INDEPENDENT ADVISER S REPORT OPEN COUNTRY CHEESE LIMITED

Transcription

1 INDEPENDENT ADVISER S REPORT OPEN COUNTRY CHEESE LIMITED June 2007

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3 TABLE OF CONTENTS GLOSSARY 2 1. BACKGROUND TO THE OFFER 3 2. MERITS OF THE OFFER 6 3. INDUSTRY OVERVIEW OVERVIEW OF OPEN COUNTRY CHEESE OVERVIEW OF DAIRY TRUST LIMITED VALUATION 29 APPENDIX 1: SOURCES OF INFORMATION 33 APPENDIX 2: QUALIFICATIONS & DECLARATIONS 34 APPENDIX 3: DESCRIPTION OF AUSTRALASIAN COMPARABLE COMPANIES 35 APPENDIX 4: COMPARABLE COMPANY TRADING MULTIPLES 36

4 GLOSSARY ABARE AFFCO AFFCO NZ Balle Bros CAP DCF DIFL DIRA DTL EBIT EBITDA EU Fonterra ICC Kiwi NPAT NZDF NZDG NZSX NZX OCC or the Company SPM Talleys Tatua Waipahi Westland Australian Bureau of Agricultural Resource Economics AFFCO Holdings Limited AFFCO New Zealand Limited Balle Bros Holdings Limited Common Agricultural Policy Discounted Cashflow Dairy Investment Fund Limited New Zealand Dairy Industry Restructuring Act Dairy Trust Limited Earnings Before Interest and Tax Earnings Before Interest Tax Depreciation and Amortisation European Union Fonterra Co-operative Group Limited Invercargill City Council Kiwi Co-operative Dairy Limited Net Profit After Tax New Zealand Dairy Foods NZ Dairy Group of Companies New Zealand Stock Exchange New Zealand Exchange Limited Open Country Cheese Limited South Pacific Meats Limited Talleys Fisheries Limited Tatua Co-operative Dairy Company Limited Waipahi Dairy Farms Limited Westland Co-operative Dairy Company Limited 2

5 1. BACKGROUND TO THE OFFER The Open Country Cheese Company Limited ( OCC or the Company ) produces and exports a range of commodity cheeses. The Company was founded in 2001 to take advantage of opportunities created by the enactment of the New Zealand Dairy Industry Restructuring Act, which abolished the single desk seller system and enabled companies such as OCC to export directly to world markets. OCC s cheese factory is located at Waharoa in the eastern Waikato, one of New Zealand s prime dairy farming regions. OCC is listed on the Unlisted securities market, and has a current share price of $2.60 and a current market capitalisation of $98 million. The shares have traded between $2.00 and $2.65 over the past 12 months. On 10 May 2007, Dairy Trust Limited ( DTL ) served on the Company a notice of its intention to make a full takeover offer for OCC, offering 1.68 DTL shares for each OCC share. The independent directors of OCC, being the directors of the Company not associated with DTL, have requested Ferrier Hodgson prepare this independent adviser s report in accordance with Rule 21 of the Takeovers Code. Our appointment as independent adviser has been approved by the Takeovers Panel. 1.1 DTL OFFER DTL was incorporated in March 2007 for the purpose of undertaking dairy based investments and developments. The takeover offer represents DTL s first dairy based investment. DTL is currently a wholly owned subsidiary of NZX listed AFFCO Holdings Limited ( AFFCO ). AFFCO is 50.01% owned by Talleys. DTL is a shell company with no assets, liabilities, or business activities. However DTL has entered into an agreement with AFFCO to purchase several AFFCO sites for the purpose of dairy processing development. DTL has also entered into a share subscription agreement with various parties, issuing new equity at $1.34 and raising $23.5 million of cash. DTL expects these agreements to complete before the takeover offer becomes unconditional, at which point AFFCO s holding in DTL will be diluted to 70%. Once these agreements are executed, we estimate the net tangible asset backing of DTL at $1.10 per share. DTL is offering 1.68 DTL shares for each share in OCC. There is no cash component to the offer. The offer is subject to a minimum acceptance condition of 50.1%, and a range of other conditions typical in takeover offers of this sort. 1.2 PRE-BID AGREEMENTS Three of OCC s major shareholders, Talleys Fisheries Ltd ( Talleys ), Dairy Investment Fund Ltd ( DIFL ) and Balle Bros Ltd ( Balle Bros ) have entered into pre-bid agreements with DTL to accept the offer. We refer to these parties as the Pre-bid Parties in this report. In aggregate, the Pre-bid Parties currently hold 42.53% of the shares in OCC, as shown in Table 1.1. Table 1.1: OCC Shareholders Committed to Accept DTL Offer % Holding Talleys 29.89% DIFL 9.63% Balle Bros 3.01% TOTAL 42.53% The takeover offer is conditional upon DTL receiving acceptances in respect of at least 50.1% of the OCC shares on issue. Accordingly DTL will need to receive further acceptances in relation to at least 7.57% of the remaining shares of OCC for the takeover offer to succeed. 1.3 OCC BOARD OF DIRECTORS OCC s Board of Directors comprises: Duncan Milne (Chairman) (Independent) Wyatt Creech (Independent) Bruce Clothier (Independent) Andrew Talley Geoff Taylor Mr Talley is a representative of Talleys. Talleys is the major shareholder in OCC, and is also the 50.01% owner of AFFCO. DTL is currently a wholly owned subsidiary of AFFCO. Mr Talley is also a director of DTL. Mr Taylor is a representative of DIFL. DIFL is a 9.6% shareholder in OCC, and has committed to accept the DTL offer. Accordingly Mr Talley and Mr Taylor are associated with DTL. 1.4 DISCUSSIONS WITH BIDDER As part of this process we have had discussions with Mr Talley in his capacity as a director of Talley s and a director of DTL. During those discussions Mr Talley: 3

