MONEY TALKS: Fonterra units - what to think?

By Paul McBeth

In a week's time the great unwashed who haven't managed to own a dairy farm will get the chance to buy into Fonterra… kind of.

New Zealand's biggest company will close its offer to invest in the Fonterra Shareholders' Fund, a unit trust that hopes to raise $525 million and which gives investors rights to the dairy exporter's dividend stream, albeit no voting rights.

On the face of it, it seems like an amazing opportunity. Local investors have wanted to get some skin in Fonterra for a long time, and simply buying Fonterra bonds hasn't cut the mustard.

And given the amount of interest, you would be dead lucky to get your hands on a parcel of units as a lowly retail investor. The big institutional players desperately want a slice of a good New Zealand agriculture asset allocation to make their portfolios seem a little more balanced in a country that offers precious little publicly tradable exposure to our backbone primary sector.

Where it starts to get a little tricky is when you start making your back of the envelope calculations to see how well you'll do.

The indicative price range for the float that's not a float is $4.60 to $5.50 per unit, and Fonterra can take that even higher if it feels so inclined. That's not so ludicrous when you think about how many billions of dollars are sitting patiently in term deposits at the lowest interest rates for a generation.

So what sort of return might these Fonterra units offer?

Fonterra is forecasting a dividend of 32 cents per share next year. That matches the 2012 return, and is a small step up on the 27 cents a share declared in 2010 when the dairy exporter rejigged its capital structure to align dividends with the value-added component of its earnings.

That means if by some means, foul or fair, you get some units in the Fonterra fund, you're looking at a 7 percent gross return if they're priced at the bottom of the range, or a 5.8 percent return if they go at the top. After tax, that's a net cash distribution of between 5 percent and 4.2 percent.

All of a sudden, at the lower end, things don't look that much better than current term deposit interest rates.

Before the offer documents were released to the market, there was speculation (most likely plumped by the investment banks involved) that investors could be looking at a cash yield of between 6 percent and 7 percent.

They were also thinking the pricing would settle at about eight to 10 times pre-tax earnings, a tad below the 10.3 to 11.6 times cited by Fonterra.

I was already a bit sceptical. Call me old-fashioned, but I don't much like the idea of taking on equity risk without having associated rights like voting.

Fonterra holds the whip-hand.

What's more, the board that governs the fund doesn’t have much input into Fonterra. There's an innate tension between the dairy exporter paying dividends and increasing milk prices for its farmer shareholders versus the Fonterra unit investor.

Large instos may be able to flex their muscles, but retailer investors won't have any influence.

The final clincher for me was investment rating agency Morningstar's recommendation that retail investors stand aside from the initial public offer and wait for prices to fall on the open market.

"Our main concern is that prospective investors won't know the price they are paying and quantity of shares they would be receiving until after the bookbuild process is completed," analyst Nachi Moghe said in his report. "As a result of this uncertainty, we would advocate investors wait for the units to list on the market and consider buying at a price below $4.95 per unit."

At that price investors would be looking at a gross dividend yield of 6.5 percent, which is comparable to some of the larger listed companies on the New Zealand Stock Exchange such as Contact Energy and Sky Network Television, and ahead of NZX leader Fletcher Building.

Morningstar also cautioned that while Fonterra is a solid beast, the dairy exporter lacks the pricing power of its global competitors because it remains largely commodity-focused and is still seeking global scale in higher value branded products.

Getting a slice of the Fonterra action is a welcome addition for New Zealand's capital markets, but the last thing you want to do is overpay.



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