Ricegrowers (RGWB.NSX)

Transcription

1 27 July 2012 Analyst Lou Capparelli Authorisation Damien Williamson Initiation Company Data & Ratios Share Price $2.90 Issued Capital 55.8m Market cap $161.7m Enterprise value $335.9m Valuation $3.90 Avg. daily vol. (52wk) 3, month price range $1.85-$3.00 Dividend yield 6.2% Table of Contents 1. Company Overview p.3 2. Key Factors about SunRice p.8 3. SWOT Analysis p The Governance Dilemma p Paddy Price Analysis p Review of Financial Statements for FY05-FY12 p Valuation Considerations p.26 (RGWB.NSX) Share Price Chart Ricegrowers (RGWB.NSX) An ASX Listing May Let The Sun Shine on SunRice We initiate coverage on Ricegrowers Limited (trading as SunRice), Australia s primary rice processor. Given its history as a grower co-operative, SunRice is not shareholder friendly in a governance and corporate structure sense, despite being listed on the NSX. Under its monopoly export licence, it has a statutory obligation to deliver the best possible returns to rice growers. However, this obligation conflicts with its duty to shareholders, including to maximise profits, which creates a Governance Dilemma. It also has a convoluted share capital structure, with voting interests and economic interests held by two separate classes of shares, with restrictions on ownership and transfer. We see substantial latent value in SunRice, with an EV/EBITDA valuation range of $3.60 to $4.20. At the midpoint valuation of $3.90, this represents around 35% upside to the current $2.90 share price. This valuation is before applying any control premium in the context of a takeover scenario. In addition, we see further upside (to $4.85) if better selling prices can be achieved. In our view, this large valuation gap will persist while current governance and shareholding arrangements remain in place. We see the process of unlocking value in SunRice shares as a three step process involving: 1.Replacing SunRice s statutory obligation to growers with a clearly defined commercial one: A greater level of transparency in relation to the paddy price determination process and outcomes would provide both growers and shareholders a better understanding of how paddy rice proceeds are divided between these key stakeholders. This would resolve the Governance Dilemma and still require SunRice to support growers to ensure their continuing participation in rice growing. SunRice s obligation to growers and duty to shareholders would then become a commercial matter, no different from the normal challenges any company has in balancing the needs of suppliers and shareholders. In due course, new entrants may emerge to compete with SunRice to buy rice from growers for export, giving growers freedom to deal with any party (including SunRice) to achieve the best outcome for them. Given its incumbency and position established over the last 80 years, any new entrant would start a long way behind SunRice; 2.Simplify the shareholding structure: The separation of SunRice equity into two classes of shares separating voting and economic interests is a relic of its co-operative past and not an appropriate structure for a corporation in the 21st century. In addition, the restrictions on SunRice share ownership and transfer mean that liquidity in the shares is depressed. Even in the absence of these restrictions, the Governance Dilemma makes the shares unattractive as potential investors would have no transparency around how the SunRice Board can act in their interests given its obligations to growers; and Index: See overleaf 3.ASX Listing: If the above two steps are completed, an ASX listing would benefit the Company as it would broaden the potential investor base, provide better access to capital, likely improve the liquidity in the shares and create a more transparent market. Comparison with other listed food and agricultural companies would be easier and assist in certainly highlighting, and potentially narrowing, the valuation discount. Two reviews currently underway (NSW Government review into the continuation of the monopoly export licence and a Company review into governance and capital structure) are likely to be concluded in CY12. We believe these will be significant catalysts to determine the future direction of SunRice. Favourable outcomes of these reviews (as outlined above) could hasten the process of unlocking value in SunRice. BELL POTTER SECURITIES LIMITED ACN AFSL DISCLAIMER AND DISCLOSURES THIS REPORT MUST BE READ WITH THE DISCLAIMER AND DISCLOSURES ON PAGE 32 THAT FORM PART OF IT. Page 1

