Brian Gaynor: Finance company faces tough questions

South Canterbury Finance has had a fantastic reputation, mainly because of the high standing of controlling shareholder Allan Hubbard.

The company's disclosure was poor but that didn't matter because it was seen as a conservative and astute lender.

These perceptions have changed in recent weeks with the announcement of a $37 million pre-tax loss for the June 2009 year and a possible credit rating downgrade by Standard & Poor's.

The Timaru-based company has a strong cash position, with $332 million of cash or cash equivalents as at December 31, but it has a great deal to do to restore its dented reputation.

South Canterbury Finance (SCF), which was incorporated on February 10, 1926, was originally called South Canterbury Loan & Finance Company Ltd.

Its original shareholders were a group of South Canterbury investors, including James Todd of the wealthy Todd family, who ran a garage and vehicle assembly plant in Timaru.

In the 1950s Hubbard, a Timaru accountant, gained control of the company and it is now 100 per cent owned by Southbury Group. Hubbard controls Southbury, which has nearly 30 shareholders, while SCF's chief executive Lachie McLeod owns 10 per cent of Southbury.

The four SCF directors are Hubbard (chairman), Edward Sullivan, Robert White and Stuart Nattrass. Sullivan and White are long-time business associates of Hubbard in Timaru.

SCF has made a profit and paid a dividend every year except for 1933 and 1934.

SCF was a fairly low growth company until the 1990s and 2000s but its growth accelerated after McLeod was appointed chief executive in September 2003.

McLeod had worked for Continental Illinois Bank in London for two years, then Rural Bank and Westpac in New Zealand.

He was also a well-known rugby union referee, with seven first division NPC games and an international between Italy and Southland.

In the three years after McLeod took over, total assets increased by $627.6 million or 85.9 per cent (see table).

The mix of loans also changed, with property and agriculture advances representing 46.9 per cent of total advances in June 2006 compared with 31.5 per cent three years earlier.

Credit expansion was a major characteristic of all financial institutions in the 1990s and 2000s but SCF grew faster than most.

In terms of total assets SCF was ranked by KPMG as the country's 10th largest finance company in 1992. It had climbed to seventh in 1997 and third by 2007.

Property continued to be the driving force behind its lending growth although it is difficult to know where this lending was focused, either in terms of property type or location, because its prospectuses and annual reports contained little detailed information.

In November 2006 SCF issued a prospectus to raise $120 million through the issue of perpetual preference shares at $1 each. The full $120 million was raised but these $1 shares are now trading on the NZX at a 40 per cent yield.

The company weathered the collapse of the finance company sector extremely well and raised $250 million through two $125 million bond issues in late 2007 and early 2008.

However, the release of the company's 2008 annual report to the NZX caused some concern because it contained no director or management commentary and property-related loans appeared to surge from $97.7 million to $577.6 million.

The problem with these figures, and with many others in SCF's financial statements, is that they are not explained and prior year data is often totally different to what was first released 12 months earlier.

The interim report for the six months to December 31 last showed that net earnings had fallen from $59.2 million to $14.3 million, although the prior period had been boosted by non-recurring capital profits.

However, the big concern was the massive increase in related party loans from $64.2 million in June 2008 to $170.2 million six months later.

These December 2008 related party loans included:

* $56.9 million to Southbury Group, SCF's 100 per cent owner.

* $20.5 million to Kelt Finance, which is based in Hastings and is 75 per cent owned by SCF.

* $19.3 million to Helicopter (NZ), 80.6 per cent owned by SCF and 19.4 per cent by Southbury Group.

* $15.1 million to Dunvegan Seadown, which is 100 per cent owned by SCF's chief executive McLeod.

* $13.4 million to Dairy Holdings, 33.6 per cent owned by Southbury Group.

* $12.7 million to Plum Duff, which is controlled by Hubbard.

* $11.6 million to Commtest Instruments, controlled by Southbury Group and Hubbard.

In addition, the notes to the accounts revealed that subsequent to December 31 SCF undertook to acquire interests in various farm properties from related parties for $67.2 million.

Why is SCF buying farm properties from related parties during a recession, particularly when farm prices are falling and are difficult to sell? This strategy doesn't make sense and the company has made no attempt to explain these transactions.

Then on April 27 McLeod revealed that the company had provided a facility of up to $25 million of subordinated debt to PGG Wrightson with the right to convert all or part of the amount drawn down into ordinary shares at a strike price of $1.50 a share. These share-related deals are a concern to Standard & Poor's.

Finally, since the end of June there have been a number of important announcements in relation to SCF, as follows:

* The company is now expecting a pre-tax loss of $37 million for the June 2009 year. This implies a second half pre-tax loss of $56 million.

* Hubbard has injected $40 million of new capital into the business and he has indicated that he will underwrite any further impaired loans.

* S&P confirmed the company's BBB- credit rating but has put it on negative credit watch. SCF's announcement to the NZX failed to note that the providers of a US$100 million ($159 million) private placement can review or withdraw their funding if SCF's credit rating is downgraded.

SCF has survived the finance company meltdown but there are a number of important questions that need to be answered:

* Why has it lent so aggressively during the recession, particularly to the property sector?

Why has it not improved its reporting and disclosure standards, particularly as investors are now demanding higher standards?

* Why has there been a dramatic rise in related party loans when these advances are now considered to be inappropriate?

* Why is the company buying farms from related parties?

* Why hasn't the board been freshened up with younger and more independent directors?

The good points about SCF are that it had $322.5 million of cash and cash equivalents at the end of December, Hubbard has injected $40 million of new capital and he is prepared to underwrite any further loan losses. No other finance company has had a major shareholder with such deep pockets who was prepared to support their company.

However, he also has to address the issue that SCF's total assets have grown from $0.4 billion to $2.2 billion since June 2000 but its disclosure, corporate governance structure and related party rules are more appropriate to a small 1970s company.

These issues will also have to be addressed before full confidence in the company is restored.

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