Comment

The upsides and risks of three big deals

Rod Oram digs into the sales of Vodafone NZ, Trade Me and Tip Top to foreign investors, and finds Fonterra's ditching of its Tip Top ice cream brand is the sweetest.

The new overseas owners of Vodafone New Zealand, Trade Me and Tip Top will be bringing some $6 billion of new equity and debt capital into New Zealand. They will also free up some capital from domestic investors exiting from two of the three companies. If that’s reinvested well, it will add to the economic upside.

Thus, these three deals demonstrate the merits of good foreign investment. That is, overseas capital that helps us to do things we couldn’t do on our own. However, the upsides and the risks they embody, vary widely across the three.

The deal that most clearly benefits New Zealand is the sale of Tip Top, though the economic impact will be the smallest because the deal is worth only $380 million; the next most beneficial is the $3.4b sale of Vodafone NZ; and the least beneficial is the $2.56b sale of Trade Me.

Tip Top is the best because Fonterra is exiting a business in which it has no future, given the harsh realities of the global ice cream market. For more than two decades Unilever and Nestlé, two of the world’s greatest makers and branders of fast moving consumer goods, slugged it out for leadership of the global market, both in developed markets such as Europe and North America and developing ones such as China.

In this global ice cream war, two of my journalistic experiences were trips in the mid-1990s to the opening of Unilever’s Shanghai plant making Magnums, and to the opening of Allied-Domecq’s Baskin-Robbins plant in Moscow.

Three years ago, Unilever had eight of the world’s top 15 global ice cream brands and a 22 percent global market share which generated €5b of sales a year. Yet for all its enormous strengths, Nestlé was an also-ran with only four global brands and a smaller market share.

So, Nestlé quit. It folded all but its premium North American brands such as Mövenpick and Häagen-Dazs into a joint venture with R&R, a UK maker of private label ice cream – the antithesis of a premium brand business – owned by PAI, a French private equity investor. They called the new company Froneri.

There was no way Fonterra could compete in such an intense global market through its Tip Top brand. The business’s chequered history is a testament to its limited prospects near to home. Despite its locally famous brand and long history, it was sold to Goodman Fielder in 1987, Heinz in 1992, West Australia's Peters and Brownes in 1997, Kiwi Dairy Co in 2000, and to Fonterra in 2001.

After buying the local, niche and upmarket Kapiti cheese business, Fonterra tried extending it by using the brand in a modest effort on premium ice cream. But that didn’t go far either.

This week Fonterra agreed to sell Tip Top to Froneri for $380m. Fonterra has achieved a high price, a multiple of 20 times or so Tip Top’s indicated profits last year, a clear sign Froneri thinks it can make more of the business than Fonterra ever could.

This enabled Fonterra to take a $100m gain on its book value for Tip Top, which will be worth a net 6c a share in earnings to Fonterra shareholders in their year-end accounts. But shareholders are unlikely to see much if any of that flowing to them in dividends, because Fonterra is struggling to pay off debt and rebuild its equity capital.

Fonterra is also pleased that it will continue to sell milk to Tip Top. But that will be an utter commodity transaction. The sooner Fonterra finds a higher value use for that milk, the better.

The co-op is also licensing its Kapiti ice cream brand to Froneri for global use. They might earn a bob or two in royalties. But given Froneri’s major focus in private label and Nestle’s waning interest in ice cream, the idea that Froneri will build Kapiti into a sizeable global brand stressing the attributes of Kiwi milk is highly unlikely. And even if it did, then Froneri not Fonterra or the NZ economy would be the biggest winner.

Thus this is a good example of the benefit of foreign investment. The infusion of foreign capital will make Tip Top a continuing business with some growth potential, while Fonterra is redeploying capital into higher value businesses in which it has a true competitive advantage. Winston Peters' dissing of the deal was ill-informed.

Some downsides to the Vodafone deal

Next best is the Vodafone NZ deal. Its UK parent is exiting in a $3.4b sale to Infratil and Brookfield Asset Management. They are taking 49 percent each with the residual sliver of ownership in the hands of the local management team.

Vodafone is a willing seller. It bought the NZ assets in 1998, invested in building them up and pocketed some substantial gains along the way such as a $500m dividend in 2006. But with only two million mobile customers in a mature market which is struggling to grow its revenues, New Zealand is a distraction to its global business. It has 700 million customers elsewhere, more yet to acquire, and huge technological, market and revenue challenges of its own.

The new owners face the same challenges but they will be far more committed to Vodafone NZ. It will be a material member of their portfolios and they say they have some better ideas for growing it.

Infratil is a successful NZX-listed infrastructure owner which has rewarded shareholders well to date. Brookfield is a Canadian company with an intriguing history going back to investing in trams in Sao Paulo in 1899. Today it has some US$350b of infrastructure assets under its management.

Together they make a good team. Both are successful infrastructure investors; Infratil is committed to New Zealand; Brookfield adds its own skills and large balance sheet; and will be a better long-term owner than private equity funds, which typically are after quicker, shorter-term gains, then exit.