6 Confirmed to us DTL s development plans as stated in it s prospectus: i.e. that DTL intended to build four dairy plants with the construction to commence on the first of these within the next twelve months; Confirmed that at this stage the development plans were uncertain and not firm (as stated in DTL s prospectus); Expressed his views on the three properties to be acquired from AFFCO. These are outlined at section We have also had discussions with Mr Geoff Taylor in his capacity as director of DIFL. In those discussions Mr Taylor: Confirmed that DTL had no firm development plans; Expressed his views on the properties to be acquired from AFFCO. These are discussed at 2.15; Advised that there was a significant opportunity in respect to the property to be acquired by DTL from Invercargill City Council pursuant to the nomination agreement with Talleys (see section 5.5.3); Expressed his concern with the budgeting process. On 7 June 2007, a day before this report was due to be issued, Ferrier Hodgson received a letter from DTL s lawyer advising the following: Expressed concern that budgets provided to Ferrier Hodgson by OCC were the result of a seriously flawed process, and that the budget was adopted solely by the votes of the independent directors; OCC s profitability is under severe pressure, and in the current circumstances, Talleys would be unlikely to support a capital raising by OCC to enable it to construct the planned $30 million whole milk powder plant. We understand that the construction of this plant has been planned for some time and is one of the key factors driving the significant growth forecast over the next 2 3 seasons. Mr Talley s lawyer wrote The Constitution of OCC restricts capital raising to the point where, absent unanimity among OCC directors, capital raising initiatives are unable to be pursued. OCC s lawyers advise that this is not the case and that, from a legal perspective, the challenges faced by OCC in raising further capital are not significantly different to those of any other company which has a widely held shareholding. We do not believe that any director could block a capital raising if it was in the best interests of the Company. DTL is concerned that insufficient weight may be attributed to the OCC counterfactual. DTL advised that, given OCC s profitability, Talleys, and in all likelihood DIFL s, commitment to expansion in the dairy sector may be channelled through DTL, instead of OCC; Expressed concern that Ferrier Hodgson may have valued DTL on a Net Tangible Assets ( NTA ) basis, with little regard for prospects and existing goodwill. DTL s lawyers sent Ferrier Hodgson a second letter on 7 June 2007, advising the following: Whilst the Board had authorised the release of the FY08 budget, there was no approval for, or consensus in respect of, forecasts relating to the 08/09 and 09/10 financial periods; There had been no proper process or rigour in respect of the preparation of those forecasts and that the forecasts could not be properly relied on in any valuation or merits assessment; Mr Talley was likely to raise these concerns with the Takeovers Panel. The response of the independent directors is set out in Section FINANCIAL PROJECTIONS In Section 6 of this report we detail our valuation range for OCC, which is based upon an FY08 budget and financial projections for the following seasons provided to us by OCC. These projections are set out in Section 4. OCC uses a financial model to generate its FY08 budget. The model is operated by OCC management and its key inputs include product mix and production forecasts; expected commodity prices; Fonterra payout (which is the basis upon which OCC s cost of milk is calculated); NZDUSD exchange rate; variable production costs; and overheads. The model uses the same assumptions and methodology to generate projections for the following three seasons. The Board has approved the FY08 budget, which is set out in Section 4 of this report. We note however that the budget was not approved by all directors. The same assumptions and methodology used to generate the FY08 budget, are used to generate projections for the following three seasons. The key difference between the FY08 season and subsequent years is that OCC expects to commission an Anhydro whole milk powder plant in time for the beginning for the FY09 season, which will cost $30 million and will allow OCC to produce an additional 15,000 tonnes of product per annum. Through its lawyers, DTL has informed Ferrier Hodgson that there was no Board approval for, or consensus in respect of, forecasts relating to the 08/09 and 09/10 financial years. 4

