On why even financial analysts are jumping ship on the asset sales plan
Barring a miracle, John Key will be getting the green light in 48 hours time to sell off a 49% stake in several of our most valuable state assets. In recent weeks, the issue has come down to a fairly simple question – would we lose money or save money by keeping the assets and borrowing the money instead?
A couple of weeks ago in the NZ Herald, Auckland financial analyst Brent Sheather laid out some compelling evidence to back up the conclusion he repeated to me on the phone yesterday:"They should borrow, rather than sell the assets."
But… in this uncertain global climate, isn't borrowing a risky and counter-intuitive road to take? On the campaign trail, Key has certainly been sounding the alarm about the crisis in Greece, and the spectre of getting in hock to the Chinese. Sheather doesn't even blink. It all comes down to our ability to service the debt, he says.
And in his view, we're about to dig ourselves an even bigger debt hole in the national ledger, because the government seems to be intent on selling assets that are generating a higher income than the cost of the borrowing. "If you look at it from the point of view of a business, our interest cover – i.e our ability to service the rest of the debt – is going to be worse after the sale, than it would be before the sale."
Other commentators have done the maths and reached much the same conclusion. Yesterday, NZ Herald business columnist Brian Fallow found the asset sales plan wanting, even after doing the sums in a way that bent over backwards to be fair to the government. Treasury has estimated that $5–7 billion can be earned from selling 49% of the government's stake in the assets in question. Rather than look at the current and projected yield from government bonds, Fallow used a figure of 5% for the cost of borrowing, based on that being the average cost of government borrowing over the past five years. So 5% on that $6 billion would be $300 million. That's one side of the ledger: the cost of borrowing.
Now for the other side – the dividends we forego by selling. Treasury forecasts of the dividends expected from the four SOE energy companies up for sale. Fallow says, average out at $449 million a year over the next five years. The 49% share we intend to sell would therefore come to $220 million. Throw in $20 million for selling 23% of Air New Zealand and the dividends foregone would average $240 million a year – or 4 per cent of the $6 billion sale price.
That means we barely come out ahead. Assuming absolutely everything goes right, we would be $60 million in the black. "So we are talking about a difference of 1 percentage point between dividend yields and bond yields," Fallow says. Margin of error stuff, in his opinion. And that's after looking at the deals in the most generous of lights.
Why do I say generous? Well, for one thing, in the sums above we haven't taken into account any of the likely cost of setting up and managing the asset sale process. Some estimates put that cost as anything up to $350 million, but again, let's be generous to the government. Let's assume the sales process will include the usual 1% charge exacted by sharebrokers for handling stock market launches. This, along with other related costs are likely to push the cost of the sales process up to around 3% at the very least, Sheather estimates.
On a $6 billion sales process, that comes out at $180 million, which in the first year at least, would wipe out the small advantage that Fallow discovered, three times over. Included in this bill will be the payment to the "advisers" to the Key government, such as the Australian investment bank Lazard, which is reportedly being paid $100 million to assist in the sales process.
There's more. "The other cost," Sheather says. "is that the management of the companies will expect options in the companies, which will massively reward them, just like the management of other companies get rewarded. That's something that wouldn't be happening if they remained state owned enterprises." Management costs will rise in perpetuity.
Sheather's analysis, round two
Two weeks ago in the Herald when Sheather estimated the cost of borrowing, he used the yield on government bonds as his yardstick. Looking ahead, he said then, the secondary market in 10-year government bonds were pricing them to yield 4.4 per cent. The yield on five-year government bonds was 4 per cent. The interest on $6 billion at 4% is $240 million, and that's the cost of borrowing – or about $60 million less than what Fallow calculated.
Since then, Sheather says, the rate has gone considerably lower – and is now close to 3% for five years, and just below 4% for ten years. What does this signify? Well, rather than seeing New Zealand as a similar risk to Greece and the rest of Europe, it means that investors are treating us as something of a safe haven and reducing the interest charge involved, thus making the option of borrowing the money – rather than selling the assets – an even more attractive option.
On the dividends side of the ledger, other observers besides Sheather have noted that the four energy companies have been performing extremely well. Those good times are about to get even better. Too bad the taxpayer will now be losing out once those assets are sold down, because they've just paid for the capital investment that will be driving those even higher returns – and which the private investors will begin to reap.
The evidence is clear on this point. The $1.7 billion return over the last three years from the four energy companies would have been even higher, as Greens Co-Leader Russel Norman pointed out yesterday, if the SOEs in question hadn't chosen to double their investment in new plant and machinery, in order to deliver even higher returns in future. As Norman says:
Now that the earning potential of our SOEs has been enhanced through this capital investment, the Crown can expect to see considerable growth in dividend streams from this point on. Treasury makes this point explicit in their last 2010 Annual Portfolio Report. They say the Crown should now expect to receive higher returns.
