Gaynor: Meat - a gristly downside, lean upside

By BRIAN GAYNOR

The meat industry has been grabbing headlines in recent weeks with BSE (mad-cow disease), foot-and-mouth, higher export prices, the shock resignation of Affco chief executive Ross Townshend and Richmond's sharemarket listing.

Although a modern economy is supposed to be driven by knowledge-based industries, agriculture is still the backbone of ours.

Meat and meat byproducts account for 16 per cent of the country's merchandise exports, in second place behind the dairy industry, which generates 18 per cent of overseas trade revenue.

Sharemarket investors used to have a wide range of meat companies to choose from. These included Gear Meat, Waitaki Farmers Freezing Company, New Zealand Refrigerating, R&W Hellaby, Southland Frozen Meat, Canterbury Frozen Meat, Hawkes Bay Farmers Meat, Huttons Kiwi and Fortex.

Most of these struggled to make an adequate return and were placed in receivership, closed down or taken over by Goodman Fielder or Fletcher Challenge. The two corporate giants left the industry with their tails between their legs after suffering large losses.

Goodman Fielder and Fletcher Challenge discovered that meat companies have one basic problem: they are high-risk businesses with very low margins, whereas the ideal investment is a low-risk operation with high margins.

Last year was a good one for the meat companies, yet their EBIT margins (earnings before interest and tax to revenue) were remarkably low, ranging from just 2.3 per cent for Affco to a high of 4 per cent for Alliance.

These compare with 2000 EBIT margins of 43.5 per cent for Baycorp, 39.4 per cent for Telecom, 22.5 per cent for Sanford, 14.1 per cent for Frucor, 11.4 per cent for Montana, 11.1 for Carter Holt Harvey and 10 per cent for Cavalier, to list just a few.

The meat companies are middlemen. They don't own the product, they act as agents between producers and buyers.

If there is a sharp increase in export prices because of foot-and-mouth disease, market pressure will force them to pass on these benefits to farmers.

The non-ownership of the source product is a major deterrent to profit growth. When Hugh Fletcher became disillusioned with the sector, he said he would never consider building a pulp and paper plant without controlling the source of the raw material, yet that is what happens in the meat industry.

Sanford is a similar operation, yet it achieved an EBIT margin of 22.5 per cent in 2000 compared with 2.3 to 4 per cent for the four meat companies. The big difference is that the fishing group has direct access to the raw material through its quotas.

Another problem facing the meat companies is the high stock financing cost, particularly during the peak of the killing season. This has to be financed by short-term borrowings, which have a big impact on interest bills.

The net interest cost to EBIT of the four companies range from 26 per cent for Alliance to a high of 44 per cent for Affco. By comparison, the net interest cost to EBIT of Baycorp, Telecom, Sanford, Montana, Frucor, Cavalier and most other companies is well below that of Alliance.

The Warehouse operates in a low-margin sector yet its margins are far higher than the meat companies. The company has similar revenue - $1105 million - to the four meat companies yet it recorded EBIT of $112.8 million (a 10.2 per cent margin) in 2000 and had net interest costs of only $4.8 million.

The discount retailer has huge buying power that enables it to secure product at very competitive prices. It has also created strong consumer loyalty through effective advertising campaigns and very good shop-floor service. The meat companies have limited capabilities in these areas.

The problem with a low-margin business is that there is little scope for error. But the meat industry is high-risk and prone to a number of mistakes.

The companies have a huge exposure to both the real and derivative foreign exchange markets. A mistake in this area can be very costly.

They can sell product forward but they might have to purchase stock from farmers at a higher price if the wrong decision is made.

A procurement war can force them to pay too much for stock.

If there is a drop in international prices companies might have to write down their stock levels at year-end. This can have a negative impact on earnings.

Although meat companies have a number of factors running against them, well-managed companies that avoid mistakes can make a good return to shareholders.

The two large South Island companies, Alliance and PPCS, are cooperatives. The North Island-based companies, Affco and Richmond, are stock exchange listed.

Affco was established in 1903 but took a big leap forward in 1986 when it bought the Whangarei and Taumarunui works from R&W Hellaby, and four years later, the Waingawa, Waitara, Longburn, Wairoa, Feilding and Imlay plants from Waitaki International.

These purchases, mainly financed by debt, were a disaster. In the four years to September 1994, shareholders' funds crashed from $163.1 million to a negative $23.9 million as the group accumulated losses of $180.9 million.

The 1995 share float was a recapitalisation of the group, with all $50 million raised going to the banks.

Affco started listed life on a good note with EBIT of $37 million for the September 1995 year. But since then it has been on a very rocky road. A negative EBIT of $61.5 million was recorded in 1998 because of low international prices and a domestic procurement war.

The Taumarunui, Waitara and Whangarei plants were closed.

EBIT recovered to $23 million in 2000 but it is still well below 1995 and 1996 levels.

The directors' attitude at last month's annual meeting was surprisingly upbeat. But less than a week later the company announced that chief executive Ross Townshend had resigned.

Meat company chief executives usually depart when problems have developed; Affco's previous chief executive resigned just before 1998's huge loss was announced. Mr Townshend had little incentive to leave - he was paid $460,000, 116 per cent more than the next highest paid meat company chief executive.

Has Affco made a mistake on the foreign exchange market? Did the company sell long this year and get caught by the sudden increase in export prices? Investors will want to know the answer to these questions before they commit further funds to it.

Richmond was a non-processing exporter until 1974 but in the past 15 years it has bought Dawn Meats, Pacific Freezing, Hawkes Bay Farmers Meat, Lowe Walker and Waitotara Meat to become the largest of the four companies in terms of revenue.

Under the astute leadership of chief executive John Loughlin it has avoided the industry's pitfalls but it is still a low-margin company in a high-risk industry.

Richmond is forecasting EBIT of $40.2 million and an EBIT margin of 3.1 per cent for the September 2001 year. A projected net profit of $19.4 million will give earnings per share of 47c and a dividend of 10c has been forecast.

At $2.40 the company has a prospective price/earnings multiple of only 5.1, one of the lowest on the sharemarket. This will attract some investors, but Richmond will have either to raise margins or be a consistent mistake-free, low-margin operator if it is to attract long-term investor support.

* Disclosure of interest: none

* bgaynor@xtra.co.nz