Risk off the menu for Kiwi companies

Risk off the menu for Kiwi companies

There is a stark illustration of trans-Tasman differences is CFO attitudes to debt.

Whatever anyone says, earthquakes can’t be predicted. Their likelihood can only be expressed as probabilities based on statistical evidence. Just as to speculate successfully on where the economy is heading, you need to know where it’s been. Economists say it’s almost certain the country is in double-dip recession. They are updating their figures continuously due to the Christchurch quake. Fletcher Building has downgraded its profit by $14 million to $24 million, post-quake. Others are bound to follow. Events in Christchurch put the economy deeper into recession and the longer-term risk of inflation could grow, prompting a rise in interest rates. Bank of New Zealand chief economist Tony Alexander has said New Zealand was probably already in recession in January. The quake removed any doubt. CFOs recognised recession was on the cards before February’s seismic activity. “It is conceivable,” ventured Luke Bunt, Warehouse chief financial officer and CFO summit speaker. Late last year Bunt cited disappointing retail figures and early summer drought conditions as reasons for the prospective double-dip (remember New Zealand underwent five consecutive quarters of decline ending March 2009). The Warehouse same store stales were down almost 4 percent for the two months ending 2 January; total sales were down 2.7 percent compared to the same period last year.

Alexander’s statistics are gloomy: retail spending volumes fell 0.4 percent in each of the two final quarters of last year. Dwelling consents fell 10 percent in the past three months. Tourist spending fell 10 percent last year and in the December quarter was 12 percent lower than in the corresponding period the previous year.

“Given September [quarter] was negative, given the drought conditions, which may have alleviated, and given where retail consumption is right now, it is conceivable we will have another quarter of negative growth,” says Bunt.

GDP is measured year-on-year and December 2009 recorded growth of 1 percent, the first time that has happened since March 2007. Every quarter since has been negative or sub-one percent.

Economic conditions such as New Zealand has experienced for the past three years is exercising the minds of chief financial officers who are considering options for taking on debt and divining future cashflow forecasts.

Year of uncertainty

Air New Zealand chief financial officer Rob McDonald, 2010’s ‘CFO of the Year’, believes the days of “leveraging up to the hilt” are history, irrespective of sluggish or negative growth.

The slings and arrows of outrageous leveraging, he suggests, have sufficiently stung the industry to prompt a sea change in attitude. Debt is no longer simply a vehicle to get from A to B and, if anything, the recent era of easy money was an anomaly and today’s conditions are a return to historical norms, he opines.

“New Zealand still has quite sharp [economic] imbalances and companies and people are working through their personal balance sheets,” McDonald believes. “You’re still seeing the impact [of the financial crisis].”

“For me,” offers Chye Heng, chief financial officer at privately-owned Beca Group, “this is not a time to rush out and leverage up and do all those wonderful things for the sake of leveraging. This year is an

uncertain year.”

Compare these CFOs’ attitudes with those of the Australians, where fund managers are beginning to beat the drum again about boosting returns through expansion, acquisition and merger, all funded by debt.

“They’re starting to talk about leveraging up the balance sheet again,” Chad Barton, CFO of direct marketing company Salmat commented to the Australian Financial Review.

Fund managers and other investors are even starting to talk about lazy balance sheets, as if the financial crisis were but a distant memory, Barton reports.

“Australia,” explains McDonald, “is in a very different part of the economic cycle.” New Zealand companies, under present recessionary conditions, should not be expected to mortgage the house in an effort to supercharge returns to appease shareholders, is his view.

As for lazy balance sheets, McDonald notes that critics judge the airline “based on the amount of cash there”.

“Presently, it’s just under $1 billion,” he reports. “A year ago, it was well over $1 billion — questions were asked at that point.”

Beca’s Heng concedes others do consider his company too conservatively geared but points out it doesn’t have ready access to financial markets as public companies do and has to ensure its balance sheet is strong. “We arrange our affairs so that if we require cash, we will have more than we need — that’s our rough and ready rule,” says Heng. By virtue of this policy, Beca is not beholden or dependent “on the kindness of the banks or other people”, he says.

This also allowed Beca to thrive during the financial crisis: “We had this inkling that things seemed to be running too hot,” says Heng. “We were always operating in a way that kind of prepared us for uncertain times.”

Lazy balance sheets

As an employee-owned company it’s important for Beca to run a strong balance sheet. This structure was established by founder Sir Ron Carter, whose ethos of conservative leveraging and carefully planned growth continues to hold sway.

“I learned a lot from him and although he’s no longer in the business, his shadow is always around me and my fellow executives, who are very much cut from the same cloth,” he says.

In any event, Beca’s 1000 shareholder-employees (out of a 2500 workforce) would not stand for excessive leveraging, says Heng.

