borrowed money to do it. It is even possible that Olam or other third parties might agree to fund the bond, independent of existing small shareholders. Although the overall money raised would be the same as option 2, the lower amount of equity raised in this Option 3 would increase the chance of small shareholders being able to fully take up their rights and so allow NZS to remain listed.

SNOOPY

[Snoopy]

Option 2 FY2014 result is US4.5cps based on 474m shares being issued (new shares at 70c). Option 3 FY2014 result is US4.4cps based on 397m shares being issued (new shares at 70c).

Those eps results are surprisingly similar, and this is where the ‘capital efficiency’ argument comes in. If too much capital is issued, the overall earnings per share may not improve as much as the earnings in dollars. Ultimately as investors it is earnings per share that counts, not overall earnings in dollars.

Olam’s Option 2 is based on the premise that the more capital that is invested, the greater the profits and so the more tax losses they can access. Tax that doesn’t need to be paid is retained earnings in the pocket of the shareholder. Another plus point for Olam’s Option 2 is that because significant profitability comes sooner (in FY2012), there is more of a buffer of money should climatic conditions or a plunge in milk prices significantly affect NZS income over the next two years. However good a farmer you are, and second hand reports I have heard about MD David Beca indicate he knows what he is doing, a good clout by the climate will have an effect. Being marginally capitalized in farming is risky.

On the other hand, this same risk pendulum could swing the other way. It is conceivable that milk prices and volume could improve so much that less than $80m of new capital is needed.

Even as it currently stands, the interest on all borrowings for FY2012 will only apply for nearer to six than twelve months of the year. That means the FY2012 result for Option 1 is actually liable to be much closer to breakeven than the $US6.073m loss I am projecting. However, IMO businesses should not sail as close to the wind as this, and most banking syndicates would agree.

SNOOPY

[Snoopy]

I am prepared to take the business risk on ‘Option 3’ over FY2012 and FY2013. I don’t want to be forced out of the company, which more or less eliminates ‘Option 2’. I want the farm development to continue. So I will be voting to allow the Olam loan expansion to $110m. It goes almost without saying that this will only assist the company for about six months. I will expect that within the next six months, Olam will put an ‘Option 3’ up for the consideration of the shareholders.

Nevertheless this capital-raising question is not as clear cut as I paint it. If anyone thinks my calculation assumptions need re-examining I am prepared to do it. And if any shareholder has a somewhat different view on the future NZS capital raising and can explain why then I would be interested!

SNOOPY

[Well Fed]

Snoopy, your Capital raising / debt funding calculations are very in tune with logic.
Perhaps the ebit figures in the GS report may be modified upwards at the AGM and that may lead to a change in thinking with the preferred debt to equity ratio in option 3. Perhaps even bringing option 1 back into play.
I could be wrong but it appears GS has not accounted for the natural increase of around 11,000 dairy animals at $950 each. (page 15)

[Snoopy]

Perhaps the EBIT figures in the GS report may be modified upwards at the AGM and that may lead to a change in thinking with the preferred debt to equity ratio in option 3. Perhaps even bringing option 1 back into play.

The Fonterra milk solid price payout price of $NZ7.05/kg for FY2011/12 was recently cut to $NZ6.62 without much movement in the underlying spot market price. I have heard the theory that former Fonterra CEO Andrew Ferrier put the most optimistic spin on milk prices just prior to leaving, to make him look as good as possible. Then new CEO Theo Spierings revised the outlook to something a little pessimistic so that he in turn can look good later in the year announcing a milk price upgrade! Perhaps the true price of Fonterra milk will be half way between the two CEO’s forecasts? That makes it $NZ6.84.

In Uruguay the milk pricing is done per litre. There isn’t a straight conversion to milk solid weight pricing because the amount of milk solids per litre can vary depending on herd quality. But if we go back to the original December 2006 NZS Prospectus (p25), $NZ4.00/kg was equivalent to US18c/litre. Currency appreciation has turned that today to around $NZ3.50/kg. That means US37c/share (the budgeted milk price from Conaprole for FY2012) is roughly equivalent to $NZ7.20/kg of milk solids in New Zealand. Can the payout for FY2012 in Uruguay realistically be higher than that? Or are we looking to some step increase in literage from each cow?

SNOOPY