Brian Gaynor: Left to pick up the crumbs

Graeme Hart has displayed many of the characteristics of a classic private equity investor during the past few weeks. Investors should be aware of this before they participate in the Goodman Fielder initial public offering.

A private equity investor purchases poorly managed and under-performing companies below their intrinsic value. The acquired company is privatised, loaded with debt and restructured.

Private equity operators are particularly ruthless when it comes to cost-cutting and restructuring. This usually results in a substantial increase in earnings and shareholder value within two to four years of the original purchase.

These investors are not long-term holders. After earnings have been raised, and substantial shareholder wealth created through debt leverage, the acquired company is sold through a trade sale or an IPO.

Private equity investors usually adopt a low profile as it enables them to avoid public scrutiny when they are restructuring and slashing costs.

However, they transform remarkably when they are selling a company through an IPO process. Instantaneously, they become accessible and communicative, and act more like high-powered salespersons than investors.

We have seen that with Feltex, Freightways, Frucor and Vertex, all sold through an IPO by private equity investors.

In the past few weeks, Graeme Hart has undergone a major transformation. He has become communicative and willing to talk to potential investors and the media. This has generated a huge amount of publicity, a very useful development when he is trying to sell Goodman Fielder through an IPO process in a short timespan.

The problem with private equity IPOs is that most of the value has been extracted during the privatisation process, and only limited upside is left on the table for IPO and trade sale purchasers.

One of the main questions potential Goodman Fielder investors have to ask is how much value has Hart left for them.

Hart first became involved in Goodman Fielder on December 12, 2002, when Burns Philp, which he controls, acquired a 14.9 per cent stake on market.

The next day, Burns Philp announced its intention of making a full takeover offer for the company at A$1.85 ($1.96) a share. This valued Goodman Fielder at A$2.2 billion.

The takeover was extremely acrimonious but the Goodman Fielder board finally capitulated after the offer was raised from A$1.615 to A$1.635 a share (the original offer was reduced to A$1.615 after the payment of a special dividend by the target company).

The Australian media was already reporting huge redundancies at Goodman Fielder before the company was delisted from the ASX and NZX on June 12, 2003.

At the time of the takeover, Goodman Fielder had historic revenue of A$2.48 billion and earnings before interest and tax (ebit) of A$185.2 million on a pro forma basis.

Goodman Fielder's historic revenue and ebit, excluding New Zealand Dairy Foods, are now A$1.92 billion and A$274 million respectively.

Since the acquisition, revenue has fallen by A$560.7 million and costs by A$649.5 million. This has been a result of Hart's cost-cutting, product rationalisation and exclusion of the snack foods operations from the float.

As a result, Goodman Fielder's ebit margin has risen from 7.5 per cent to 14.3 per cent since acquired by Burns Philp.

The Sydney-based group borrowed $1.3 billion to fund the original acquisition.

A substantial proportion of this debt effectively remains on Goodman Fielder's balance sheet. The IPO company will have A$1.1 billion of interest-bearing debt, whereas Goodman Fielder had only A$392 million of debt when it was acquired in 2003.

Although few private equity deals are through listed companies, the purchase, restructuring, cost-cutting, increased gearing and sale of Goodman Fielder is a classic private equity transaction.

The other asset included in the IPO is New Zealand Dairy Foods, which was acquired by Hart's Rank Group for $245 million in 2002.

The company underwent major cost-cutting and restructuring following Hart's purchase.

In August 2005, NZ Dairy Foods and Fonterra agreed to swap assets whereby Hart sold most of the company's operations, except the block and specialty cheese businesses, to Fonterra for $754 million.

The other part of the deal was NZ Dairy Foods' purchase of Fonterra's domestic fresh milk, cultured products and meat business including food services distribution networks for $416 million.

But the Hart money-making machine doesn't stop here.

As part of the IPO, Hart will sell NZ Dairy Foods to Goodman Fielder. The price, which will be determined by Goodman Fielder's ebitda multiple at the IPO price, could be as high as $885 million. This is based on a final IPO price between A$1.85 and A$2 and NZ Dairy Foods achieving annualised ebitda of $103.6 million.

Thus Hart purchased NZ Dairy Foods for $245 million and has the potential to realise nearly $1.2 billion, including the profit from the recent Fonterra asset swap.

The earnings forecast of the operations acquired from Fonterra, including the block and specialty cheese businesses, has been lifted from $72 million to $103.6 million on an annualised basis.

This projected profit uplift, which has a large cost-cutting contribution, is one of the main reasons why Hart is going to achieve a huge profit on the sale of NZ Dairy Foods.

One of the problems with the Goodman Fielder IPO is that Hart has already extracted an enormous amount of value from the original Goodman Fielder purchase and from NZ Dairy Foods.

Another important feature of the float is that it is aimed at New Zealand and overseas investors. As it is far too big for the New Zealand market, the success of the issue will be highly influenced by the uptake across the Tasman.

It is difficult to know whether overseas investors will be keen on the issue.

A negative feature of the float for retail investors is that the final price, which has an indicative range of between A$1.85 and A$2 a share, will be set after they lodge their applications.

The top indicative price appears to be too high and the institutional price-setting mechanism is expected to establish a lower price. There is a strong incentive for institutions to bid low because every 1c movement in the IPO price represents about $2.5 million as far as the payment to Hart for NZ Dairy Foods is concerned.

Hart told the media briefing last Friday that investors should "sell Carter Holt Harvey and buy Goodman Fielder".

That is the advice one would expect from a private equity investor who was looking after his own interests.

Why would investors sell Carter Holt on a historic ebitda multiple of 7.3 and purchase Goodman Fielder on an historic multiple of 9.4 to 10 at the A$1.85 to A$2 a share indicative price range?

The main reason is that the Goodman Fielder forecasts are positive and Carter Holt's negative. But the latter's forecasts do not take into account Hart's restructuring and cost-cutting expertise as demonstrated at Goodman Fielder and NZ Dairy Foods.

Based on Hart's track record, Carter Holt would seem like a far more exciting but riskier prospect for investors.

Depending on the IPO price, Goodman Fielder is little more than a safe and conservative investment offering a reasonably high dividend yield with limited growth prospects.

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

Hart of the matter
* Graeme Hart became involved in Goodman Fielder on December 12, 2002, when Burns Philp acquired a 14.9 per cent stake on market.
* The next day, Burns Philp announced its intention of making a full takeover offer for the food company at A$1.85 a share.
* This valued Goodman Fielder at A$2.2 billion.
* The takeover was extremely acrimonious but the Goodman Fielder board finally capitulated after the offer was raised.
* The company was delisted from the ASX and NZX on June 12, 2003.
* At the time of the takeover, Goodman Fielder had historic revenue of A$2.48 billion and earnings before interest and tax (ebit) of A$185.2 million on a pro forma basis.
* Goodman Fielder's historic revenue and ebit, excluding New Zealand Dairy Foods, are now A$1.92 billion and A$274 million respectively.