2 Index 1. Company Overview Who is SunRice Corporate history Australian Rice business Regulatory framework for Australian rice growing industry Reviews into the Australian rice growing industry SunRice global rice businesses Other SunRice activities 7 2. Key Facts about SunRice Crop year versus financial year Payment terms for NSW growers Statutory obligation to growers Share capital structure of SunRice Board and senior management Board of SunRice Senior Management of SunRice SWOT Analysis Strengths Weaknesses Opportunities Threats The Governance Dilemma Obligations to rice growers conflicts with duty to shareholders Practical considerations around Governance Dilemma How can the Governance Dilemma be resolved? Review into Rice Marketing Act to consider SunRice export monopoly Paddy Price Analysis What does "best possible returns" for growers mean? SunRice paddy price performance 1994 to SunRice paddy price performance: 2010 to date Why has the SunRice paddy price underperformed the California price? Conclusions on paddy price analysis Review of financial statements for FY05 FY Return on capital Circularity of profit versus paddy payments Balance sheet and gearing FY 12 Australian Rice Milling and Marketing result Valuation Considerations EV/EBITDA valuation Upside valuation scenario Closing the valuation gap 28 Page 2

3 1. Company Overview 1.1 Who is SunRice? Ricegrowers Limited, trading as SunRice, is the world s fourth largest rice food company and one of Australia s largest exporters of processed branded food products, exporting around 80% of Australia s total annual rice production to over 60 countries. Headquartered in Leeton, New South Wales, SunRice operates processing facilities that mill and pack rice and rice flour, and manufacture rice cakes and specialty rice foods. SunRice s operations extend to the USA, the Middle East, PNG and the Solomon Islands. Figure 1: Corporate History YEAR EVENT 1.2 Corporate history The Company commenced business in 1950 as a grower co-operative called Ricegrowers Co-operative Mills Limited. Following approval by members in 2005, it registered as a corporation under the Corporations Act and subsequently listed on the NSX on 18 June s Ricegrowers Co-operative Mills Limited was registered on 24 July 1950 as a co-operative and commenced a rice milling and 1970s 1980s 2000s marketing business in 1951 The Co-operative invested in a storage and marketing business in Papua New Guinea in 1970 A significant restructure of the industry, following a study by McKinsey & Co. in 1985, resulted in the Co-operative assuming all marketing and operating activities of the industry. RMB assumed a statutory role and continued investment in and ownership of the receival facilities The name of the Co-operative changed to Ricegrowers Co-operative Limited on 13 December 1985 A record high of 1.7 million tonnes of paddy crop was harvested in the Riverina in 2001 The Riverina was drought affected from the 2002/03 growing season to the 2009/10 growing season with production below 550,000 tonnes except for the 2005/06 growing season 19,297 tonnes of paddy crop was harvested in the Riverina in 2008, which was the smallest crop since 1929 The Co-operative was converted to a public company limited by shares on 14 December 2005 and was renamed Ricegrowers Limited The New South Wales Government announced deregulation of the domestic rice market in November 2005 to commence on 1 July SunRice was to continue as exclusive exporter of New South Wales rice Ricegrowers Ltd acquired the Storage Sheds from RMB in June 2006 for $125.8m SunRice acquired a 65% interest in SunFoods, a Californian milling and marketing business in 2008 for $12.4m 2010s Rice production returns to normal levels in the 2010/11 growing season, with a crop of 800,000 tonnes harvested in 2011 Spanish food company, Ebro Foods SA, makes a bid for Ricegrowers Limited at $5.025 per B Class share plus $0.603 in franking credits, valuing it at $315m ($610m enterprise value). Despite unanimous Board recommendation, bid fails at 2011 EGM based on A Shares vote less than 75% threshold. 960,000 tonnes harvested in 2012 SOURCE: 2011 SUNRICE SCHEME BOOKLET, BELL POTTER Page 3

4 Figure 2: Operating Regions 1.3 Australian rice business SunRice is the primary rice processor in Australia. 99% of Australian rice is produced in the Riverina region of New South Wales. When irrigation water is available, one million tonnes or more of paddy rice may be grown in New South Wales % of rice produced in Australia is of Japonica varieties while the balance is of long grain and fragrant varieties. In a normal year of New South Wales rice production, up to 80% of the rice crop is exported and sold through SunRice s well established distribution networks in the Middle East, Asia and the Pacific. SunRice, as the only exporter of New South Wales rice, can represent between 15-25% of world Japonica rice trade in normal years. SOURCE: SUNRICE 2005 ANNUAL REPORT SunRice is the primary processor of rice grown in New South Wales and most of that rice is delivered to the SunRice specialist receival and storage facilities before being milled and packed at SunRice s manufacturing locations at Leeton, Deniliquin or Coleambally. SunRice s Australian facilities are complemented with storage, processing and packing facilities in Jordan and Papua New Guinea to provide a competitive network of operations for the marketing of Australian and globally sourced rice. Rice production is volatile and highly dependent on water availability. In the ten crop years to 2001, average annual paddy rice harvested was 1.2mt (low of 0.8mt in 1991; high of 1.7mt in 2001). However, during the ten (drought affected) crop years to 2011, the annual harvest more than halved to below 0.5mt (low of 19,000t in 2008; high of 1.2mt in 2002). During periods of drought, SunRice has had to source rice from overseas to ensure ongoing supply of rice for its brands and markets. SunRice undertakes sourcing and processing strategies to ensure the supply of rice from established sources in Thailand, Vietnam, China, the United States, Egypt, India and Pakistan and has interests in a rice storage, milling and packing facility in California. Page 4

