Chalkie: Basting a chop won't make a steak

16:00, Jan 29 2013

Poor old Red Meat. There she is, best frock on, hair done, smiling with her eyes and showing a bit of leg, only to find that tarty dairy cow getting all the attention.

Dairy co-op Fonterra teased investors for years before finally letting them on to third base late last year, with explosive results. Units in its Shareholders Fund quickly shot up to well over $7 after being issued at $5.50 a mere two months ago.

Meat co-op Silver Fern Farms, on the other hand, is still working the street corner.

After a reform of its capital structure in 2009, ordinary shares in Silver Fern became tradeable by any Tom, Dick and Harry on the unlisted market, but they have not been pursued with any passion.

Initially valued at $1, the stock has been thinly traded and spent most of last year about the 85c mark until a sudden plunge in late November. The last trade on January 23 was at 65c and the only buyers currently on market are bidding 60c.

Chalkie reckons the obvious short-term culprit was Silver Fern's result for the year till September 30, released on November 13.


It was a horror. Sales dropped 3 per cent to $2.02 billion, but the bottom line went from a profit of $31 million to a loss of $31m. Debt, meanwhile, rocketed from $111m to $317m.

The latter is particularly disappointing after the co-op's strenuous efforts to reduce debt costs - after five successive years of debt reduction, the $206m surge in borrowing takes Silver Fern right back to levels last seen in 2007.

Chalkie had a look at some past results to see how bad this one was. Based on operating cashflow, a simple measure of how much money the business makes from trading, the 2012 year was the worst in at least a decade, by a long way.

In 2012 operating cashflow was minus $106m, compared to the previous year's figure of minus $8m, which was itself the only other negative number after eight years averaging about $80m.


However, Silver Fern managed to find something positive to say about it, describing its balance sheet as "strong" and "robust". This, Chalkie reckons, is like calling a chop a fillet steak.

In fact, net equity fell from 58 to 44 per cent of total assets, or from 54 to just 41 per cent if you count co-op shares as liabilities, which they technically are. The basic implication of those figures is that Silver Fern shareholders own less than half the assets.

There was also the alarming detail that the borrowing facility from a syndicate of banks was due to expire in December, after a three-month extension from the previous expiry date of September 29. Silver Fern said it was confident the facility would be renewed on acceptable terms - as, apparently, it turned out - but surely not many corporates would want to cut it so fine.

Silver Fern chief executive Keith Cooper told Chalkie the new facility is for one year rather than the previously typical two-year term, "because our view is the capital markets in a year's time will give us a favourable opportunity".

Let's hope so.

But what has been going on to give the co-op such strife?

Dunedin-based Silver Fern is both a processor and a marketer of meat, mainly beef, lamb and venison. It buys stock from its supplier shareholders, slices it up and sells it all over the world.

As a result it must juggle numerous issues, including weather-related production variations in New Zealand and elsewhere, exchange rates and competition from other protein providers.

The official line seems to be something like this: there was lots of grass, so animals were kept in the fields, so there was a shortage of meat, so the price went up, so consumers stopped buying, so when the animals came in from the fields there was too much meat, so Silver Fern ended up buying more than it could sell.

The unfortunate sequence shows up in the accounts as a big jump in inventories of meat and livestock, from $145m the year before to $227m at the end of September, which had to be funded by borrowing.

Rival co-op Alliance Group seems to have had exactly the same problem.

Over the same period its operating cashflow plummeted to minus $164m, its meat inventory doubled to $180m and borrowing soared from $2m to $196m.

The irony here is that Silver Fern's capital restructure was part of a strategy aimed at delivering what the market wants, rather than trying to sell whatever the farmers produce.

Indeed, a 2009 shareholder information pack discussing the changes noted the business was undercapitalised and overly reliant on bank support.

A report from financial consultancy Grant Samuel included in the document said: "As currently structured Silver Fern Farms does not have sufficient equity capital, particularly at the peak of the season when it becomes overly dependent on bank funding [which is imprudent in the current environment]. Further, Silver Fern Farms does not have the capital to undertake the investment necessary to fully implement the ‘plate to pasture' programme."

As a result, Silver Fern gave its suppliers the chance to swap their existing shares for new ordinary shares and subscribe for new shares under a rights issue to raise up to $128m.

The capital raising appears to have been a flop. The exchange offer garnered 75 per cent of eligible shares, or 43 million of a total 58 million. The terms of the rights issue gave ordinary shareholders the right to buy two new shares for every one they had, at a price of $1 each, which Chalkie reckons meant farmers could potentially have subscribed for $86m worth. The 2009 annual report said they actually subscribed $22m and described this as "a high level of positive shareholder engagement".

When you consider Silver Fern modelled three scenarios for its balance sheet from the rights issue, one raising $128m, one raising $80m, and one raising $30m, to imply $22m is a great result is taking positive thinking to extremes - especially since the Grant Samuel report said farmers were getting $1.40 of value for every dollar spent in the rights issue.

To Chalkie, the numbers suggest farmers were highly reluctant to invest their hard-earned cash in the co-operative.

After the latest result you could say they were right, but there may be other ways to interpret events.

One is that the lack of farmer investment severely inhibited Silver Fern's ability to pursue its market-led strategy, which contributed to the shocker of a 2012 result.

Another is that farmers simply do not trust the co-op's leadership.

When farmers can choose to supply Silver Fern or Alliance with relative ease, it is tough to get them to accept short-term pain for long-term gain unless they believe the story.

Fonterra went to great lengths to get its shareholders onside with its strategy, and was mostly successful, but Chalkie reckons Silver Fern has some way to go.

According to Cooper, the high inventory has since been sold down and the trading position is more positive. "Overall we're very pleased," he said last week. "We're in a far better position than this time last year."

That's a good thing - and it will be interesting to see whether the share price responds accordingly.

However, until Silver Fern and its farmers are on the same page, Chalkie has his doubts. Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.