Can Fletcher meet the challenge?

Dividing the group into letter stocks has failed to benefit shareholders, finds BRIAN GAYNOR


Month after month, the lights have burned late into the night at Fletcher Challenge's head office in Penrose. Senior executives have spent countless hours working on the long-awaited restructuring of the company, but a final agreement has yet to be concluded.

Shareholders are becoming restless. Market sentiment towards the group has been adversely affected by the poor operating performance of its four divisions, leaked information on the restructuring, and rumours of conflict at board and executive levels.

Mike Andrews, the group's new chief executive, is in an unenviable position. The company's four letter stocks have fallen by 15 to 36 per cent since Mr Andrews took up his position at the end of 1997, but Fletcher Challenge's difficulties go back a long way and cannot be directly attributed to him.

The group's main problem is that it has too many diverse operations and has been reluctant to sell non-core assets. It has also borrowed heavily to fund acquisitions.

At one stage, it was involved in nearly everything from the meat industry in New Zealand to newsprint in Canada and from banking in this country to oil exploration at home and overseas.

Some of these activities have been sold or spun off to shareholders, but the group has struggled to develop a successful long-term strategy.

The first major restructuring was at the end of 1993, when Wrightson was split into a separate company and shares were issued to Fletcher Challenge shareholders at $1.30 each. Large losses have been suffered on this investment as Wrightson shares are now worth only 34c.

At the same time, Fletcher Forests was split off as a separate division, called a letter stock, and shareholders received one Fletcher Forests share and four Fletcher Ordinary Division shares for every four Fletcher Challenge shares.

This decision was taken because "the board and management have been concerned that the historical price performance of the ordinary shares fails to reflect adequately the present value of the estimated future underlying cash flows of the group, particularly in respect of the forests division."

This restructuring has not been successful from a share performance point of view. The combined value of the Fletcher Challenge shares has fallen 18 per cent since October 1993, while the NZSE40 Index has risen 4 per cent over that period.

This calculation includes the Fletcher Forests bonus issue in 1995, but takes no account of the disastrous performance of Wrightson.

In 1996, a second recapitalisation was completed when the ordinary division was split into three more letter stocks. For every four ordinary division shares, shareholders received one Fletcher Building share, one Fletcher Energy share and two Fletcher Paper shares.

Again the directors claimed that the market failed to recognise the full value of the group and the creation of three new letter stocks would have a positive impact on shareholder value.

But they were wrong a second time, as the combined value of the three new shares has fallen 23 per cent since February 1996 while the NZSE40 index has risen 1 per cent in that time.

The letter stock concept is flawed because it is a mirage, it is not a genuine split of Fletcher Challenge into four companies.

Although investors hold shares in the name of the individual divisions, they are actually shareholders of Fletcher Challenge Ltd and not of the separate divisions.

Group debt is notionally attributed to each division, but shareholders are subject to all the liabilities and risks associated with Fletcher Challenge as a whole.

If one division experiences severe financial difficulties, the other three may not be able to pay a dividend and may have their borrowing capacity restricted even though they continue to trade satisfactorily.

Takeover bids cannot be made for individual divisions because they are not legal entities. Therefore, there is no ability for shareholders to receive a premium for control for any one division under the current structure.

The letter stock concept becomes a major problem when one of the divisions performs badly and has a high level of debt.

The bad egg in Fletcher Challenge's basket of letter stocks is Fletcher Paper, which is a pulp and newsprint producer with operations in Canada, Brazil, Chile, Australasia and Malaysia.

The division accounts for 48 per cent of Fletcher Challenge's assets but 61 per cent of the group's long-term debt. Fletcher Paper's earnings have been hurt by the downturn in commodity prices.

The division's biggest problem is that its major asset, Fletcher Challenge Canada, is only 51 per cent-owned. The Canadian company has a very strong balance sheet, with more than $900 million in cash and no long-term debt.

However, Fletcher Challenge cannot get its hands on this money because the Canadian operation is listed on the Toronto, Montreal and Vancouver stock exchanges and is not 100 per cent-owned.

The high level of debt associated with the paper division, its poor operating performance, and inability to get its hands on Fletcher Canada's cash are having a negative impact on the other three divisions because they are jointly liable for total group debt.

Fletcher Challenge's long-awaited restructuring must include the sale of Fletcher Canada for cash or a complete merger between the Canadian operations and Fletcher Paper.

The latter is the preferred option because Fletcher Canada is cash-rich and could absorb the New Zealand division's debt without destroying the combined balance sheet.

But why would the cash-rich Canadian company want to merge with a debt-ridden New Zealand operation? Everyone has a price and the weak negotiating position of the head office in Penrose is the main reason the restructuring has taken so long to achieve.

The restructuring must also include the abolition of the letter stock concept and the separation of the four divisions into independent, stand-alone companies.

Critics of the letter stock concept have been vindicated and full shareholder value will be achieved only when Bill Wilson and his fellow directors have the courage to break up the group into separate companies.

Mike Andrews may not be responsible for Fletcher Challenge's problems, but his stewardship will be judged by his ability to execute a successful restructuring of the group.

The long delay suggests that Mr Andrews is struggling to deliver in this important area.

Fletcher Energy would be one of the major beneficiaries of a comprehensive restructuring. This week's announcement that it will sell its 33.3 per cent shareholding in Natural Gas, for an estimated $250 million, will strengthen the division's balance sheet.

A total separation from the other divisions would remove the restrictions imposed by the paper division's debt and allow energy's new chief executive, Greig Gailey, to concentrate on counter-cyclical acquisitions and oil and gas exploration and production activities.

Fletcher Building was the darling of analysts 15 months ago, many of them strongly recommending the stock. It is now almost forgotten after a number of disappointing results, and research reports on the division are few and far between.

The division is struggling and needs to show that it can produce a satisfactory performance in difficult economic conditions.

Fletcher Forests will also be a significant beneficiary of a major restructuring of the Fletcher Challenge group.

A shareholding in Fletcher Forests is a much better investment than most of the illiquid forest partnerships that are constantly being promoted to New Zealand investors.

* Disclosure of interest: Brian Gaynor is a shareholder of all four letter stocks and Wrightson.