5 Figure 3: SunRice Paddy Harvest Figure 4: SunRice Rice Sales by Supply Region SOURCE: SUNRICE SOURCE: SUNRICE Regulatory framework for Australian rice growing industry The Rice Marketing Board for the State of New South Wales (RMB) is a statutory body established under the Rice Marketing Act All rice grown in the state is currently vested in the RMB under the Rice Marketing Act except rice sold to Authorised Buyers of RMB. After domestic deregulation in 2006, SunRice ceased to be the only domestic Authorised Buyer of RMB and is now one of seven Authorised Buyers for domestic rice sales. RMB, however, has entered into the Sole and Exclusive Export Agreement with SunRice under which SunRice is the only organisation permitted to export rice grown in New South Wales from Australia. Under the Sole and Exclusive Export Agreement SunRice has the obligation to buy all rice of merchantable quality grown in New South Wales which is offered to SunRice for purchase. While the export of Australian rice is regulated, the import into Australia of white milled rice from overseas is not. White milled rice is relatively freely imported into Australia and has a significant market share due to consumer demand for Indica and fragrant varieties which are not grown in Australia Reviews into the Australian rice growing industry The rice growing industry has been the subject of various reviews into the Rice Marketing Act over the last decade. Reviews in 2005 and 2010 recommended the maintenance of the current vesting arrangements. These arrangements are in place until January There is currently a Review of Rice Vesting under the Rice Marketing Act underway to determine, among other things, whether current vesting arrangements should be retained or changed. While the NSW Department of Trade and Industry is due to report to the NSW Government by the end of September 2012 it is not expected that the NSW Government will announce its decision much before the end of calendar SunRice is also conducting a review, announced on 4 June 2012, into its governance and capital structure to consider the objectives set during SunRice s conversion to a company, as well as the expectations of shareholders in the current commercial environment. While no timeframe for the conclusion of the review was given, Chairman Gerry Lawson stated that we expect this process could take considerable time as we intend to consult extensively with shareholders to consider whether change is desirable. Page 5

6 1.4 SunRice global rice business Trukai Industries Trukai Industries is a rice product packaging, distribution, sales and marketing company which is two thirds owned by SunRice. It is Papua New Guinea s leading supplier of quality rice products. Registered in 1970 by SunRice, Trukai Industries has a number of well established brands including Trukai, and Roots Rice. Trukai Industries head office and processing base is located in Lae, with distribution facilities located throughout Papua New Guinea. SunFoods SunRice owns a 65% interest in SunFoods, a rice milling, distribution and marketing company which was established in 2008 to acquire Gold River Mills. SunFoods is the owner of the Hinode brand, which was created by the California based Rice Growers Association in the 1930s. The Hinode brand is very strong in medium grain rice in Hawaii and Northern California. SunFoods head office and milling base is located in Woodlands, California. Aqaba Processing Company Aqaba Processing Company, which is 80% owned by SunRice and 20% owned by Yousef Nader and Sons Co., is in the business of receiving, storing and packing rice as well as operating grain handling and storage facilities. The business is located in the Aqaba port in Jordan. Solrice Solrice, located in the Solomon Islands, is a distribution, sales and marketing company wholly owned by SunRice. It is the Solomon Islands leading supplier of quality rice products, including the well established Solrais brand. Solrice s head office and distribution facility is located in Honiara. Page 6

