Brian Gaynor: Many questions over Hart offer

The latest developments in Graeme Hart's takeover offer for Carter Holt Harvey raise a huge number of questions.

How can the profit forecasts of a major company change so dramatically in a few weeks?

Who is responsible for these predictions?

Why did Grant Samuel not identify the flawed forecasts in the original independent report?

How can the long-term valuation of a company fluctuate so widely?

Hart launched his $2.50 a share takeover offer for CHH on September 14 and became the beneficial owner of International Paper's 50.5 per cent stake seven days later. The US firm's five representatives resigned from the board on the same day.

Mark Burrows, Tom Degnan, Tim Hardman, Hart and Bryce Murray replaced them. Hardman and Murray are employees of Hart, Degnan is managing director of Burns Philp, which is controlled by Hart, and Burrows is a director of the Sydney-based food group.

Under NZX rules, all five directors are associates of Hart and are non-independent. As there were only four remaining CHH directors - John Maasland (chairman), Helen Nugent, Kerry McDonald and chief executive Peter Springford - Hart had five of the nine board seats and effective control after only seven days of the 72-day offer period.

But the NZX in its naivety granted Hart a waiver that allowed him to declare Burrows an independent director in the first week of the offer. As a result, the board consisted of the four Hart representatives, four independent directors and Springford, who is not independent.

The next development was on October 4 when McDonald and Nugent announced their resignation as directors to become effective when the offer closes. McDonald said they were asked to resign but Hart insists the two independent directors offered their resignation.

There is little doubt that when individuals either resign or are asked to resign, their influence is substantially reduced.

An obvious example of this is former TVNZ boss Ian Fraser who announced his resignation this week and will have little influence through the remaining six months of his contract.

Two weeks ago, Burrows replaced Nugent as chairman of the audit committee and Murray was appointed to join Maasland as the remaining member. Hart told the Business Herald that Nugent resigned from the committee. Thus two of the three members of this committee, which plays a major role in scrutinising profit announcements, were associates of Hart.

Audit committees don't get much attention in New Zealand but they play a vital role in the corporate governance process in North America. Institutional Shareholder Services (ISS) ranks the governance performance of 5200 US companies on the basis of 63 criteria. ISS places a great deal of importance on the audit committee and its highest weighted criterion is that the audit committee is comprised totally of independent directors.

Hart had effective control of the board and the audit committee when CHH made its third-quarter profit announcement on October 26. The result was fairly reasonable, with net earnings for the September quarter of $50 million compared with a loss of $43 million in the September 2004 quarter and net earnings for the first nine months of $171 million compared with just $36 million in the same period last year. These figures include changes in forest values.

But the sting in the announcement was the net earnings forecast of just $200 million for the full December 2004 year. This compared with a September 12 profit guidance in the $253 million to $258 million range and an earlier forecast of $283 million.

How can a company's profit forecast fall by $53 million/$58 million to $200 million in six weeks?

The immediate response from the committee of independent directors, which is chaired by McDonald, was that the revised December 2005 year forecast did not warrant a change in the recommendation that shareholders should not accept Hart's $2.50 a share offer.

But the committee decided to re-engage Grant Samuel, the authors of the original independent advisers' report, to assess any implications of the revised forecasts of the original valuation of $2.55 to $2.95 a share.

It is important to note that McDonald, the chairman of the independent committee, was appointed to the CHH board in April 1998 and is the longest-serving director. McDonald has had a distinguished business career including roles as executive director of the New Zealand Institute of Economic Research, managing director of Comalco New Zealand and as chairman of the Bank of New Zealand.

As McDonald has been on the CHH board for more than seven years, it is reasonable to assume he knows more about the company than Grant Samuel, Hart and his associates.

Another point to note is that all valuation processes have two distinct inputs: the profit forecasts and the valuation methodology.

The target company, not the independent valuer, prepares the profit forecasts. If the profit forecasts are too low then the valuation will be understated and vice versa.

Hart is adamant that the original profit forecasts presented to Grant Samuel by the independent directors were far too optimistic. They seemed to reflect the independent directors view of what management should rather than what they could achieve.

He told the Business Herald that the forecasts were only changed for the October 26 profit announcement because the previous figures were totally unrealistic.

On Tuesday, McDonald released the new Grant Samuel valuation of $2.43 to $2.90 a share compared with the $2.55 to $2.95 range in September.

The revised valuation is based on a reduction in forecast earnings before interest and tax (ebit) from $250 million to $207 million for the 2005 year and from $251 million to $141 million for 2006.

Grant Samuel said it didn't have sufficient time to verify the 2005 and 2006 forecast changes. It also signalled that the 2006 forecast now excluded $38 million of forest land sales, a cost inflation allowance of $70 million had been added and foreign exchange gains were expected to be $36 million lower in 2006.

In a letter to shareholders, McDonald noted that his independent committee had been unable to verify the latest forecasts and reconcile them with the earlier projections because they:

* Were prepared on a different basis.

* Were less detailed and do not allow an examination of underlying margins, cashflow and capital expenditure.

* Appear to exclude several significant productivity improvement projects that were included in the earlier projections.

In the world of corporate directorships, where discretion, secrecy and politeness are core components, McDonald's letter is as strong as one could expect.

In ordinary language, McDonald is saying that he has been severely restricted in carrying out his duties as an independent director.

There is no love lost between McDonald and Hart, with both giving a totally different view of the same situation. Hart claims McDonald offered his resignation and the profit forecasts originally presented were far too optimistic.

The committee of independent directors is now unanimously recommending that shareholders accept Hart's offer. But McDonald noted he will not be accepting in respect of his 30,000 shares other than by compulsory acquisition.

This week's developments suggest that Hart has a better chance of reaching 90 per cent of CHH and moving to compulsory acquisition.

The conflict between McDonald and Hart is not a healthy development. It indicates that it is inappropriate for a bidder to gain effective control of the target company just seven days into a 72-day offer period.

Careful audit

* Audit committees play a vital role in the corporate governance process in North America.

* Institutional Shareholder Services (ISS) ranks the governance performance of 5200 US companies on the basis of 63 criteria.

* ISS places a great deal of importance on the audit committee.

* Its highest weighted criterion is that the audit committee is comprised totally of independent directors.

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