7 The independent directors refute DTL s claim that the FY08 budget provided to Ferrier Hodgson by OCC was the result of a seriously flawed process. The independent directors are of the view that the budget process involved all the normal processes and rigours that the board has established for its budgeting since the commencement of the business in Budget discussions for FY08 were commenced with a report prepared by the CEO for the April board meeting. Directors discussed the budget in great detail at that meeting. This initial budget was amended by management to address a range of issues raised at the April board meeting and was readdressed at the May board meeting. Management believed that sufficient work had been done on the budget for the board to be in a position to rely on the figures, although the basic assumptions on milk price, cheese price, whey and WPC34 powder price, other relevant powders and exchange rate should be confirmed by directors. The independent directors claim that every effort was made to come to a common position at Board level on these assumptions, but these proved to be in vain. When this point was reached the chair moved a vote on the issue, and the budget was approved 4 to 1. The operating budget for FY08 was approved on the basis of the assumptions set out in Section 4.8, all of which the independent directors believe to be conservative in the context of the current environment at the time the decision was made. Shareholders should also be aware that a large portion of the significant growth forecast to occur post FY08 is due to the assumed construction of the $30 million whole milk powder plant. Talleys have stated that they are unlikely to support the required capital raising in the current circumstances, and have pointed out that if there is not unanimous agreement among OCC directors, then OCC can be prevented from raising the capital by other means. Talleys has also stated that its commitment to expansion in the dairy sector may be channelled through DTL. 1.6 OTHER The sources of information, to which we have had access and upon which we have relied, are set out in Appendix 1 of this report. This report should be read in conjunction with the statements and declarations set out in Appendix 2 regarding our independence, qualifications, general disclaimer and indemnity and the restrictions upon the use of this report. References to $ relate to New Zealand dollars. References to years or financial years mean the financial years ended 31 May. The independent directors acknowledge however that forecasts by their very nature are uncertain, and that the assumptions on which the projections are based may well turn out to be inaccurate, or the Company may be subjected to unforeseen events, so that actual results may differ significantly from the projections set out in this report. Ferrier Hodgson s valuation of OCC is based upon the FY08 budget and subsequent financial projections. When OCC shareholders are considering our valuation and analysis of the merits of the DTL offer, they need to be aware of the disagreement at OCC board level regarding the financial projections. 5

8 2. MERITS OF THE OFFER The Takeovers Code requires the independent adviser to form an opinion as to the merits of the offer, and in doing so, to take into consideration issues wider than just valuation. In this section we discuss the fundamentals of the dairy processing industry and of OCC. We evaluate the scrip-based consideration of the offer and compare this to our valuation of OCC. We also examine various considerations for shareholders depending on the level of support the offer receives. 2.1 INDUSTRY FUNDAMENTALS OCC is well positioned to benefit significantly over the next few years from the expected strength in the dairy market. World prices for the major dairy products rose sharply late in 2006 and have remained very strong in the first half of Higher world dairy prices have been driven by constraints on growth in supplies from the major exporters at a time of rising global demand. The ongoing nature of some of these production constraints (both seasonal conditions and institutional arrangements) means that world dairy product prices are expected to remain relatively high over the next few years. In Australia, the current drought will result in sharply reduced production and exports in and as dairy farmers reduce herds in order to control expenditures. In the European Union - the world s largest producer of dairy products - milk production is estimated to be relatively flat in as a result of poor seasonal conditions in many dairying regions and the Common Agricultural Policy reforms that have reduced incentives to produce milk. In contrast to the supply situation, world demand for dairy products particularly in the key growth markets of south east Asia, the Russian Federation, the Middle East and north Africa continues to increase as a result of strong economic growth and rising average incomes in these countries. Whilst dairy processing is a major contributor to the New Zealand economy, only dairy farmers are able to invest in Fonterra and the other dairy co-operatives. OCC is the only publicly traded vehicle through which non-farmer investors can gain exposure to the New Zealand dairy processing industry. 2.2 OCC FUNDAMENTALS OCC has grown very rapidly since the completion of its dairy factory in September OCC made over 6,000 tonnes of cheese in its first season, 10,000 tonnes of cheese in the 2005/06 season and will produce approximately 21,000 tonnes of cheese and 6,500 tonnes of whey powder in the 2006/07 season. OCC comfortably exceeded its prospectus forecasts in FY06. In FY07, OCC will exceed its prospectus revenue forecast but will miss its prospectus EBITDA forecast by a significant margin. This underperformance is due primarily to (i) significant underperformance of the new whey plant; (ii) much higher than expected effluent disposal costs (largely caused by additional effluent issues arising from the underperformance of the whey plant); (iii) the relative appreciation of the milk powder price versus cheese price that occurred this season; and (iv) the Company s hedging policy did not match the very rapid escalation of the NZD exchange rate. OCC has made significant progress in addressing the reasons for the disappointing financial performance in FY2007. The problems with the whey plant have been fixed. Over the next two seasons, OCC will invest in ultra filtration technology and a whole milk powder plant. This will significantly increase OCC s total capacity to 50,000 tonnes per annum, and underpins the strong financial growth OCC expects to achieve over the next 2 3 seasons. A key risk to OCC is its ability to maintain a competitive milk payout to its farmers compared to Fonterra. The new investment in plant will enable OCC to mitigate this risk by enabling the production of a range of dairy products, not just cheese and whey powder, so that OCC can withstand any adverse variations in relative product prices amongst the various dairy products such as powders and cheese. OCC is forecasting strong growth in production and earnings over the next 2-3 seasons (see Section 4), primarily as a result of expansion at its Waharoa plant. Given the Company s experience in developing a dairy processing operation from scratch, and its position as the only listed New Zealand dairy processor, we believe OCC is well-positioned to consider further plant development in other areas over the coming years. 6

