Contact Energy's application to take over Manawa Energy is before the Commerce Commission.
Fonterra’s shares and units have performed strongly over the past 12 months, reflecting market confidence that the co-operative dairy giant is delivering on its stated strategy.
The NZX-traded units – which can be bought by investors outside the co-op – have gained 65% over the past 12 months, while the farmer-only shares have risen by 68%.
Forsyth Barr analyst Matt Montgomerie said the market’s rerating did not necessarily reflect a step-change.
He said it was more a matter of the market rewarding Fonterra for doing what it said it would do.
“I would not say that it’s been a big shift, but I’d say it’s more a reflection of the market rewarding Fonterra for what has been a fruitful three- or four-year period, including the most recent result,” he said.
Last month, Fonterra reported earnings before interest and taxes (ebit) from continuing operations of $1560 million, well above previous years, and a profit after tax of $1168 million – the equivalent to 70c per share.
Days later, it released a revised strategy that will involve the co-op sharpening its focus on its high-performing ingredients and food service businesses.
The revised strategy means some of Fonterra’s key targets have changed, compared with its prior strategy shift in September 2021.
They are: Increased return on capital to 10%–12%, up from 9%–10% (FY18–FY23 average of 8.6%), increased dividend policy to 60%–80% of normalised earnings per share, up from 40%–60%.
“They have done everything that they said they would do,” Montgomerie said.
“They have tidied up the balance sheet, disposed of non-core assets, and have improved earnings, return on capital and dividends as a result.
“Given the balance sheet position, investors are reasonably comfortable with their ability to pay relatively high dividends over the medium term as well.
“We think that Fonterra, with the increase in the payout ratio, can broadly speaking hold its dividend at around 30c a share even if the consumer business is ultimately sold and they lose the earnings contribution from that, which if that’s right would be a very good outcome.”
Competition for milk will, over time, become more of a factor as milk volumes continue their slow decline.
But Montgomerie says Fonterra’s competitive positioning in terms of the dividend and advance rate payments – relative to its competitors – is as good as it has ever been.
In terms of the sale of the consumer division, he says there is a lot of water to go under the bridge.
The process could involve multiple sales, and it is possible that not all of the “in-scope” business would sold together.
“Given the scale of the consumer business, we assume that it is most likely to be an industry buyer rather than private equity,” he said.
Fonterra’s managing director of co-operative affairs, Mike Cronin, is leading the divestment process full-time.
The Commerce Commission has received a clearance application from Contact Energy (NZSE: CEN) to buy up to 100% of the shares in Manawa Energy, and market expectations are leaning towards it going ahead as planned.
Contact and Manawa are both generators and wholesalers of electricity.
Contact generates electricity from two hydro dams in the South Island as well as from geothermal and thermal power stations across the North Island.
Manawa – formerly known as Trustpower – generates electricity from 25 hydro schemes and has one thermal power station.
Unlike the far larger Contact, Manawa does not directly sell electricity to residential customers.
“I would suggest the market is reasonably confident that it will get through ComCom,” Craigs Investment Partners portfolio manager Mohandeep Singh said.
He said water storage is a key component of how an electricity company can capture value, but most of Manawa’s assets are run-of-river hydro assets so it wouldn’t materially change CEN’s storage position.
“Obviously, the sector is in the political spotlight, particularly from NZ First, but the ComCom is an independent entity so that has no influence on its decision – all they do is assess the facts.”
Singh says there is always an element of uncertainty and there are a range of outcomes – such as the 2016 Z Energy and Caltex merger – which surprised the market when it got the go-ahead.
One company buying another in the same industry will obviously increase the level of concentration in terms of market share, Singh says.
In the case of Contact Energy, it currently holds a 21% share of the national electricity generation market.
The acquisition of Manawa Energy would lift this level to 25%, making Contact the second largest player in the generation space.
The other thing the acquisition will do is lift Contact’s share of national hydro storage from 7% to 11%, arguably providing it with a more stable and flexible earnings base to help support more “intermittent” renewable development such as wind and solar.
“It’s worth remembering that there are many industries in New Zealand which are dominated by a handful of large players, so electricity is certainly not an outlier,” Singh said.
While the market appears to be confident that the deal will proceed, independent competition lawyer Michael Wigley is not so sure.
“There is heavy concentration of market power at generation and retail level in just four gentailers, including Contact, being both generator and retailer.
“There’s only limited competition from independent retailers and from independent generators such as Manawa,” he says.
Wigley puts the sector’s current problems down to a lack of competition.
“Such market concentration across production, wholesale and retail can be a recipe for failure in a number of industry sectors.”
He pointed to the Telecom example, when the company was split into two separate companies – Spark and Chorus – in 2011.
“Electricity regulators and industry can learn and have learned much from cribbing off the telco experience.”
There are plenty of recent examples where the competition watchdog has given the green light to consolidation.
Most recently, the commission granted clearance for NZ Post to acquire PBT Group’s courier customer contracts.
Notable mergers to be declined by the commission include the proposed merger of Sky Network Television and Vodafone New Zealand; Vero Insurance’s acquisition of Tower; and the proposed merger of NZME Limited and Fairfax NZ.
This month, the commission declined to give Foodstuffs North Island and Foodstuffs South Island permission to merge into a single national grocery entity.
The competition watchdog expects to issue a statement of preliminary issues on the Contact-Manawa application this month.
The Government’s announcement of 149 projects to be included in its Fast-Track Approvals Bill – expected to pass later this year – is welcome news, Forsyth Barr says.
“This has the potential to give a much-needed injection of energy into the downbeat New Zealand economy,” a broker said in a report.
Paired with all but certain continued interest rate cuts, the contours of an economic recovery are starting to take shape, it said.
“While many of the projects would have eventually gone ahead either way, time matters.”
The biggest overall beneficiaries are likely to be the building materials companies, but we note a few specific projects that could have a meaningful impact on other listed companies.
Winton’s Sunfield project, Mercury’s wind farms, Port of Tauranga’s Sulphur Point berth extension, Kiwi Property Group’s Drury project and Precinct’s Downtown Carpark are all significant for the respective companies, Forsyth Barr said.
Jamie Gray is an Auckland-based journalist, covering the financial markets and the primary sector. He joined the Herald in 2011.
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