Shareholders in Australia are pushing for quicker, larger returns, via debt-funded growth. What’s the view of New Zealand shareholders? John Hawkins, Shareholders Association chairman, is broadly supportive of conservative gearing and CFOs strengthening balance sheets in order to withstand future shocks.

“Lazy balance sheets” — and Hawkins spits the phrase out to convey his contempt — “we don’t believe there’s such a thing. Strong performing companies are conservative in their financial arrangements,” he says.

Several CFOs talk of the importance of communicating more clearly their balance sheet strategy to shareholders who, CFOs say, are increasingly distrustful about company management.

“The concept of a lazy balance sheet comes about where shareholders believe the appropriate mix between debt and equity is not being achieved and, as a result, return on equity is not being maximised,” explains the Warehouse’s Bunt. “I have not sensed anything coming from the New Zealand investment community about wanting to accelerate growth through leverage.”

Bunt says this is certainly the case with The Warehouse balance sheet, which three years ago might have been considered lazy: “We never considered our balance sheet lazy, but we always considered it to be not as efficient as it could be [and] we’ve gone though a process of dealing with that surplus cash.”

Today, he argues The Warehouse “is now structured appropriately for current economic conditions. It would be viewed as conservative, not lazy.”

New Zealand, claims Air New Zealand’s McDonald, does not suffer the sort of “short memory syndrome” that seems to afflict so many Australian investors.

The corporate sector retains the “knowledge of trauma”, McDonald contends, citing Canada and Sweden in the early 1990s, where lessons were learned to the benefit of the wider corporate community.

Similarly, events of 1987 and 1991 in New Zealand, says McDonald, resulted in a wiser executive community: “Generally, the New Zealand corporate sector’s balance sheets — with a few exceptions — aren’t in bad shape.”

McDonald points to the late 1990s, when the Ansett fiasco unfolded, which led to the airline’s nationalisation.

“How we approach things is coloured a little bit by what occurred and making sure we never go back into that,” he admits. “Having said that, you don’t want to let history cripple you in terms of being so conservative.”

Standards in the works

One potential spanner in the commercial works, according to Bunt, is the mandatory adoption of international financial reporting standards (IFRS).

“This is a serious issue,” Bunt comments. “Right now, corporates can finance their assets through bank debt and acquire them and hold them as real assets on the balance sheet.” Alternatively, he says, they can lease assets and finance them through operating lease structures. Commitment to those leases has historically been set out in the notes to the accounts. “What the IFRS are moving towards is a situation where those lease obligations will have to be valued and physically put on to the balance sheet, which will impact the perception of what a corporate’s balance sheet will look like,” he says. “On the one hand, it’s a liability and on the other hand an asset.”

Potentially worse is the way the standards suggest lease obligations should be amortised through a company’s profit statement, Bunt says.

Also challenging the acumen and skill of CFOs will be unheralded changes to the regulatory framework in the wake of the finance sector collapse, a particular concern for Heng.

“Businesses have had to bear the brunt of extra administration over the years, there’s no doubt about that,” he says. In his opinion, government needs to be cautious in introducing knee-jerk law that captures large swathes of the business community, rather than finance companies.

“They shouldn’t have a rule that tars everybody; it’s got to be pitched at the right level and sensibly,” Heng says.

Investment security

Sourcing funding isn’t easy for airlines, either, as governments in the US and Europe have removed some of the export credit market support put in place at the height of the crisis, says McDonald. “Money will cost more; supply and price will change in the future as airlines [including Air New Zealand] return to the commercial market,” is his summation of recent trends.

It helps that Air New Zealand has been upgraded to investment grade — one of only four airlines in the world to achieve such a status, the others being Southwest, Lufthansa and Qantas.

“Being investment grade is really important [and] we got over the threshold,” comments McDonald.

Although the national carrier has a robust balance sheet, “without that strong liquidity position things get dire pretty quickly,” he admits.

Air New Zealand is in a better position because its investment quality grading now allows it to tap the domestic debt market, something which it has not done before.

“It’s kind of a milestone for us to begin to think about the domestic market,” he says.

Future corporate fortunes now depend on a stronger economic recovery, particularly in retailing, says Bunt.

“Retailers’ performance is significantly influenced by sentiment around employment security,” he says. “What you need is a sustained period of confidence that translates into investment and into employment and then into employment security.”

Until that happens, Bunt believes shareholders will have to be patient: “It’s going to be difficult for shareholders to see capital growth in the next 12 to 24 months. Those companies that are strong cash generators [such as Air NZ, Beca and the Warehouse] are well-placed to provide dividend returns.”

With the prospect of a rising cash rate, decreased lending to the private sector and rising prices, economists will be even more alert to statistical aftershocks than usual this year.

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