Correspondence

 

Any equity or bond holder will be concerned by the current deterioration in company balance sheets. Some is a result of the worldwide recession, some self-inflicted. Too often we are seeing a reactive approach as matters reach crisis point, resulting in huge destruction or potential dilution of shareholder wealth. For investment bankers, underwriters and those who have the funds, this crisis offers opportunity. For smaller shareholders with limited resources, the outcome can be disastrous.

 

Even companies that are continuing to trade profitably (albeit at narrower margins) are affected for the simple reason that their bankers want certainty that if things go pear-shaped, their advances will be secure. 

 

Some time ago NZSA Chairman Bruce Sheppard wrote a private blog (“Stirring-the-pot” - available on stuff.co.nz and summarised in the June Scrip) in which he outlined an analysis of debt he had done on 47 companies based on their 2008 annual report figures. You would think that with the advent of international accounting standards (IFRS) this would be straightforward. Nothing could be further from the truth. Every company presents its accounts in a different format and important information is often buried deep in the notes to the accounts.

 

Even the treatment of such basic information as interest paid varies. Some companies set it off against interest earned (which is hardly a reliable ongoing income source) and some capitalise part of it – a treatment commonly practised by many now defunct finance companies.

 

Debt itself is another minefield; frequently in multiple currencies with various levels of hedging, often spread though a range of subsidiaries and not even treated on the same basis. For example, many Capital Note holders would be astonished to know that their debt instrument is treated as equity in some (but not all) cases. As a consequence they have the same risk profile as shareholders without any of the potential upside. No doubt this was disclosed at the time though we doubt the risk was widely understood.

 

All companies have agreements with their bankers covering various ratios relating to debt, earnings, interest and asset levels. If a company does not meet the terms of these so-called covenants then the banks can and do demand remedial action, or in extreme cases appoint receivers. So it follows that business owners (the shareholders) should take a very active interest in whether their companies are comfortably in compliance with these requirements.

 

But what do we find? Most companies refuse to disclose their covenants to their owners. Often they cite commercial confidentiality, but this does not seem to be a problem for the few that do disclose. Whatever the reason, the outcome is that investors cannot determine how secure the debt position really is. All companies publish bland compliance statements in their reports, but there is no way of knowing how rapidly changing circumstances (falling revenues, downward asset revaluations etc) are likely alter this situation.

 

The apparently sudden Nuplex meltdown changed everything. Finally some typical covenants for a large company were in the public domain. So Bruce decided to research further and to look at this from a “bankers” perspective. To do this he set 4 covenants that explore various debt stresses. Not all will apply to all types of company and some are not widely used. The levels set may be arguable and certainly we accept that different companies have different levels for the same ratio. Since so few are prepared to share this information, it s necessary to set some “reasonable” average levels and a “standard” set of parameters and that is what Bruce did.

 

He then asked the NZSA to take on the task of dealing with his findings. We reviewed the figures based on the assumptions made, and after a very robust debate decided that the questions raised were worth asking. The squeals of protest from the NZX, analysts, some companies and other vested interests were proof enough that we were on to something. Interestingly, they wanted raw figures published and companies named before being given any chance to respond to the data or the questions we asked. This would have been extremely irresponsible and we question their motivations. In reality we expect many companies will be able to provide fair and reasonable explanations.

 

Since the 2008 reporting season a number have moved to strengthen their balance sheets. It is only right that they are given the opportunity to comment on why these actions should give considerable comfort to their shareholders and bond holders.

 

We are also well aware that a number of Chairmen have taken exception to our initiative. They would apparently rather not have shareholder/owners (and especially the NZSA) question their actions, keep everything quiet and definitely not rock the boat.

 

Some worry that even when their company’s position is shown to be sound, they will be damned by association. To them we would say: there is a new paradigm internationally – transparency is the way of the future. Those who have nothing to hide have nothing to fear.

 

It is also notable that two of the companies identified on 2008 figures have since suffered very public meltdowns. In other words, although the methodology may be imperfect, it does show where debt stress is occurring well in advance of the event.

 

Following are our letters to the companies and their replies which we will progressively post after they are considered by your Board. We suggest you read them carefully and draw your own conclusions.