Brent Sheather: So what's the value of Meridian?

Photo / NZ Herald

The fallout from the Mighty River Power (MRP) float continues ... the IPO was priced at $2.50 and now languishes at $2.20. Since listing MRP shares have returned - 12.2 per cent during which time the NZ stockmarket as a whole is up by 5.5 per cent.

I naively thought that being on the other side of a deal with the NZ Government guaranteed a profit. That was stupid. It now seems, with the benefit of hindsight, that John Key and his crew extracted a good deal for New Zealanders in selling MRP at $2.50, in the short term anyway.

That is the good news. The bad news is that with MRP turning out so badly retail demand for SOE IPOs has plummeted such that the Meridian shares that were allocated to retail seem to have gone to wealthy New Zealanders, most of whom are existing clients of stockbrokers, rather than the "mum and dad investors" that the National Party spin had suggested would line up to buy the stock. That wealthy New Zealand and overseas investors would expropriate the wealth of ordinary New Zealanders is what many critics of the SOE sales had suggested would happen and, despite National's promises, happen it has.

The MRP sale has also prompted various changes to the way future SOE sales will be done and maybe even IPO's in general. One of the main criticisms of the MRP sale, aside from the fact that just about the only New Zealanders in favour of the sale were MRP executives who will benefit from free share options and the people who work for stockbrokers, law firms or investment banks associated with the sale, was the information vacuum for retail investors at the time of the sale.

Apparently all of the stockbrokers involved with the sale were not able to publish much in the way of comment for their retail clients due to disclosure regulations so Mum and Dad didn't have the benefit of their views.

The NZ Stock Exchange (NZX) moved to address this problem with the Meridian float by commissioning a number of broking firms to provide "independent" research on Meridian prior to the float and made this research available to the public on its website. Today's story takes a close look at that pilot study whereby the Stock Exchange commissioned the research and asks the question whether it is satisfactory in its current form and whether it should be extended for other stocks. Later on we put the Meridian dividend policy under the microscope.

Garth Ireland of specialist business advisory group, Ireland, Wallace and Associates, wasn't too impressed. He has looked at the research on the NZX website and highlighted some potential anomalies within the discounted cash flow (dcf) models used in the five reports.

Before we discuss those, first some background on dcf, a dcf model is simply the forecast future annual net cash flows of Meridian discounted back to today's dollar terms. The key variables are the rate which you discount the cash flows and this reflects, amongst other things, the risk premium associated with the cash flows and the risk free rate of return, and obviously, the size of the cash flows. You then add each year's discounted cash flow up, divide the total by the shares on issue and that's the dcf value of Meridian.

The valuers started with a dcf valuation for 100 per cent of Meridian and then used comparative analysis of other listed generators to determine a price for a 49 per cent minority holding on a per share basis.

However Ireland observed that there are major differences in the assumptions underlying each valuers' dcf models but, mysteriously, all of them conclude that Meridian shares should be valued within the price range that the government said it would sell them at in the first place. LOL, very convenient.

First up the various valuers' reports derive a weighted average cost of capital which ranges between 7.5 per cent and 9.5 per cent. The WACC can be used as the discount rate to discount the cash flows so it is very important and a variation between 7.5 per cent and 9.5 per cent changes the value of an annuity of say, $100 pa in perpetuity (a proxy for the Meridian cash flows) by 23 per cent.

In plain English what he is saying here is that the variation in just one key input to the DCF model suggests a 23 per cent difference in the theoretical value of Meridian.

Another issue is that some of the valuers have used just two years of explicit cash flow whereas other valuers have used up to twenty years of explicit cash flow and then applied a standard growth rate from that point onwards. Terminal value growth rates are used to forecast the cash flows further out in time after the first two or up to twenty years. But to give up after two years is unusual.

Last but not least the cash flow forecasts used include inflation but the terminal value growth rates appear to be an "inflation rate" and thereby possibly double accounting for inflation. This is saying that the value of Meridian beyond the explicit forecasts will grow forever at the inflation rate without any net new investment. In many of the models it is impossible to determine how the authors got to their results and it is Ireland's view that any research needs to be sufficiently open so that an expert can rebuild the model and make variations to suit themselves. Ireland raises lots of other issues but these are the most easily explained!

It is Ireland's view that the NZX pilot represents the chance to greatly improve standards in the provision of independent research for future IPOs, like Meridian, and for NZX listed companies not researched by brokers. However, this needs to be done with a careful review of exactly how that research is to be done and for whom it is targeted.

Whilst on the subject of valuation it seems that whenever anyone comments on the attractiveness of Meridian they inevitably mention its dividend yield (dividend per share/share price). Dividends are important for sure but concentrating on them, whilst ringing the bells of most retail investors, isn't altogether healthy because they are not the ultimate arbiter of value.

Dividends just represent the proportion of profits which are paid out and this proportion can be manipulated such that an expensive stock can have a high dividend which makes it look cheap. We will ignore the fact that the Meridian shares are partly paid but will rank for the full dividend for a year because this impact is short term and, let's be honest, it's really just cheap marketing - a bit like getting a free tank of gas in your Porsche - nice but it doesn't alter the value proposition materially. The dividend in 2014 is forecast to be 10.5 cents per share. With imputation credits that is a yield on the $1.50 price of around 9.0 per cent. With one year bank deposits at 4.0 per cent the shares are cheap, right?

Maybe. Professional investors tend to assess the relative attractiveness of companies by comparing the price of a company to its earnings per share. This is known as the PE ratio. On this basis Meridian looks fully priced. For the year ended June 2014 the prospectus says Meridian will earn 7.3 cents per share after tax. At $1.50 that is a PE ratio of 20.6 times ($1.50/7.3).

A PE ratio of 21 times wouldn't usually be regarded as cheap unless the stock had high growth prospects and for some perspective in the last 50 years Wall Street has sold down as low as a PE of 6 times.

The other interesting thing about Meridian's dividend is that whilst Meridian will earn 7.3 cents per share in 2014 it will apparently pay out 10.5 cents per share in dividend. Common practice around the world is for companies to retain 50 per cent or more of their profits. So the question is, was Meridian's high dividend policy a function of the Government's need to make the stock attractive to retail investors? One wonders how many retail investors would have bought Meridian if the dividend payout ratio was a more modest 60 per cent of earnings and the dividend yield was under 4 per cent?

A widely held theory developed by Franco Modigliani and Merton Miller says a company's value doesn't alter whether it pays out dividends or not. Foreign exchange traders know better.

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