9 2.3 VALUATION OF OCC In Section 6 of this report we detail our valuation range for OCC, which is $3.10 to $3.47 per share with a midpoint of $3.29. The valuation is based upon OCC s financial projections, which are set out in Section 4. When considering our valuation of OCC, shareholders need to be cognisant of the issues set out in Section 1.5 surrounding the disagreement over the projections between the independent directors and the directors associated with DTL. DTL values its offer at $2.25 per OCC share, based on the consideration of 1.68 DTL shares issued at $1.34 for each OCC share. $1.34 is the price at which DIFL, Balle Bros and Waipahi have agreed to subscribe for shares in DTL. DTL is currently a shell company with no assets. Whilst it has a stated strategy that is similar to that of OCC, it has no track record and no financial projections in its prospectus. Consequently it is very difficult to value DTL by any means other than net tangible assets. In our view the stated issue price of $1.34 for the DTL shares is irrelevant in assessing the actual offer price. We note that OCC has grown very quickly since it commenced production in September 2004, reaching production of 28,000 tonnes per annum in less than three years. OCC effectively achieved its prospectus forecasts in FY05 and comfortably exceeded its prospectus forecasts in FY06. In FY07, OCC will exceed its prospectus revenue forecast but will miss its prospectus EBITDA forecast by a significant margin. OCC believes that it has made significant progress in addressing the reasons for the disappointing financial performance in FY2007, and the Company is forecasting significant growth in earnings in FY2008 and FY2009. Shareholders will need to consider OCC s track record when determining if they believe OCC s forecasts are achievable. The FY2008 budget has been approved by the Board. In Section 6 we apply comparable company EBITDA multiples to FY08 budget EBITDA, which results in a valuation range for OCC of $1.97 to $2.85 per share, with a midpoint of $2.41. It is not surprising that this range is less than our DCF range, because OCC is forecasting significant growth in FY2009 when the whole milk powder plant is commissioned. However, this range gives an indication of the value of OCC should the whole milk powder plant not be constructed. Again, shareholders should note Talley s comments in this regard in Section EVALUATION OF THE DTL OFFER Consideration for the offer will be paid by way of issue of 1.68 new shares in DTL for each OCC share. There is no cash element to the consideration. Effectively, OCC shareholders are being asked to exchange a direct share in OCC for an indirect share in OCC through DTL. If the offer is successful, DTL s main asset will be its shares in OCC. The value of DTL therefore depends on the number of OCC shares for which it receives acceptances. Consequently the value of DTL s offer depends upon the value of OCC and upon the number of acceptances DTL receives. We have therefore evaluated DTL s offer by reference to its NTA. By the time the takeover offer becomes unconditional, DTL will have assets including cash and property such that its net tangible asset backing will be $1.10 per share. Our valuation of DTL therefore does not reflect any option value contained in its dairy processing strategy. Table 2.1 shows the implied value of DTL s offer for different valuations of OCC and assuming acceptances of 50.1%. The table shows that as the value of an OCC share increases, so does the value of DTL s offer (because DTL s main assets will be its shares in OCC). More importantly however, Table 2.1 demonstrates that, at a 50.1% acceptance level, an investor would need to believe the value of OCC was less than $1.80 per share in order to make accepting the DTL offer more attractive than holding the OCC shares directly. At higher valuations of OCC, the DTL offer becomes less attractive. At an acceptance level of 50.1%, the DTL offer reflects a discount of approximately 28% to our base case OCC valuation of $3.29 per share. This discount is a reflection of the dilution that will occur if investors exchange shares in OCC for shares in DTL. As Table 2.2 shows, at a 50.1% acceptance level, accepting OCC shareholders go from holding 50.1% of OCC to holding only 35% of DTL. At a 100% acceptance level, accepting OCC shareholders go from holding 100% of OCC to holding only 52% of DTL. Table 2.1: Implied Value of DTL Offer, Assuming 50.1% Acceptances Valuation of OCC (1) $1.80 $2.00 $2.25 (2) $2.60 (3) $3.29 (4) Implied value of DTL offer (per OCC share) Premium / (Discount) 2% (5%) (11%) (19%) (28%) (1) Assuming 50.1% acceptances (2) $2.25 was the OCC share price immediately prior to the offer (3) $2.60 is the current OCC share price (4) $3.29 is the mid-point of our valuation range for OCC Table 2.2 illustrates the implied value of DTL s offer under various acceptance scenarios, based on our valuation of OCC at $3.29 per share. Table 2.2 demonstrates that the implied value of the DTL offer is less at lower acceptance levels. 7

