Brian Gaynor: Carter Holt lost in woods over cost structure

What is wrong with Carter Holt Harvey? Why are most New Zealand companies reporting record earnings while the forestry giant has just announced an operating profit (earnings before interest and tax, or EBIT) of $259 million for the just-completed December year, compared with $315 million for 2003?

The latest figure is well below EBIT of $548 million in the March 1996 year and $570 million in 1995.

Is Carter Holt's poor performance totally due to difficult commodity markets, escalating freight costs and the high New Zealand dollar or does the company have fundamental problems that the last three chief executives, John Faraci, Chris Liddell and Peter Springford, have failed to address?

Carter Holt reported net earnings after tax of $435 million for last year compared with a loss of $656 million for the previous year. On the surface this is an impressive turnaround but both figures included large abnormal items.

The 2003 result contained abnormal losses of $918 million, including an $822 million forest write-down, and the latest result had abnormal gains of $387 million, including a $440 million profit for the sale of the group's tissue division and a number of write-offs.

The $56 million reduction in operating profit (EBIT) was primarily due to the sale of the tissue division ($41 million of lost earnings) and charges associated with the company's share growth plan and pension fund ($14 million, largely non-cash).

Although senior executives put a positive spin on the latest figures the result was extremely disappointing.

The group's return on assets, in EBIT terms, was only 4.6 per cent compared with 16.5 per cent for Fletcher Building. Its EBIT/sales ratio was 7.3 per cent compared with Fletcher Building's 11.6 per cent.

The latest results indicate that Fletcher Building took full advantage of the Australian housing boom whereas Carter Holt did not.

Fletcher's building products division had an EBIT margin of 17.7 per cent and Placemakers 8.5 per cent whereas Carter Holt's wood products division (which includes the Carter Holt building supplies chain) had an EBIT margin of just 3.8 per cent.

In building and wood products Fletcher Building's margins are rising whereas Carter Holt's are falling. In the building supplies area Placemakers seems to be performing far better than Carter Holt.

Carter Holt's management blames the difficult trading conditions on a combination of factors including export markets, freight costs and the New Zealand dollar.

Commodity prices were generally firm in 2004. For example:

* Japanese A-grade logs averaged US$67.10 per JAS (Japanese Agriculture Standard) in 2004 compared with $57.50 in 2003 and $54.30 in the previous year.

* Bleached kraft pulp prices averaged US$549 a tonne compared with $466 in the previous year and $410 in 2002.

* Asian linerboard rose from US$382 a tonne in 2002 to $397 in 2003 and $424 last year.

The big negative as far as Carter Holt is concerned was the huge increase in freight costs from US$18.00 per JAS in 2002 to $28.60 in 2003 and $45.20 last year. Freight costs are extremely important as Carter Holt is still heavily reliant on bulky, low-value wood exports.

The other major negative factor was the rise in the dollar from 65.4USc at the end of 2003 to 71.2USc on December 31. This had a significant impact because commodity products are transacted in US dollars, although the group's successful hedging policies reduced the effect of the strong NZ$/US$ cross rate by $122 million in 2004.

Freight costs and the dollar have had a negative impact on earnings but there are deeper problems at Carter Holt.

Chris Liddell recognised this when he succeeded John Faraci as chief executive in 1999.

The 2000 annual report, Liddell's first, had strong innovative and performance enhancing theme that took up 22 of the 78 pages. The new chief executive wanted to encourage an entrepreneurial culture and this included the establishment of a $15 million venture capital fund with the assistance of Direct Capital Private Equity.

The clear message was that Carter Holt needed to create added- value products as it could not continue to rely on bulk commodities.

In 2001 the company's six business divisions were broken up into 32 smaller businesses. Liddell wrote in that year's annual report: "Smaller operations have the edge in terms of responding quickly to market opportunities, understanding their customers and having an entrepreneurial outlook." He went on to say: "By separating our six business groups into 32 smaller businesses, we are giving our best people the chance to prove their leadership. This is their opportunity to run their own business."

Although the golf course has disappeared at Carter Holt's spacious Manukau head office complex the atmosphere is still relatively laid back. Liddell's experiment seems to have failed and there is little indication of the entrepreneurial spirit that exists at most successful listed companies.

Carter Holt remains heavily dependent on commodity markets yet it has a cost structure that is more appropriate to a value-added organisation.

The accompanying table of the NZSX10 Index companies includes their sharemarket value, the number of employees paid $100,000 or more and the sharemarket value for each person in this remuneration group.

Although each company is different in terms of staff requirements and overseas operations - where salaries are higher - the table is a useful guide to the shareholder value created by each highly paid employee.

Carter Holt is at the bottom of this group even after adding back the recent $480 million capital repayment to the company's sharemarket value.

The group's employees are also extremely well paid compared with Fonterra, another commodity producer. In its latest financial year the dairy giant had 1169 employees in the $100,000 plus bracket and sales of $11.8 billion whereas Carter Holt had 809 employees in the top pay bracket and revenue of $3.9 billion (the Carter Holt figures are for the 2003 year).

There are also a number of corporate governance concerns regarding Carter Holt. These include:

* The New Zealand operation seems to be used as a training ground for 51 per cent shareholder International Paper as Faraci, Liddell and current chief financial officer Jonathan Mason have all been offered better positions in the US.

* The board didn't appear to undertake an external search before it appointed Peter Springford, an IP representative on the Carter Holt board, as chief executive.

* Departing chief executives remain on the Carter Holt board. This could make it difficult for the new appointment to stamp his authority on the company (both Faraci and Liddell remained as directors when Springford was appointed).

Carter Holt Harvey has been adversely affected by the higher freight rates and the dollar but its disappointing performance cannot be totally attributed to these factors.

Five years ago Liddell initiated a programme to make the company more innovative but there is little to show for this, particularly in terms of earnings and shareholder value.

The group hasn't taken full advantage of the Australian housing boom and in a number of areas, particularly building supplies, it seems to have lost ground to major competitors.

The obvious solution is for major senior management changes or a significantly lower cost structure that is more appropriate for a commodity producer.

But minority shareholders shouldn't get carried away about the prospect of change as International Paper has proven to be a conservative controlling shareholder that doesn't rush major decisions.

* Disclosure of interest: Brian Gaynor is a Carter Holt Harvey shareholder and an executive director of Milford Asset Management.