7 1.5 Other SunRice activities AGS SunRice s wholly owned subsidiary AGS owns and operates Riverina based grain storage infrastructure with capacity exceeding one million tonnes. With an extensive Grower base in the Riverina and beyond, AGS is well placed to meet storage requirements for all grain types. Under the Sole and Exclusive Export Agreement, SunRice is obliged to make this infrastructure available to other Authorised Buyers of rice in New South Wales on reasonable commercial terms and to the extent it is not required by SunRice. Rice Research Australia Pty Ltd (RRAPL) RR APL, a wholly owned subsidiary of SunRice, undertakes rice varietal and agronomic research and development in partnership with Industry & Investment New South Wales and the Rural Industries Research and Development Corporation. RR APL operates a leased farm in the Riverina for its activities. Riviana Foods Riviana Foods is a gourmet food manufacturing, distribution, sales and marketing company which is wholly owned by SunRice. It has the largest share of olives and pickled vegetables in the retail channel in Australia. Riviana Foods head office is located in Melbourne, with manufacturing, sales and distribution facilities located throughout Australia. Established in the 1950s, and acquired by SunRice in 1993, the Riviana Foods business has over 500 products. In its grocery business, important brands include Always Fresh, Admiral, Captain, Riviana and Mahatma. Riviana has a strong presence in the foodservice sector and an extensive portfolio of brands including Riviana, Menu Master, Garden Supreme and Ocean Supreme. CopRice CopRice is a division of SunRice. CopRice has been supplying quality animal feeds for over 30 years through its plants in Leeton, Tongala and Cobden. The CopRice business was originally established in response to the availability of rice by-products such as rice pollard, a high quality feed which is high in energy and protein. Today, rice is only one of many ingredients CopRice uses in producing stockfeed as a result of the drought affected rice crops in Australia. Traditional feed ingredients such as wheat and barley are used as well as vegetable proteins such as canola and lupins to produce feed for livestock. CopRice also operates a pet food business which caters for a wide variety of companion animals including dogs, cats, horses, etc. Page 7

8 2. Key facts about SunRice 2.1 Crop year versus financial year Australian rice is sown in September-October and harvested in April-May, subject to weather conditions and water availability. SunRice s financial year runs from 1 May to 30 April, so rice harvested in the month of April will be sold in the following financial year. Accordingly, the profit generated in the FY12 year (to 30 April 2012) included the sale of paddy rice harvested in April-May The most recent harvest in April-May 2012, which yielded over 960,000 tonnes of paddy rice, will be sold in the FY13 year (to 30 April 2013). Appendix 1 sets out the financial statements for SunRice from FY05 to FY Payment terms for NSW growers SunRice operates a pool mechanism to set the paddy price it pays to growers. Accordingly, it takes zero price risk on paddy rice acquired from Australian growers, with the price paid determined by SunRice after it has sold the rice and deducted its costs. However, in some drought affected years, a minimum price has been offered but only shortly in advance of sowing. Growers are paid by SunRice on a deferred basis, with 60% of the estimated paddy price paid as soon as the rice is harvested around April/May, and the balance paid over the next 15 months. This obligation represents a significant working capital commitment for SunRice as it is required to pay for 60% of the crop upfront. The table below sets out the payment terms for Australian rice growers for the 2011 crop. Figure 5: SunRice Timing of Grower Payments SunRice timing of payments Payment No. Timing $ % of Price 1 Harvest and Delivery (April, May, June) $ November $ February $ April $ May $ Final July $ $ SOURCE: Bell Potter Research Page 8

9 2.3 Statutory obligation to growers Under the Rice Marketing Act, the RMB has oversight responsibility for SunRice in its capacity as the holder of the monopoly export licence. According to the 2010 Review of the Rice Marketing Act, the RMB s objects are to: encourage the development of a competitive domestic market for rice; ensure the best possible returns from rice sold outside Australia based on the quality differentials or attributes of Australian rice (single desk); and liaise with and represent the interests of all NSW rice growers in relation to the Board s functions and objects. Specifically on the term best possible returns, the 2010 Review concluded that the Act s objectives are to maximise export single desk price premiums for growers. However, this term is not further defined or explained beyond this statement. We return to this issue below (section 5.1 What does best possible returns mean? ) 2.4 Share capital structure of SunRice SunRice has two classes of shares: A shares, which confer voting rights but no direct economic interest (no entitlement to dividend nor any entitlement to share in any surplus on a winding up) B shares, which are non-voting (except for matters affecting the rights attaching to the B shares) and hold the direct economic interest in SunRice with an entitlement to dividends and to share in any surplus on a wind up. Appendix 2 sets out the key terms for each class of share. Page 9