10 Table 2.2: Implied Value of the DTL Offer at Different Acceptance Levels, Assuming an OCC Valuation of $3.29 per share ($000s) Acceptance Level 100% 75.1% 50.1% Net Asset Value of DTL Pre-Offer 64,546 64,546 64,546 Value of OCC Acceptance $ ,948 93,086 62,098 Value of DTL post Takeover 188, , ,644 DTL Shares on issue pre Takeover 58,571 58,571 58,571 DTL Shares issued for OCC shares 63,293 47,533 31,710 DTL Shares on issue post Takeover 121, ,105 90,281 Value per DTL share post Takeover $1.55 $1.49 $1.40 Number of Number of DTL shares issue for each OCC share Value of Offer to an accepting OCC shareholder (per OCC share) $2.60 $2.50 $2.36 Premium / (Discount) to Valuation (21%) (24%) (28%) Accepting OCC Shareholders holding in DTL 52% 45% 35% The largest shareholder outside the pre-bid parties holds 5.4% of the OCC shares on issue. As illustrated in Table 4.6, the shares in OCC are relatively widely held. Accordingly at present no single shareholder can control OCC outright and the pre-bid parties cannot control OCC in aggregate. Because the takeover offer is conditional on DTL receiving minimum acceptances representing only 50.1% of the shares of OCC, there are a number of potential shareholding outcomes that could result from the takeover offer being successful. Table 2.4 is an illustration of the resultant shareholdings in DTL of a successful takeover offer at 100% acceptances, 75% acceptances and 50.1% acceptances respectively. Table 2.4: Potential Shareholding Outcome 50.1% Acceptance 75% Acceptances 100% Acceptance DTL Shareholder Shares % Shares % Shares % AFFCO 41,000, % 41,000, % 41,000, % Talleys 18,915, % 18,915, % 18,915, % At 50.1% acceptances, the implied value of the DTL offer is $2.36 per OCC share. This value rises to $2.50 at a 75.1% acceptance level, and to $2.60 at a 100% acceptance level. The value of the offer increases with acceptances because DTL is acquiring OCC shares at a significant discount to valuation. Therefore the more OCC shares acquired, the more value that accrues to DTL, making DTL shares more valuable. DIFL 17,812, % 17,812, % 17,812, % Balle Bros 4,835, % 4,835, % 4,835, % Waipahi 2,928, % 2,928, % 2,928, % Other OCC shareholders 4,788, % 20,548, % 36,371, % TOTAL 90,281, % 106,041, % 121,864, % 2.5 MINIMUM ACCEPTANCE CONDITION The offer is conditional on, amongst other things, receipt of acceptances that will result in DTL holding or controlling 50.1% or more of the voting securities in OCC. Accordingly, depending on the level of acceptances received the offer could result in various share ownership scenarios for OCC/DTL. These are discussed in Section IMPACT ON CONTROL The current shareholding structure of OCC is summarised in Table 2.3. Table 2.3: OCC Shareholding % Holding Talleys 29.89% DIFL 9.64% Balle Bros 3.01% Total held by pre-bid parties 42.54% Total Held by other OCC shareholders 57.46% % DTL Secures 50.1% Acceptances If DTL secures 50.1% of the voting securities in OCC, it will be able to pass ordinary resolutions and control the Board of OCC and its strategic direction. Under this scenario, Talleys would directly hold 21% of DTL. Given that Talleys owns 50.01% of the voting securities of AFFCO, Talleys controls AFFCO s voting securities in DTL. Talleys would therefore hold or control 66.4% of DTL. This would give Talleys effective control of DTL. To achieve the minimum acceptance condition of 50.1%, shareholders not associated with DTL representing 7.57% of the OCC voting securities would need to accept the offer. Accordingly, if shareholders not associated with DTL representing only 7.57% of the OCC shares on issue accept the offer, control of OCC will effectively be handed to Talleys DTL Secures 75% Acceptances If DTL secures 75% of the voting securities in OCC, it could pass special resolutions including major transactions representing acquisitions or disposals exceeding 50% of the Company s assets. Under this scenario, Talleys would control 56.50% of DTL, and would therefore effectively control all ordinary and special resolutions of OCC. 8

11 2.6.3 DTL Secures 100% Acceptances If DTL receives acceptance in respect of 90% of OCC shares, it can move to compulsory acquisition of OCC shares. If DTL achieves 100% ownership of OCC, Talleys would hold or control 49.1% of the DTL shares on issue. In aggregate, Talleys, DIFL, Balle Bros and Waipahi would hold or control 70.2% of the DTL shares on issue. Under this scenario, Talleys would not achieve outright control of DTL. Together with the Pre-bid Parties, Talleys would control over 70% of DTL, and would most be likely be able to control major transactions as defined in the Companies Act. Under this scenario the shareholders of OCC not associated with DTL would hold or control 29.9% of DTL, as compared to 57.5% of OCC at present Creep Provisions If DTL owned between 50% and 90% of OCC shares post offer, it would have the opportunity to increase its shareholding by 5% per year under the Takeovers Code s creep provisions 1. This can be effected without making a full offer to shareholders. The first time that DTL would be able to utilise these provisions would be 12 months from the date that it holds or controls more than 50% of OCC s voting securities. 2.7 LIKELIHOOD OF THE OFFER SUCCEEDING DTL has entered into pre-bid agreements with Talleys, DFIL and Balle Bros representing 42.53% of the OCC voting securities on issue. Accordingly DTL requires further acceptances representing only 7.57% to meet the minimum acceptance condition of 50.1%. The largest shareholder other than the Pre-bid Parties is Robec Ltd at 5.4%. Robec is owned by the Independent Chairman of OCC. After Robec, the next two largest shareholders hold 3.9% and 3.8% respectively. A combination of any two of these shareholders accepting the offer would result in the minimum acceptances condition being satisfied. 2.8 LIKELIHOOD OF DTL INCREASING ITS OFFER PRICE AND/OR OFFERING CASH CONSIDERATION DTL advises that it has made a scrip offer because it views the transaction as an amalgamation or merger rather than a takeover. Accordingly it is unlikely to revise its offer to include a cash component to the consideration. 2.9 IMPACT ON SHARE PRICE IF THE OFFER IS UNSUCCESSFUL If the offer is unsuccessful, OCC shares will continue to trade on the Unlisted exchange. Table 4.7 shows that in the three months prior to the announcement of the takeover offer, OCC shares traded between $2.00 and $2.30. Prior to the takeover offer there were no projections released to the market other than those presented in the prospectus dated June The current projections represent a material uplift in profitability as compared to the prospectus projections, and this is reflected in our valuation of OCC, which is significantly higher than the pre-takeover retail share price. This may impact on the post-offer share price IMPACT ON SHARE PRICE IF THE OFFER IS SUCCESSFUL If the offer is successful and DTL does not receive acceptances representing 100% of the voting securities of OCC, DTL advises that OCC shares will continue to be quoted on Unlisted. Under this scenario the share price could settle at a level higher than the pre-takeover price because of the new projections disclosed to the market. However the share price would also be impacted by: liquidity the shares (free float) available to be freely traded would reduce market perception towards DTL and Talleys influence on OCC and future prospects of OCC LIQUIDITY OF DTL SHARES DTL shares cannot currently be traded on any exchange. However the existing shareholders of DTL have agreed that they will use best commercial endeavours to obtain a listing on NZSX or NZAX within 12 months of the subscription agreement becoming unconditional. DTL advises that in the meantime, its shares will be quoted on Unlisted to provide shareholders with a market to trade their shares DTL S INTENTIONS FOR OCC DTL states in its takeover notice that it does not intend to make any material changes to the OCC business, except that regardless of whether the offer is successful, DTL intends to explore with OCC whether there are opportunities for the two companies to work together to identify and implement joint initiatives in the dairy industry. Such initiatives may include the joint ownership and/or management of dairy operations. 1 Provision 7(e) of the Takeovers Code

