KEY POINTS:
The proposed closure of PPCS's Oringi and Burnside plants demonstrates once again that the meat processing industry, which is the country's second largest export sector after dairy, continues to struggle.
Sharemarket investors have seen a huge number of companies come and go over the past few decades, including Canterbury Frozen Meat, Fortex, Gear Meat, Hawkes Bay Farmers Meat, Huttons Kiwi, R&W Hellaby, Richmond, Southland Frozen Meat and Waitaki-NZR Refrigerating, while export growth has slowed to a crawl in recent years.
This is due to a number of factors including the resurgence of the dairy sector, a massive decline in sheep and beef cattle numbers and poor quality marketing by the meat export companies. But farmers and investors shouldn't write off the industry just yet as a number of astute investors are betting that sheep and beef may be a better investment than dairy over the next year or so.
The first point to note is the dramatic decline in sheep numbers in Australia and New Zealand over the past few decades (see table).
Australian mid-winter sheep numbers have fallen from a high of 179.8 million in 1970 to 92.7 million while New Zealand sheep numbers have also plunged from a peak of 70.3 million in 1982 to 38.5 million as at June 30, 2007. The decline in sheep meat production has not been as severe because of a big boost in the yield per animal.
Beef cattle numbers have been relatively stable in comparison with Australian going from a 1976 high of 29.3 million to 21.2 million in 1982 and 26.1 million now, while the New Zealand total has declined from a 1975 peak of 6.3 million to 4.4 million.
The sharp fall in Australian livestock numbers has been due to a combination of drought and poor marketing while in New Zealand the main contributing factors have been the strong performance of the dairy sector and disappointing returns for mutton, lamb and beef.
There has been a dramatic shift from beef to dairy in New Zealand over the past three decades and we now have 5.3 million milk cows and 4.4 million beef cattle compared with only 3.0 million dairy cattle and 6.3 million beef cows in 1975.
Sheep and beef cattle numbers are expected to fall further in the 2007-08 season because a large amount of capital stock has been killed over the past few months. The industry has been in the news in recent weeks because of the proposed closure of two plants by PPCS, the Dunedin-based company owned by 9000 farmer suppliers.
These are the Oringi sheep and lamb facility near Dannevirke, which employs 466 at the peak of the season, and the Burnside venison operation near Dunedin, which has 138 staff. The deer operation is being closed because of a recent sharp drop in deer numbers from 1.76 million in 2004 to 1.40 million last June.
PPCS has also indicated that it may close two more plants.
Theoretically, the closure of up to four PPCS plants should benefit the other operators, including the NZX listed Affco, but there are a number of reasons why these gains are unlikely to occur including:
* Stock numbers are falling more rapidly than meat processing capacity and this trend is likely to continue because of the ongoing liquidation of capital stock
* Procurement wars, which force meat processors to pay too much for stock, have become more frequent as livestock numbers have fallen
* Large meat works become less and less economic as throughput declines.
But the basic problem is that the meat processing industry has a flawed business model.
Meat companies are middlemen. They don't own the product, they act as agents between producers and buyers. They only receive a small margin yet often have to take large risks that are totally inconsistent with this margin. Meat processors have huge financing requirements, particularly during the height of the killing season. In its latest financial year PPCS had negative earnings before interest and tax (ebit) of $15.1 million and interest costs of $24.9 million, while Affco had ebit of $9 million and interest costs of $7.6 million.
Companies also have a huge exposure to foreign exchange and derivative markets. For example, they often sell product forward but may have to purchase stock from farmers at a higher price if their price forecasts are incorrect.
The ideal investment is a low risk business with high margins and good growth prospects. Unfortunately New Zealand meat processing is almost the complete opposite of this as stock numbers are falling, it is a high risk industry and PPCS had negative ebit in the August 2007 year, while Affco had an ebit margin of just 0.9 per cent for the September 2007 year.
Meanwhile, Sanford had a 9.9 per cent ebit margin in the September 2007 year, even though it was also adversely affected by the high New Zealand dollar. The big difference between the fishing group and the meat companies is that the former has direct access to its raw material through quotas whereas the latter have to compete with one another to purchase stock from farmers.
Affco, the only remaining listed meat processing company, was established in 1904 as Auckland Farmers' Freezing Co-operative. It took a big step forward in 1986 when it purchased the Taumarunui and Whangarei works from R&W Hellaby and in 1990 when it acquired the Feilding, Longburn, Imlay, Waingawa, Wairoa and Waitara plants from Waitaki International.
Affco listed on the NZX in May 1995 following the issue of 100 million shares to the public at 50c each. The company, which has been a woeful investment performer, is now controlled by the Talley family.
It is difficult to know where Affco is heading because its disclosure has been dreadful since the Talleys took control and its annual report and other shareholder publications offer minimal insights.
The group's most recent initiative has been the establishment of Dairy Trust of which it owns 44 per cent. Dairy Trust has purchased a 52.4 per cent shareholding in Open Country Cheese but the latest Affco annual report has little information on Dairy Trust and its future strategy.
Why did the Talleys invest in Affco, and then diversify into dairy, when the meat sector needs far more investment in marketing and downstream operations? Although neither Affco nor the other meat processing companies have investment appeal sheep and beef cattle could be on the threshold of a meaningful upturn.
This is based on a number of factors. World population has risen from 3.7 billion in 1970 to 6.7 billion at present and is estimated to reach 7.3 billion by 2015. Population growth will reduce the land available for agriculture. Incomes will rise and red meat will become more affordable, most food prices have risen in recent years but red meats have lagged behind. There has been a substantial reduction in livestock numbers, particularly in Australasia. And the New Zealand dollar is expected to ease.
The sceptics will argue that these features have been in place for a while and the price of land will continue to increase as farmers convert to dairy making. This will make it more and more uneconomic for sheep and beef.
One thing is for sure, the country's sheep and beef producers would be in a much better position if we had a meat processing industry with a more viable business model, particularly one that had made a far bigger commitment to the development of downstream marketing activities.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com
