KEY POINTS:
There are a number of disturbing features regarding the gigantic Fonterra bond issue.
In particular the overwhelming response from investors, and their advisers, before offer documents were widely available clearly indicates that we have learned little from the finance company debacles.
It confirms that all one has to
do in New Zealand is issue securities in a well-known name, with a high interest rate, and the money will come flooding in.
Our capital markets will continue to struggle until we take a far more analytical and sophisticated approach towards public offerings.
Fonterra's $300 million fixed rate bonds prospectus was registered on February 2, yet just three days later a company press release announced that the company had given "a firm allocation of $800 million to NZX participants and institutional investors ... after receiving applicants significantly in excess of this amount".
How many potential investors had read the prospectus or investment statement before they asked for a firm allocation?
According to the Securities Commission: "If an investment is recommended by a financial adviser he or she should have read the prospectus." How many advisers had read the Fonterra prospectus before they registered their firm allocations?
Surely one of the major lessons from the last few years is that investors and their advisers should read offer documents before committing any money.
The second concern is the total absence of any financial information in the investment statement, the main document distributed to potential investors.
In terms of public offers there are two documents in New Zealand - the prospectus and the investment statement. The prospectus, which has to be vetted and approved by the Companies Office with the Securities Commission having an oversight role, is a comprehensive document with a large number of requirements.
The investment statement, which has minimal requirements, is not registered or vetted by any regulator. Unfortunately it has become the prime offer document in New Zealand even though it is not required to contain any financial information.
Neither the investment statement nor the prospectus contains any specific information on Fonterra's performance for the first half of its 2009 financial year, which ended on January 31.
This omission is unsatisfactory because the company probably had a poor six months and its debt levels may now be materially higher than they were at the end of its 2008 financial year.
Another concern is the absence of any information in the investment statement on brokerage or commission payable by Fonterra.
This is important information that should be included in the offer highlight section of the investment statement because investors would then be in a better position to assess whether their financial adviser was influenced by the commission.
This brokerage or commission should be partially or fully rebated to investors who are charged a management fee by their advisers.
There is considerable confusion regarding commissions because Fonterra quoted brokerage of 1.0 per cent in its presentation to financial institutions yet one broker states on its website that we "will be paid commission of up to 1.75 per cent of the application amount on all applications".
Does this mean that some brokers are being paid more commission than others?
Why don't all financial advisers clearly identify the commission they are being paid and whether they are rebating any or all of this, particularly to individuals who are charged an annual fee or are investing substantial amounts in the Fonterra bond offering?
Another concern is the statement by Fonterra on February 5, the last business day before the offer officially opened, that it had firm applications of $800 million "after receiving applications significantly in excess of this amount".
There are a number of reasons why this statement was inadequate and incomplete including:
The original objective was to raise $300 million yet Fonterra gave no indication what it is going to do with the additional $500 million.
As the bonds will be traded through the NZDX, the debt market of the NZX, the disclosure of the exact amount of applications would have been helpful in determining potential demand after the bonds list.
This column has major concerns about the release of these types of vague but optimistic comments before issues open to the public.
These bullish statements were a common feature of the 1980s IPO market and at least one large bond issue in recent years was well short of its target until the company announced that the offer had attracted so much interest that it would accept oversubscriptions.
This announcement, which was not accurate, turned a relatively unsuccessful issue into a huge success.
There is no suggestion that Fonterra's February 5 statement was inaccurate, but if the country's largest company can make these vague but optimistic comments, how can others be curtailed from doing the same even though they may not be telling the full story?
Although there are major concerns regarding disclosure, and the willingness of investors to rush into the Fonterra issue without reading the offer documents, the offer is attractive because it offers a minimum rate of 7.75 per cent per annum.
However, investors should remember that higher interest rates normally mean higher risks.
The co-operative has an A+ rating from Standard & Poor's and other NZ issues with a similar rating are currently trading on lower yields.
However, Fonterra is operating under extremely difficult conditions with international dairy prices trending down as follows:
International skim milk powder prices have fallen from a high of US$5200 ($9965) per tonne in mid-2007 to U$1700 a tonne last week.
Export cheddar cheese prices have declined from US$5500 a tonne in January 2008 to US$2450 per tonne
The Oceania butter price has slumped from US$6000 a tonne in September 2007 to US$2625 per tonne.
Fonterra also had a large amount of borrowing at the July balance date and the $800 million to be raised in this issue is relatively significant as total parent company equity was only $3348 million at that date.
Another important issue is the group's capital structure which is inappropriate in the modern age. The board presented a number of options to farmer shareholders in 2007, including a preferred option, but this didn't gain traction.
The group would be a more attractive proposition for fixed interest investors if the board's preferred capital structure had been accepted by its farmer shareholders.
Finally, these farmer shareholders are both the strength and potential weakness of Fonterra.
The strength is that they have the long-term vision to accept any short-term reduction in the payout but the weakness is that a large number of the more substantial farmers could walk away from the group and set up their own company with a more appropriate capital structure and a strong emphasis on non-commodity products.
With this in mind the concept of creative economic destruction, which was championed by Czech-born economist Joseph Schumpeter (1883-1950), is important.
Schumpeter's ideas, which have come back into vogue recently, are based on the belief that the business world is in constant revolution with new and more efficient organisations being relentlessly created and replacing older ones that are not performing in line with stakeholders' expectations.
Schumpeter's supporters believe in a diversified investment strategy because no organisation is immune from creative destruction and they also disagree with the buy and hold investment approach because most companies only prosper for short periods in a creative destruction environment.
The prospect of some creative destruction in the New Zealand dairy sector is one of the main reasons why investors should not have most of their fixed-interest portfolio in Fonterra bonds even though the interest rate on offer is relatively attractive.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
