Brian Gaynor: A2 Milk takes flight as Fletcher plummets

The Convention Centre deal is expected to cost Fletcher $410m. Photo / File

Wednesday was a watershed day for the NZX, with a2 Milk surging to the top of the market in terms of value, with a capitalisation of $8.6 billion.

It is hard to believe that the company was worth a mere $9 million when it first listed in April 2004 and only $46m in November 2010.

A2 rocketed to the top after announcing a 150 per cent increase in net earnings after tax, from $39.4m to $98.5m, for the six months to December 31.

Investors responded immediately, with $56m worth of shares trading on the NZX, a staggering A$336m on the ASX and the share price surging 26.5 per cent over the day.

On the same day, Fletcher Building shares fell 6.9 per cent after reporting a loss of $273m for the six months to December 2017. This compared with a net profit of $176m for the same period in the previous year.

At Wednesday's market close, a2 Milk was worth $8.6b, followed by Auckland International Airport with a market value of $7.7b, Fisher & Paykel Healthcare ($7.4b), Meridian Energy ($7.4b), Spark ($6.1b), Ryman Healthcare ($5.3b) and Mercury NZ ($4.5b).

Fletcher Building was eighth with a market value of $4.5b. It would have slipped to ninth if Xero had remained listed on the NZX.

The past 12 months has been an annus horribilis for Fletcher Building shareholders, with the company's market value plunging $2.8b or 38 per cent since the end of January 2017.

Meanwhile, the benchmark NZX50 Gross Index has appreciated 18 per cent and a2 Milk's market value has soared $7.6b or 477 per cent over the same period.

At week close, a2 Milk had a market value of $9.3b and Fletcher Building $4.5b. The latter had stepped over Mercury NZ into seventh place.

A2's success has been due to a number of factors including its intellectual property licences, identifying growth prospects in Australia and China, particularly infant formula in the latter, and superb execution of its growth strategy.

Business success is all about people and a2 has a strong six-person board and an excellent management team under chief executive Geoff Babidge.

Chairman David Hearn has had extensive executive experience of the fast moving consumer goods (FMCG) sector, including a role as chief executive of Goodman Fielder.

Three of the other six directors, including Babidge, have considerable consumer goods experiences.

The two New Zealand resident directors have accounting and legal backgrounds.

An important feature of a2 is its huge increase in marketing spend and its ability to continue to increase this.

In the six months to December 31, a2 spent $26m on marketing compared with $16m for the same period in the previous year. The latest $26m spend represented 6.0 per cent of group revenue for the period.

By comparison, Air New Zealand had a sales and marketing spend/revenue ratio of 6.4 per cent for the same six-month period while Fonterra had a selling and marketing expenses/revenue ratio of 3.3 per cent for the year to July 31, 2017.

New Zealand shareholders generally prefer dividends to marketing expenditure. As a result, our companies tend to underspend on marketing.

Overseas studies suggest consumer goods companies can spend 10 per cent or more on marketing and a2 has indicated further increases in this area in the second half of the June 2018 year.

The company has plenty of capacity to do this, as it has a strong balance sheet with $240m of cash and no debt at the end of 2017.

Coinciding with this week's result was the announcement that a2 had formed a strategic relationship with Fonterra, whereby the latter would supply A1 protein-free milk for products to be sold into southeast Asia and Middle Eastern markets.

Fonterra and a2 have been dancing around each other for more than 15 years. In early 2003, a2's Howard Paterson and Wayne Burt negotiated a deal with Fonterra's Craig Norgate to bring the companies closer together. The agreement wasn't completed because of Paterson's untimely death, at 50, in mid-2003.

There is a strong argument that a2 wouldn't have reached its full potential under the proposed 2003 arrangement, whereas a2 was in a position of strength when it negotiated this week's deal with the co-op giant.

A2 is facing a major change with Babidge's retirement and the appointment of Jayne Hrdlicka, the highly successful former Jetstar chief executive, to replace him.

Babidge and Hrdlicka are chalk and cheese in many respects.

Babidge is private, understated and has been totally devoted to a2 whereas Hrdlicka has a high media profile and late last year was appointed non-executive president and chair of Tennis Australia, which runs the Australian Tennis Open.

Steve Healy, the previous president of Tennis Australia, resigned to devote more time to his external executive commitments and a2 shareholders will be hoping that Tennis Australia doesn't consume too much of Hrdlicka's time.

This is important because the new chief executive — who will continue to live in Melbourne and commute to a2's Sydney office — will play a key role in executing a2's growth plan and its new Fonterra arrangement.

The Fletcher Building result was a major disappointment, with the group's construction division reporting an EBIT (earnings before interest and tax) loss of $619m and the remaining operations reporting positive EBIT of $297m (see table). The latter figure was disappointing in view of the buoyant economy.

Fletcher Building's construction operations have three separate divisions:

• Building + Interiors (B+I), which has a work backlog of $926m, reported an EBIT loss of $631m for the six months to December 2017 compared with a $47m loss for the same period in the previous year
• Infrastructure & Higgins, which has a backlog of $1,330m, reported EBIT of only $11m for the six months compared with $47m for the six months to December 2016
• South Pacific, with a backlog of $61m, reported EBIT of $10m compared with $23m for the previous corresponding period.
B+I, which predominantly signs fixed price or guaranteed maximum price contracts, is the major problem, with massive losses being experienced on its SkyCity Auckland Convention Centre (NZICC) contract.

On October 27, 2015, SkyCity announced it had a binding $477m contract with Fletcher "to build and to complete the design of the NZICC, the 5-star, 300 room Hobson Street Hotel, the retail laneway linking Nelson and Hobson streets, and 1327 carparks under the NZICC".

This contract, which is due for completion in mid-2019, is estimated to cost Fletcher Building $887m to finish. This represents a massive loss of $410m, accounting for just over 50 per cent of B+I's assessed losses.

The important words in the October 2015 SkyCity media release are "to build and to complete the design". Fletcher agreed "to complete the design" on this fixed price contract even though it didn't have the people or skills to carry out this requirement.

Fletcher Building chief executive Ross Taylor believes these design inadequacies are endemic and B+I will no longer tender for vertical commercial building projects. This will reduce the work backlog figure in the accompanying table from $2.3b to the $1.0-$1.5b range.

The B+I debacle is a shocking indictment of Fletcher Building's governance, particularly the lack of industry experience on its board and failure to ensure that these fixed priced design and build contracts weren't scrutinised far more vigorously.

A2 Milk, which has four out of six directors with considerable consumer goods experience, has demonstrated that industry knowledge plays an important role in successful companies.

Considering this, why has Fletcher Building placed far more emphasis on appointing retired accountants, retired lawyers and retired chief executives from totally unrelated industries to its board?

- Brian Gaynor is an executive director of Milford Asset Management which holds shares in a2 Milk and Fletcher Building on behalf of clients.