Brent Sheather: Synlait and values

File photo / NZ Herald

Although it is fashionable to cosy up to China these days and ignore their dodgy behaviour in Tibet, industrial espionage, ruining the environment and killing sharks and rhinos, it is not obvious that selling off our farms and companies to overseas investors in general and the Chinese in particular is a particularly sensible move.

Selling productive assets is bad enough but local history frequently records that, despite the experts assuring everybody at the time that we were getting a great price for the assets we sold, sure enough a year or so down the track the buyer flicks it on to another overseas investor for a 50 per cent profit. New Zealanders have a very short term perspective when it comes to valuing assets and this myopic view may be, at least in part, a function of advice from the experts who are hired to provide independent valuations of the assets being sold down the river. The fact that apparently one in five New Zealanders doesn't even understand percentages is, of course, a bit of a worry as well.

What prompted today's article is the decision by the independent directors of Synlait Farms to recommend that Synlait Farms shareholders sell 4,500 ha of prime, irrigated dairy farms in Canterbury to a Chinese company at a price which could prove to be low not just in the future but today. We have highlighted the lemming-like behaviour of NZ investors when assessing takeover offers several times previously ... notably Caveat Venditor in July 2011 where this column criticised the independent valuation of NZ Farming Systems Uruguay and as long ago as May 2005 as regards selling Fletcher Forests at what turned out to be a bargain price.

I took a close look at the independent expert's valuation of Synlait Farms and wasn't impressed. Before we get into that I should disclose that I have a small shareholding in Synlait Farms and would like to continue as a shareholder but it looks very much like the Chinese company, Shanghai Pengxin, will get a 90 per cent shareholding and force those people who don't want to sell to sell.

Shareholders considering any takeover offer need to consider the Target Company Statement (TCS). This is a document prepared by the independent directors and it is intended to provide a balanced view and independent valuation so that shareholders can make a considered decision.

In the Synlait Farms offer the independent directors got Grant Samuel (GS) to prepare a report on the merits of the offer. GS were responsible for saying that the NZ Farming Systems Uruguay offer was okay at 70 cents but did all the retail investors who accepted the offer understand the implications of the GS analysis?

Mike Staunton of the London Business School reckoned that because GS applied a whopping 12 per cent discount rate to discount the NZS cash flows the future value of Farming Systems would be approx. $5.63 in eighteen years time. This is the sort of interpretive data that should be presented in the TCS and one wonders whether Mum and Dad would be so keen to accept offers if the implications of high discount rates were pointed out in a more easily understood fashion.

In any event there may be major fundamental problems with the discounted cash flow (DCF) approach that are peculiar to NZ. GS use the standard DCF methodology which we looked at a couple of weeks ago in valuing Meridian. It is not a difficult theory to understand and it is critical that Mum and Dad do have a basic knowledge of it so they can make an informed decision whether to sell their country or not.

Retail investors should understand firstly that the DCF value is the theoretical value of a company, farm etc etc and it should approximate the share price. Secondly the lower the discount rate used the higher will be the DCF value. Wikipedia defines the discount rate as "the rate of return that can be earned on an investment".

The Synlait Farms valuation uses a discount rate of 8.7 per cent. One farming valuation expert I spoke to thought it should be closer to 6 per cent meaning a price much higher than the offer. In addition 8.7 per cent sounds pretty good compared to the 2.7 per cent pa currently available from 10 year US government bonds and especially good when compared with the 6 per cent pa that the authors of the Global Investment Returns Yearbook reckon that the world stock market will return for the next 100 years.

But concerns don't finish here ... overseas experts reckon even their discount rates are too high which makes ours look stupid and thus our valuations much too low. An article in the London Financial Times cited a report by the Bank of England speculating about a possible disconnect between the rates of return as implied by the stock and bond markets and the discount rates being used by companies to determine whether capital investment or acquisitions get the go-ahead or not.

Specifically research has shown that "the discount rates applied to future cash flows were much higher than either equity holders' average rate of return or the return on debt". If that is the case there it is even more the case here, read on ....

Interest rates in NZ are higher than those of most other developed countries around the world and NZ's cost of equity is certainly not lower than overseas companies so this implies the weighted average cost of capital calculated in an overseas investors DCF model is likely to be lower therefore the DCF valuation of Synlait Farms, Fletcher Forests and NZ Farming Systems is likely to be much higher for a buyer overseas than a local buyer.

If in China the government is prepared to lend the company making the takeover at a low or zero interest rate then their WACC and thus NPV will be much higher so independent experts and independent directors will inevitably say sell. The NZ Takeover Panel, Federated Farmers, politicians etc, need to be urgently aware of these issues.

If the Chinese government lends XYZ Chinese company NZ$100b at a 0 per cent interest rate enabling XYZ to pay a price 25 per cent higher than its locally assessed present value for all the dairy farms in NZ an independent expert would inevitably say "yes, take the money". That would be good wouldn't it.

The other issue with the GS analysis is that they provide an alternate way to value Synlait Farms, if the first wasn't bad enough. They also looked at what multiple the offer price is of earnings before interest, tax, depreciation and amortization. For perspective, they looked at three companies; Fonterra, Synlait Milk and an Australian company called Warrnambool.

None of these companies are in any way, shape or form comparable because, duh, they are milk processors not milk producers. But the silliness doesn't stop there - in the table GS points to the fact that Warrnambool trades at just a 10.5 times multiple but notes that there have been takeover offers for that company.

It doesn't say that the latest offer by Kirin (a Japanese company with, surprise, surprise, very low interest costs) values Warrnambool at a 23 times multiple, ie 2.3 times the valuation in the table. It does say however that the 10.5 multiple isn't relevant because Warrnambool is subject to a takeover. Hello, Synlait Farms is subject to a takeover, duh.

Just for the record, and to quote Father Ted, "Not a racist".

Synlait Farms shareholders who have not accepted the takeover offer should not rely on this article for financial advice but should get advice having regard to their specific financial situation.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.