We have seen this before. Like our energy SOEs, Telecom had invested significant amounts of capital in building a modern telecommunications network in the years before privatisation. In the years following Telecom's privatisation, dividend streams for its new private owners doubled, then tripled within six years. History now seems to be repeating itself with our energy SOEs. National has allowed the taxpayer to build up the asset, only to then on-sell it to the benefit of others.
More than anything, those current 17.5% returns on average over the past five years are an astonishing testament to the efficiency of the SOEs. Despite the election campaign propaganda that asset sales will bring private sector disciplines to bear on the SOEs, the reality is the exact opposite. The SOEs are at serious risk of being reduced to the same general levels of incompetence as the private sector.
"Those returns suggest the SOEs are managed as well or better than stock exchange companies," Sheather says, "because stock exchange companies haven't returned anything like that rate of return. On average in the last five years ended in October, the New Zealand stock market has returned minus 2 per cent per annum." They've lost money? "Yes, they've lost money. The world stock market in the same period is down minus 4.3% . So 17.5 % is pretty good work."
In all probability, that stellar SOE energy company performance also reflects the pretty harsh prices for electricity that New Zealand consumers have been paying in recent years. Which raises a rather alarming concern about the situation once our energy assets are sold down – because if electricity prices are already sky high, how are the profit expectations of the new private sector investors going to be met? Not by racking up prices, Sheather agrees. "What they can do is use the famous venture capital saying – that there's lazy capital there, the balance sheet isn't being optimised. What we've got to do is pay out a special dividend to shareholders and take on more debt…"
Whaaat? So, rather than run the alleged risk of the government taking on more debt up front, we're going to sell these things – only then to turn around and satisfy the new private investors' thirst for dividends by taking on more debt, half of which will then be owned by every taxpayer in New Zealand? "I would say that is inevitable," Sheather replies." The share market, he adds, usually responds to such special dividends by ramping up the share price even further. Managers then get rewarded, and the taxpayer is left to pay for the bailout if and when the bubble finally bursts.
Sheather's own argument for why selling the assets makes no sense is based on the simple mechanics of the deal. The average yield on the NZ stockmarket is about 6%, so Sheather says he would expect the assets to be sold around that yield. Then, growth is averaged at inflation plus one [over the four companies] which gets you to 10%. That means, he says, a lot more will be being given away by selling the assets, than the circa 4% cost of borrowing. As he explained in the Herald.:
To get these asset sales, the Government will need to price the companies at price-earnings multiples of somewhere around 14 to 16 times, which implies after-tax earnings yields of 6 to 7 per cent.
"The 7% is the profits of the company after tax," Sheather further explained to me. "So the company could pay out 4% as tax free profit, and re-invest the other 3% for more growth. Either way, that's going to be nearly twice the 4% cost [of the borrowing option.]" Again, these sums indicate that ordinary New Zealanders stand to lose by selling down the assets.
To be perfectly clear on that point: in Sheather's view, would the annual cost of servicing the extra debt needed to retain these assets exceed the annual dividends derived from keeping full ownership of them?
"No, I don't think they would. Because if they swell them at an earnings yield of 7%, they can pay out 4% of that to the government to service the debt and retain the residual 2-3% in the company for extra capital for growth plus they've got depreciation as well. You could probably argue that those companies could fund their growth from the depreciation charge, anyway."
There will be a lucky (and relatively few) private investors who will stand to make a killing, given the fairly dismal investment options that are available elsewhere. "They'll underprice it, so the buyers feel good. They're going to get a tax free dividend which is 4% – which is tax free, which grosses up to six plus they'll get growth, which is another four. Look at it – if I can get 6% return from Mighty River plus growth, versus 4% in the bank, then the price is going to be right. And if the price is right for the buyer, it is going to be wrong for the seller." Who happens to be the New Zealand public.
There are other reasons why the sellers are likely to get short changed. Elsewhere, Scoop has explained why the need to diversify their portfolios will mean that few local investors – and even fewer foreign investors – are likely to want to invest in four energy companies one after the other, especially since there are already other energy related stocks (Vector, Trustpower, Contact Energy) crowded into the New Zealand share market.
Meridian will be the big prize for local investors, and Solid Energy's coal deposits and related technologies will make it the only one that foreign investors will be rushing in to buy. For political reasons, the Key government will therefore be selling Solid Energy last, in order to minimise the furore over selling our precious natural assets into foreign hands.
Finally… it is quite hard not to be depressed then by this asset sales process, isn't it? "It is," Sheather says. "I'm assuming Mr Key is a rational person." The public don't want the sales, he says, and the financial sector can't see the logic behind them.
What Sheather would like to see is a last minute offer of a referendum on the subject, as a sign that Key has listened to the public's concerns, and has responded in kind. "If he does that, all will be good. If he doesn't, he needs his head read."
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