12 DTL also states in its takeover notice that it may seek to take advantage of possible synergies with OCC through the integration and coordination of certain functions such as operations, sales and procurement. The extent of integration will be influenced by the level of acceptances that DTL receives under the offer. We note however that DTL has yet to commence operations, has no firm plans for the properties it intends to acquire from AFFCO, but intends to commence construction of a new dairy plant within 12 months PROSPECTS FOR DTL IF THE OFFER IS SUCCESSFUL DTL was established for the purpose of undertaking a number of dairy based initiatives. Its stated strategy is twofold: 1. DTL will look for opportunities for direct investment in established companies operating in the New Zealand dairy sector. The takeover offer for OCC commences that strategy. 2. In parallel with its first strategy, DTL will develop, own and manage a small number of dairy plants in New Zealand. For that purpose DTL intends to acquire the three sites from AFFCO and one site from Invercargill City Council ( ICC ) for the purposes of constructing and operating dairy processing facilities. DTL intends to develop these four dairy plants over the next several years. However, other than an intention to commence construction of one plant within the next 12 months, DTL has no firm development plans. Post a successful takeover, accepting OCC shareholders will be presented with new opportunities and risks associated with DTL. These are likely to include: (1) An accelerated growth path associated with DTL s development strategy, which involves rapid construction of four dairy plants on four separate sites. (2) Increased risk profile associated with the construction and startup nature of DTL s development strategy. (3) A potential IPO and NZX market listing within 12 months. (4) If DTL is successful in developing several dairy plants, DTL shareholders will benefit from economies of scale in milk procurement, production costs, and market presence which OCC on its own may not be able to deliver. (5) Continued exposure to OCC, albeit at a diluted level. These benefits will take some time to materialise while DTL develops its dairy plants and those plants become operational. In the meantime, accepting OCC shareholders will share in the development risks of what is effectively a start-up operation AFFCO PROPERTIES TO BE ACQUIRED BY DTL DTL has acquired three AFFCO sites for $26.0 million, with consideration to be paid by the issue of 26 million new shares in DTL at $1.00 per share. Quotable Value Limited ( QV ) have assessed the fair value of the land and buildings to be acquired at $18 million (see Table 6.3). DTL has also acquired an ownership interest in certain water and effluent discharge resource consents, and the usage rights (but not ownership) for the effluent/water treatment systems. Given that the land and buildings have been valued at $18 million by QV, the purchase price of $26 million implies a value of approximately $8 million in respect of the resource consents, and the usage rights for the effluent/water systems. OCC management advise that they consider that the AFFCO properties offer suboptimal development opportunities, and OCC believes better opportunities lie in the Central North Island. DIFL also concedes that the three AFFCO properties represent suboptimal dairy plant development opportunities for OCC. Talleys advises that it believes that the Wanganui property may not be ideal, but it is adequate for a 300 million litre milk capacity plant. Talleys believes that with their associated water discharge and resource consents, the other two sites are ideal for dairy plant developments PROSPECTS FOR OCC IF THE TAKEOVER OFFER DOES NOT SUCCEED If the offer does not succeed, OCC is likely to continue along the current path laid out by the Board. OCC is considering an equity issue in the next few months to help fund the whole milk powder plant construction. OCC is forecasting strong growth in production and earnings over the next 2-3 seasons (see Section 4), primarily as a result of expansion at its Waharoa plant. Given the Company s experience in developing a dairy processing operation from scratch, and its position as the only listed New Zealand dairy processor, we believe OCC is well-positioned to consider further plant development in other areas over the coming years. From our discussions with Talleys, in the event of the offer not proceeding, we understand Talleys are likely to remain as a shareholder and OCC will continue to have access to Talleys expertise on its Board. However in respect of new site development opportunities, Talleys is likely to focus on these via DTL and this could create conflict if these opportunities are also considered to be attractive to OCC. 10