Marko Bogoievski, CEO of Infratil and Morrison, gave some examples this week of how the owners hope to run Vodafone better. A key one for the NZ economy is to persuade other telcos to invest together in some common infrastructure to avoid expensive duplication. This will be particularly important with the expensive and rapid build out in the next few years of 5G, the next generation of mobile technology. By comparison, global Vodafone is much more inclined to go-it-alone.

But there are some potential downsides for customers and the country from this deal. Infratil/Brookfield are paying a high price, funded by significant debt. They plan to increase Vodafone’s cap ex next year to $300-350m from $223m in 2017 to catch up with Spark’s investment in technology, business skills and structures, products and markets. But that will suppress operating profits from $246m to $110-190m, the new owners' forecast.

They can’t run that financial model for long. So they have to ensure Vodafone can pull off quickly the big task ahead of it. In recent years it has languished under its UK owners which skimped on its investment; it has been distracted by its abortive merger with SKY TV and then its UK parent’s plan to float it here. Now it has to come up with a third structure and strategy in three years, execute it, and quickly reap revenue growth and profits.

But profitable growth has long eluded telcos worldwide. They invest heavily in infrastructure but the biggest rewards go to companies such as Facebook, Google and Netflix that offer highly attractive and profitable services over the networks. Telcos still have no useful counter to these “over the top” providers; it’s hard to imagine that Infratil and Brookfield can do either; and the pressure from OTT companies is only getting more intense.

Meanwhile, in addition to the high price and debt the new owners will continue to pay a large annual fee to global Vodafone for the brand, technological help, roaming and other benefits of its global network.

Taken together, these pressures are evidence that telcos are a very difficult asset class. Moreover, small, under-capitalised and under-resourced players, such as 2degrees in our market, will only find life ever harder. In due course our market could become a Spark/Vodafone duopoly. Then regulators and consumers would have to monitor them very carefully to ensure they maintain their appetite for competition and innovation.

There is another big risk of this deal. Some investors are hoping Vodafone’s new owners will pull off a corporate reinvention as spectacular and profitable as Infratil and the NZ Superannuation Fund did turning Shell NZ’s downstream operations into Z Energy. More on this in this recent Newsroom article. If that happens, they hope they’ll get a small piece of the action in a subsequent share market float of Vodafone NZ.

There are good reasons, however, to doubt that will happen. In Z’s case the downstream fuel business was dominated by local subsidiaries of distant multinationals who had starved it of capital and innovation. It was ripe for a shakeup, which Z led enthusiastically then cemented its gains by acquiring Caltex’s operations.

With the float of Z in 2013 at $3.50 a share, Infratil exited with a massive profit, while the Super Fund reaped almost as much but kept a small stake. The shares subsequently peaked at $8.60 in August 2016 but have since under-performed the NZX 50 by some 20 percent. It’s hard to see how Z can deliver superior returns in the future.

Vodafone is quite a different case. Its sector is not stagnant, it has two vigorous and innovative competitors, its revenues and margins are under great pressure from OTT companies and others, and its cap ex needs are very large. If Infratil and Brookfield do an excellent job reviving Vodafone they will make good money for their own investors. But there might be little upside left on the table for other investors in a float.

Despite those caveats, this deal is a good example of a partnership between New Zealand and foreign capital which will enhance a company crucial to our economy.

Trade Me: the least appealing deal

Of the three recent deals, Trade Me, though, is the least compelling example of the merits of foreign investment. Giving a fully priced exit for existing investors is the best thing that can be said for it. The offer from Apax Partners of the UK was $6.45 a share versus the independent valuation of $5.93-$6.39.

Before the offer came last November, Trade Me’s shares were around $5, compared with their all time high of $5.62 in September 2016. Even with the offer, which closed last month, the shares had under-performed the NZX 50 by 11 percent over the past two and a half years. If they had continued to drift sideways in the absence of an offer they would have under-performed by almost 40 per cent.

Hopefully the exiting shareholders will reinvest well. It’ll be more interesting, though, to watch for employee-shareholders taking their gains, leaving the company and starting new ventures.

Trade Me is an admirable company. It not only provides highly effective and useful online marketplaces but it has done so in very Kiwi ways that have created real engagement and trust through its culture and strong online communities. For example, parenting is by far the largest thread on its message boards. By contrast, the likes of eBay and Chinese online marketplaces are purely transactional.

But for all the power of its culture and innovation skills, Trade Me has failed to make them work overseas. Meanwhile, rapid diversification and growth have proved elusive at home in recent years.

Apax has a few investments akin to Trade Me but the synergies seem limited. Worse, it might squeeze Trade Me hard to earn a big return on its pricey investment or in seeking a profitable exit later. The risk in that is Apax could seriously impair the culture, trust and community Trade Me has created. That would be a big negative for New Zealanders and potentially open the way for the likes of eBay to have another crack here.

For these reasons, this is the least appealing of the three deals.

The overall message is simple. Foreign investment is welcome when it helps us do things we couldn’t do as well on our own. But each case needs to be considered on that fundamental benchmark. We should reject those that fail the test.

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