Richard Inder: Replenished war chest tempting for Fletchers

Investors are betting on Fletcher Building issuing shares to pay for its latest takeover target, the Australian building products group Amatek.

It is likely, but it is far from a sure thing. The argument for a cash call goes something like this:

The acquisition of Amatek, at the rumoured price tag of around $550 million, will lift Fletcher Building's net debt to more than $1.3 billion by June. It will also lift its gearing to around 52 per cent.

The group's balance sheet reached such a state when it acquired wallboard manufacturer Laminex in 2002 and insulation group Tasman Building Products last year. Both moves were accompanied by cash calls.

The time is also clearly right. Fletcher Building's shares, which languished at around $2 in 2001, are now riding at an all-time high of $6.60. This is as much to do with confidence in the group's management team led by chief executive Ralph Waters as it is with the belief they will over-deliver on their promise to lift annual operating profits from last year's $475 million to at least $500 million.

Waters and his divisional chiefs (and potential successors) Mark Binns, Andrew Reding, David Worley and Jonathan Ling are ambitious. They are likely to leap at the chance to replenish the firm's war chest to follow on the successful acquisitions with more deals.

It is not clear that Fletcher Building wants to hold all of the Amatek assets over the long term.

The jewel in the crown is the Insulation Solutions business - a maker of fibreglass and foil insulation, for residential and commercial markets as well as for export. It would leave Fletcher Building with one major Australasian competitor in this segment of the market - the building materials giant CSR.

But the logic for keeping Amatek's Rocla and Stramit divisions, without getting into details, is less than clear. Rocla makes concrete pipes, railroad ties and concrete materials and Stramit makes steel building products.

If Fletcher Building wants to quit these, the need for a capital raising is less compelling.

It could arrange a back-to-back deal to sell Stramit and/or Rocla as it makes the takeover, potentially avoiding the need for extra cash.

Alternatively, it may decide to weather the strain on its balance sheet as it waits to find a buyer.

Still, weighing up the two arguments, the ambitions of the executives and the willingness of investors to back them tip the balance in favour of a cash call.

Furthermore, if no back-to-back deal to sell Rocla or Stramit has been arranged, equity funding of the buy gives Waters more latitude to get the price he wants.

The deal is far from in the bag, and the Australian Competition and Consumer Commission will look closely at the tie-up.

However, if Waters prevails in his plan to buy the whole of Amatek, expect plenty of rhetoric about the need for "balance sheet flexibility". And in the absence of his enunciating why concrete pipes are a strategic asset, investors should expect more buys.

Fonterra dilemma

Dairy farmers are biting their nails over the likelihood Fonterra will lift its bid for Australia's National Foods beyond its current offer of A$5.45 ($5.86) a share.

Even at the current offer price the initial returns are not spectacular. Back-of-the-envelope sums that take into account savings from merging National Foods with Fonterra give an after- tax return on investment of around 2.5 per cent in 2005 and 2.9 per cent in 2006.

Now Fonterra is mulling a higher offer to trump the A$6 from its rival for National Foods, the Philippines brewer San Miguel.

As the bid increases the returns steadily decline. At $6.10, just short of the A$6.11 to A$6.65 National Foods values itself, the returns fall to 1.8 per cent in 2005 and 2.3 per cent in 2006. At A$6.50 the returns to farmers fall away to 1.5 per cent in 2005 and 1.9 per cent in 2006.

Such calculations do not take into account the long-term gains that come from Fonterra dominating the Australasian dairy industry, or the benefits such a foundation provides for further expansion.

Fonterra must make this move into Australia if it is to achieve its ambitions. Its next opportunity will not come until next year at the earliest, when Australia's Dairy Farmers may float.

How much is too much? Lifting Fonterra's bid from A$5.45 to A$6.20 boosts the cost to Fonterra's average farmer shareholder from $136,597 to $152,615. The difference of A$16,000 seems to be in the noise.