13 Talleys have advised that, in the current circumstances, it would be unlikely to support a capital raising by OCC to enable it to construct the planned $30 million whole milk powder plant. We do not however believe that Talleys would be able to prevent a capital raising, if it was in the best interests of the Company. DTL has stated that regardless of whether this offer is successful, it intends to explore with OCC whether there are opportunities for the two companies to work together to identify and implement joint initiatives in the dairy industry PROSPECTS OF DTL MAKING ANOTHER OFFER IN THE FUTURE One of DTL s stated strategies is to invest directly in established New Zealand dairy sector companies. Given this and the commonality of shareholdings in the two companies, if the current takeover offer is not successful, we believe there must be a real prospect that OCC will remain a takeover target for DTL LIKELIHOOD OF AN ALTERNATIVE OFFER World dairy prices are expected to remain relatively high over the next few years driven by production constraints and increased consumption. The New Zealand dairy industry is likely to be an attractive investment for potential investors. Accordingly a takeover offer for OCC from another investor in the future is a reasonable prospect. Any investor making a full takeover offer would need to get agreement from Talleys to sell into the offer. However an investor could gain more than 50% of the voting securities and therefore control all ordinary resolutions without Talleys support for the offer CONCLUSION OCC has experienced significant growth since commencing production in 2004 and has delivered on its prospectus forecast other than in 2007 when the poor performance of the whey plant and spike in milk powder prices relative to cheese has had a material impact on profitability. We have assessed the value of OCC by applying a discounted cashflow methodology to OCC s financial projections. Shareholders need to be cognisant of the issues set out in Section 1.5 surrounding the disagreement over these projections between the independent directors and the directors associated with DTL. We have assessed the value of DTL by reference to its net tangible assets backing, because it is a startup operation with no earnings history and no financial projections. DTL s offer represents a discount of between 21% - 28% to our base case valuation of $3.29 per share, depending on the ultimate level of acceptances. DTL s offer represents a discount of approximately 10% to the OCC share price immediately prior to the takeover of $2.25 per share. This discount is a reflection of the dilution that will occur if investors exchange shares in OCC for shares in DTL. OCC shareholders may be attracted to the potential accelerated growth path that DTL s development objectives represent. However we note that there is significant start-up risk associated with DTL s objectives and that its plans are still preliminary. We also note that OCC management do not consider all the properties to be acquired by DTL as optimal for dairy plant development. We also note that, given the Company s experience in developing a dairy processing operation from scratch, and its position as the only publicly traded New Zealand dairy processor, we believe OCC is wellpositioned to consider an expansion of its own in coming years. OCC shareholders are being asked to exchange a direct interest in OCC for an indirect interest in OCC via DTL, and to relinquish effective control of the Company to Talleys. Moreover we believe that the DTL offer is at a significant discount to both our valuation of OCC and to the current share price. We therefore see no compelling merit in OCC shareholders accepting this offer unless they believe that DTL will deliver significantly larger growth than OCC can achieve on its own. OCC is well positioned to benefit significantly over the next few years from the expected continued strength in the dairy market. OCC believes that it has now addressed the reasons for its disappointing financial performance in FY2007, and is forecasting significant earnings growth in FY08 and in FY09. 11

14 3. INDUSTRY OVERVIEW OCC produces bulk cheese and is moving into the production of milk powders. These products are commodities and OCC exports almost 100% of its production. World demand for the various dairy products has diverged over the past few years, with demand increasing for cheese relative to other products such as butter and skim milk powder. Increases in cheese production in response to growing demand have come at the expense of other dairy products particularly milk powder production. Strong growth in global demand for cheese largely reflects rising consumer incomes, leading to increasing per person cheese consumption, particularly in the major developing countries of Asia and eastern Europe. In response to continuing strong growth in global demand for cheese, world cheese prices are expected to be higher over the next two years. Over the medium term, significant increases in world cheese production are projected in response to continuing strong demand growth. After 2009, growing cheese production and exports from major producers is projected to lead to an easing in cheese prices. The Australian Bureau of Agricultural Resource Economics ( ABARE ) projections for the world cheese price are shown in Figure GLOBAL DAIRY OUTLOOK 2 World prices for the major dairy products rose sharply late in 2006 and have remained relatively high in the first half of Higher world dairy prices have been driven by constraints on growth in supplies from the three major exporters the European Union, New Zealand and Australia at a time of rising global demand. The ongoing nature of some of these production constraints (both seasonal conditions and institutional arrangements) means that world dairy product prices are expected to remain relatively high over the next few years. In Australia, the current drought will result in sharply reduced production and exports in and as dairy farmers reduce herds in order to control expenditures particularly the higher feed costs associated with reduced irrigation water allocations. Poor seasonal conditions were also evident in New Zealand, with limited growth in production expected for the year. 2 ABARE, Commodities Outlook, March Quarter 2007 Figure 3.1: World Dairy Price Projections Price (Nominal US$/t) 3,300 Butter Skim Milk Powder Cheese 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 1, / / /07F 2007/08P 2008/09P 2009/10P 2010/11P 2011/12P Source: ABARE, March 2007 In the European Union - the world s largest producer of dairy products - milk production is estimated to be relatively flat in (despite increased milk quotas) as a result of poor seasonal conditions (heat and drought) in many dairying regions. Also contributing to lower growth in EU milk production has been the impact of Common Agricultural Policy ( CAP ) reforms that have reduced incentives to produce milk. However, increased dairy supplies are expected from some emerging exporters such as Argentina and the Ukraine, while China s dairy production (which is mostly used in domestic consumption) continues to rise strongly. In contrast to the supply situation, world demand for dairy products particularly in the key growth markets of south east Asia, the Russian Federation, the Middle East and north Africa continues to increase as a result of strong economic growth and rising average incomes in these countries Dairy Prices Decline After 2008/09 With world dairy supplies expected to remain constrained in the short term, prices for most dairy products are forecast to average higher over the two years to Over the five years to , demand for dairy products is expected to remain strong, with firm economic growth projected for all major importers of dairy products. However, from , growth in production in major exporting countries is forecast to exceed growth in world import demand putting downward pressure on prices. Also, further expansion of dairy industries in developing countries, such as China and India, may lead to domestic production accounting for an increasing proportion of their domestic consumption. The latter development can be expected to reduce import demand in those countries and contribute to increased world supplies. 12

