Brian Gaynor: Balance sheets show real performance

The reporting season is in full swing with the media focusing on profit figures, dividend increases and capital repayments.

These are important considerations but comments on balance sheets, which often give a more insightful view of a company's position, are extremely rare.

Balance sheets are important and this week's column takes a look at the Air New Zealand, Sky City Entertainment, Sky Network Television and Auckland International Airport results from this angle, rather than the more traditional earnings perspective.

As the accompanying graph shows, Air New Zealand's balance sheet has been all over the place since 1996. Its equity ratio (total shareholders' funds plus minority interests to total assets) fell from 49.9 per cent in 1997 to 17.7 per cent at the end of its June 2000 year.

This was due to the debt-funded acquisition of Ansett Australia.

Borrowings peaked at $3.9 billion in June 2001 when the equity ratio had dropped to 6.4 per cent and the firm was bailed out by the Government.

Air NZ's recovery under chief executive Ralph Norris has been remarkable. This is reflected in its December 31, 2004, balance sheet.

The company's equity ratio has risen to 36.8 per cent; it has less than $0.7 billion of borrowings but nearly $1.1 billion of cash and short-term deposits.

Norris, a former banker, looks particularly happy when his improved balance sheet is mentioned. In the past 12 months, Air NZ has received net interest of $14 million whereas in 2001 it paid net interest of $227 million.

But, more importantly, the healthy balance sheet places it in a strong position to buy new aircraft.

In the next two years, Air NZ will receive 31 new planes and dispose of 25. This will reduce its average fleet age from 7.9 years as at December 2004 to 5.8 years in June 2007.

A new and modern fleet will be attractive to customers and will reduce the cost per passenger. The new 50-seat Q300 aircraft, which will run on domestic regional routes, take 60 per cent more passengers than the aircraft they replace but will cost only 9 per cent more a flight to run.

Although Air NZ is now in a much stronger financial position, investors should not get too excited. The company operates in an extremely volatile industry and it needs to have a strong balance sheet.

Whereas many other companies have dividend payouts of 80 to 90 per cent, Air NZ will have to adopt a much more modest approach.

Sky City Entertainment's balance sheet is heading in the opposite direction to Air NZ's.

Since 1996, the casino operator's equity ratio has fallen from 37.4 per cent to 13.2 per cent and its borrowings have escalated from $269 million to $1.11 billion.

This has raised its interest bill to $63.7 million for the 12 months ended December 2004.

The weaker balance sheet is due to a number of factors including a high dividend payout ratio, debt-funded purchases and the poor return on these acquisitions, particularly Adelaide.

In the past 18 months, Sky City's equity has fallen from $246.6 million to $187.7 million even though it has reported net earnings of $157.3 million for the same period. This is due to three major items: dividends paid ($164.5 million), a share buyback ($34.1 million) and the negative impact from the translation of its Australian assets to New Zealand dollars ($30.1 million).

The last item is non-cash but the disappointing performance of the Adelaide casino does give cause for concern. It had operating earnings of only A$11.9 million for the six months to December 31 compared with A$14 million for the six months to June 30, 2004.

More importantly, the South Australian casino, which is Sky City's second biggest operation, had an operating margin of only 21.2 per cent compared with 50.4 per cent for Sky City, Auckland.

But the latter, which still accounts for in excess of two-thirds of group earnings, has hit a flat spot. Earnings have been virtually static over the past 30 months and Auckland's operating margin has fallen from 53 per cent for the six months to December 2003 to 50.4 per cent in the latest six-month period.

This is due to a number of factors including lower Asian migration, legislation to discourage excessive gambling and disruptions caused by the renovation of its premium player facilities (the smoking ban came into force only 23 days before the end of the December 2004 half).

Sky City's falling equity ratio and rising debt levels are not a cause for concern because the company operates in a stable and less competitive industry where low equity ratios and large borrowings are acceptable.

But the disappointing performance of its two major operations, the Auckland and Adelaide casinos, is a worry. Unless Evan Davies and his management team can generate higher earnings at these two casinos, the group may not be able to maintain its dividend growth policy.

Sky Network Television's balance sheet is more like Air NZ than Sky City. In its formative years, Sky TV operated at a loss and had a high level of capital expenditure. During the early 1990s, it had little or no shareholders' funds and large borrowings.

The group's debt peaked at $332 million at the end of its June 2002 year but has more than halved since then. This is due to the group's strong performance in terms of subscriber growth, advertising revenue and cashflow generation.

In the past 18 months, Sky TV has generated surplus cash of $274.6 million from its operating activities.

As it didn't pay a dividend during this period, the surplus funds were mainly used to repay debt ($153.1 million) and on capital expenditure ($86.8 million).

The pay-to-view operator announced a maiden 12.5c dividend for the six months to December 2004. This will cost $48.6 million, almost exactly the same as its reported net earnings of $48.7 million.

Chief executive John Fellet was at pains to explain that the 12.5c dividend was not an indication of future dividend policy. The company is planning to merge with Independent Newspapers and the board of the new merged company would determine the long-term payout policy.

But with its strong operating performance, balance sheet and cash flow Sky Television has the ability to have a high dividend payout.

Finally, Auckland International Airport has the most stable and conventional balance sheet of the four companies. Its equity ratio has fallen and debt has risen in recent years because of an active capital management programme. This involves a high dividend payout ratio and capital returns.

Thursday's announcement that the company was raising its dividend payout to 90 per cent and would be making a further $100 million to $300 million repayment is consistent with recent decisions.

A lower equity ratio and increased debt is not a concern for Auckland International Airport as it operates in a relatively stable and non-competitive environment.

Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.