Brian Gaynor: Investors willing to pay for quality

There are three key questions regarding the Vector IPO: Where are the 249 million shares being allocated? Do they represent reasonable value at $2.38? Is Vector a good investment?

The three major claimants to the new shares are: Vector bondholders with 66 million shares, beneficiaries of the Auckland Energy Consumer Trust (AECT) 61 million shares and NGC shareholders 160 million shares.

As this adds up to 287 million shares, or nearly 40 million more than are available, there will be a shortage if the main claimants take up all their entitlements.

Vector bondholders can subscribe for $500 worth of Vector shares for every $1000 of bonds they hold. These shares will be issued at $2.32, a 2.5 per cent discount on the $2.38 issue price (the issue price is assumed to be $2.38 as it will be the lower of $2.38 and a final price that may be determined through an institutional bidding process).

It is reasonable to assume that there will be a high uptake from bondholders as one of the attractions of this security is the entitlement to Vector shares.

The response from AECT beneficiaries has been staggering with substantially more applying for shares than voted at the 2003 trustee elections. This is a huge vote of confidence in the AECT and indicates strong support for the partial privatisation of Vector.

It also raises the question whether there is widespread electoral support for the Auckland Regional Council's takeover of Ports of Auckland.

AECT beneficiaries have been offered the opportunity to have two bites of the cherry. The trust will maintain a 75.1 per cent controlling stake in Vector and beneficiaries will continue to receive an annual dividend that is expected to increase from its current level of $170 a customer.

Beneficiaries who participate in the IPO will also receive a 17.1c gross dividend on each newly issued share.

The most important issue regarding the Vector share allocation is the takeover offer for NGC.

Vector acquired a 67.2 per cent stake in NGC after last December's takeover bid. The offer was $3 a share less a 9c special dividend paid by NGC. Grant Samuel valued the shares between $2.50 and $2.76 and the independent directors recommended acceptance.

But the share price traded above the offer price and only AGL, which owned 66.1 per cent, and a small number of shareholders accepted the $2.91 a share cash offer.

Vector is now making another takeover offer, this time at $3.40 a share, through a combination of cash and Vector shares. Vector shares account for just over three-quarters of the consideration.

The latest offer should be successful because the independent valuation is expected to be below the offer price, the independent directors will recommend acceptance and many shareholders rejected last year's offer because they anticipated another bid that would contain a Vector share consideration.

An alternative is for Vector to use the creep provisions of the Takeovers Code. This would allow it to purchase up to 5 per cent every 12 months without making an offer to all shareholders.

Under the creep provisions, Vector would probably be able to purchase NGC shares for less than $3.40 and there would be no Vector shares on offer through this mechanism.

If Vector acquires 90 per cent of NGC and moves to compulsory acquisition there will be few, if any, shares available to the general public, sharebroker clients and institutional investors. If the NGC takeover is successful, the number of shares available to AECT beneficiaries will have to be cut back.

As the accompanying table indicates, Vector shares are not cheap on an earnings before interest, tax, depreciation and amortisation (ebitda) multiple basis (the ebitda multiple has been used because this is the most commonly used valuation method in independent adviser reports).

At $2.38, Vector is on a historic and prospective ebitda multiple of 9.4, which is slightly higher than the successful UnitedNetworks and Powerco offers and marginally below the unsuccessful December 2004 NGC bid.

The offer prices for UnitedNetworks, Powerco and NGC contained a premium for control whereas the $2.38 a share Vector IPO does not.

It is worth noting that Auckland Regional Council's $8 a share offer for Ports of Auckland is on a historic ebitda multiple of 12.4 and a prospective of 12.7. However, this valuation is complicated by the company's non-port waterfront land holdings that are not achieving a high return at present but could be extremely valuable in the longer term.

But Vector is not a short-term investment; its performance will be determined by its long-term earnings growth.

When Contact Energy was floated at $3.10 a share in 1999, it was on a historic ebitda multiple of 11.2 and a prospective multiple of 13.7 for the September 1999 year and 9.4 for the September 2000 year.

Although Contact Energy, which is a generator and retailer, operates in a more volatile end of the energy sector these multiples were more demanding than Vector's.

Contact's share price performance was disappointing at first because it failed to achieve its 2000 forecasts. However, the company's earnings performance has been outstanding since then and its ebitda is now nearly two-and-a-half times the level it was at the time of the IPO. As a result, Contact Energy has been one of the most successful NZX companies in recent years.

Vector, which is a network owner, operates in a much more stable end of the energy industry. Its earnings are anticipated to be less volatile than Contact Energy's and it is much more likely to achieve, and exceed, its prospectus projections.

The flip side to this is that Vector will find it much more difficult to achieve the same level of earnings growth as Contact.

Another positive point about Vector is that it is the largest electricity distributor in New Zealand with more than 651,000 customers and a 35 per cent market share. Powerco, now Australian owned, is No 2 with just under 300,000 customers.

But, more importantly, Vector has almost 94 per cent of its electricity customers in the high-density urban areas of Auckland and Wellington.

Electricity consumption is expected to grow dramatically in Auckland over the next decade and Vector is perfectly placed to take advantage of this.

Vector Gas has an extensive network that services the greater Auckland area and NGC is the country's main gas network operator.

The clear answer to the last question at the beginning of the column is yes, Vector is a good long-term investment.

AECT beneficiaries should take up their entitlements because there will be a shortage of shares, the company has good long-term prospects, it offers a gross yield of 7.2 per cent at the IPO price and it is a good defensive investment if the economy slows and other companies announce profit downgrades.

As far as AECT beneficiaries are concerned, this is the ideal investment to start a share portfolio for young children or grandchildren. It can be put in the back drawer to help fund their education, or first car, in the years ahead.

* Brian Gaynor is an executive director of Milford Asset Management and is an AECT beneficiary who will be taking up his entitlement.