15 3.1.2 World Milk Production Rising In 2006, world cow milk production rose by around 2 per cent to 425 million tonnes. This rise was mainly driven by increased production in China (up 19 per cent on 2005), Argentina (up 8 per cent), and Brazil and India (both up 3 per cent). Among the major dairy exporters, New Zealand production was up almost 5 per cent, while production fell by around 1 per cent in the European Union and in Australia. In 2007 and 2008, world dairy production is forecast to grow albeit at a slow rate with expanding production in emerging dairy producers such as China, India and Argentina expected to contribute most of the forecast increase. In the major exporting countries Australia, New Zealand and the European Union slow growth in production is expected as a result of recovery from poor seasonal conditions and irrigation water supply constraints in Australia, as well as changes to production incentives under the European Union s Common Agricultural Policy. From 2009 through to 2012, moderate increases in world milk production are expected as a result of the continued expansion of the dairy industries in China, India and Argentina. In these countries, new investment in dairy production has been spurred by rising average incomes, increasing domestic demand and higher world prices. Growth in dairy production in the major established producers, however, is expected to be relatively slow. In the United States, for example, growth in production is expected to be hindered by increased competition for grains (particularly for use in producing biofuels) and consequent higher feed costs. In Australia and New Zealand, with average seasonal conditions assumed to return from , dairy production is forecast to grow moderately as cow numbers begin to recover World Consumption Of Dairy Products Continues To Rise World consumption of milk and processed dairy products has continued to rise steadily in recent years, driven by higher incomes and changing consumption patterns, particularly in major developing countries in Asia. For example, between 2000 and 2006, total annual world fluid milk consumption rose by more than 13 per cent from 150 to 170 million tonnes. In 2006, fluid milk consumption in the major emerging economies China and India is estimated to have increased 18 per cent and 6 per cent respectively. Milk and dairy product consumption per person in these countries remains relatively low compared with that in more developed countries, and there remains considerable potential for further rises in consumption over time. Of the major dairy products, total world consumption of butter increased by 10.5 per cent in the five years to 2006, cheese by 9.5 per cent and whole milk powder by 8.5 per cent. Consumption of skim milk powder, however, was down by 9 per cent over the period. Increases in world consumption of dairy products were driven largely by increased consumption in China, India, the Russian Federation and the Ukraine. Continued strong economic growth and rising incomes in these countries particularly in China and India together with the adoption of more western style diets are expected to promote moderate growth in import demand for milk and dairy products over the medium term World Stocks of Dairy Products Low And Falling As a result of strong world demand for dairy products, set against constrained growth in supply, stocks of the main dairy products fell to relatively low levels in Stocks of dairy products remain highest in the European Union as a result of CAP production incentives. In December 2006, EU butter stocks were around tonnes; however, stocks of cheese, whole milk powder and skim milk powder had been effectively eliminated. Over the short term, further falls in stocks of dairy products are expected as the recent CAP reforms have greater effect, world demand remains strong and growth in global production slows Growth in World Exports of Dairy Products Expected To Slow Growth in world exports of dairy products is expected to slow in and as a result of production constraints in the major exporting countries, the European Union, Australia and New Zealand. Reflecting a trend that has been apparent over the past few years, the mix of dairy product exports is expected to continue to change as producers seek to maximise earnings. Over the medium term, however, moderate growth in world dairy product exports is expected in response to production growth in the European Union, Australia and New Zealand. However, with low stocks in the United States and the European Union, the growth in global dairy exports over the next few years may be fairly limited. An additional factor in the market is that, with increasing dairy production in China, Mexico and Brazil, these countries may be able to supply an increasing proportion of their dairy consumption needs from internal sources, thus potentially reducing their import demand CAP Reform Expected To Limit Growth In EU Milk Output The European Union is the world s largest dairy producer, and one of the top exporters of dairy products. Over the five years to 2006, EU dairy product exports accounted for around 42 per cent of total world cheese exports, 36 per cent of world butter exports, 22 per cent of world skim milk powder exports and 32 per cent of world whole milk powder exports. With EU dairy exports accounting for such large proportions of world trade in dairy products, changes in EU dairy output can have a large effect on trade flows and world prices. 13