10 2.5 Board and senior management Board of SunRice The SunRice Constitution provides for a very large Board which comprises up to 10 directors from the following categories: a. up to three elected Grower members of the RMB (Elected RMB Members) (who must also be holders of A Shares); b. up to four other directors who must be holders of A Shares; and c. up to three other directors who are persons with appropriate experience nominated for election by the other directors and only one of which may be an employee of SunRice. It is a requirement of the Sole and Exclusive Export Agreement that the Elected RMB Members be appointed to the Board. The current Directors of SunRice are: Gerry Lawson, Chairman, Grower, non-executive Director (Elected RMB Member) Mark Robertson, Deputy Chairman, Grower, non-executive Director Laurie Arthur, Grower, non-executive Director Noel Graham, Grower, non-executive Director (Elected RMB Member) Rob Gordon, executive Director Russell Higgins AO, non-executive Director Gillian Kirkup, Grower, non-executive Director (Elected RMB Member) Grant F Latta AM, non-executive Director Glen Andreazza, Grower, non-executive Director Alan Walsh, Grower, non-executive Director We make the following observations about the Sunrice Board: A 10 member board seems excessive and unwieldy in an enterprise of the size of Sunrice; RMB directors on the SunRice Board is inappropriate given RMB s oversight responsibilities over SunRice; and The lack of any specific representation for B Class shareholders is a concern given that the direct economic interest in Sunrice is held by this class of shareholders. Page 10

11 2.5.2 Senior Management of SunRice The SunRice corporate management team includes the following people: Rob Gordon, Chief Executive Officer Brad Hingle, Chief Financial Officer Milton Bazley, General Manger, International Commodity Sharyn Brown, General Manager, People and Culture Mandy Del Gigante, Company Secretary Mike Hedditch, General Manager, Grower Services David Keldie, General Manager, Consumer Markets Gerard Woods, General Manager, CopRice and AGS Patrick Youil, General Manager, Operations Page 11

12 3 SWOT Analysis 3.1 Strengths Established network in Riverina, encompassing relationships with rice growers and infrastructure No price risk as growers receive a paddy price based on SunRice sales. Growers are not offered a guaranteed minimum price, but SunRice must deliver growers the "best possible return" Global procurement and trading of rice complements Australian supply Sales network in Australia and globally Monopoly export licence from RMB 3.2 Weaknesses Volatility in domestic rice production, especially compared with key competitor California High working capital investment in Australian paddy rice (60% initial payment for entire harvest) Lack of operating leverage beyond ~1mtpa of annual paddy crop Statutory obligation to growers conflicts with duties to shareholders Equity structure unattractive Ability to raise capital limited 3.3 Opportunities Return to more normal growing conditions New market expansions Loss of monopoly export licence would eliminate buyer of last resort obligation Capital structure review 3.4 Threats Changing Australian consumer preferences to competing rice imports Increasing concentration / competition in Australian grocery retailing Potential loss of monopoly export licence from 2013 Rice growing land can be put to alternative uses (like cotton) if grower returns are poor Page 12

13 4 The Governance Dilemma 4.1 Obligations to rice growers conflicts with duty to shareholders SunRice has two key sets of stakeholders, namely, rice growers and shareholders. Since 2005, when SunRice ceased being a grower co-operative and became a corporation, the interests of both sets of stakeholders have been diverging such that, while all shareholders are or have been active growers, not all active growers are shareholders. Even if the members of the shareholder and grower groups were identical, their financial interests will likely be different depending on the extent of their shareholding and the size of their rice crop. This creates a significant governance challenge because SunRice s obligations to each stakeholder group are in direct conflict. SunRice has a monopoly on rice exports under the Rice Marketing Act and has a statutory obligation to achieve the best possible returns for NSW rice growers. However, as a corporation, SunRice is required to act in the interests of shareholders, which includes maximising profits. To take an absurd example to illustrate the conflict, SunRice could, in pursuit of its duty to act in shareholders interests, seek to maximise profit by simply lowering the price paid to growers. This action would, of course, be in breach of its obligation under the monopoly export licence to ensure the best possible return for growers. We are not suggesting that SunRice deliberately favours one set of stakeholders over another we merely make the observation that the current obligations on SunRice are in conflict and may therefore subject the Company to criticism that it may favour one stakeholder at the expense of the other. 4.2 Practical considerations around the Governance Dilemma While it is not unusual for a company to have competing objectives (pay suppliers less versus increase profit for shareholders), these are usually addressed by commercial negotiation and arms length dealing. Ultimately, the company will not prosper if it produces outcomes that consistently favour shareholders at the expense of growers or vice versa. SunRice is incentivised to achieve good outcomes for growers to ensure their continuing participation in rice growing. If SunRice achieves poor paddy price outcomes for growers, then this may incentivise them to grow less or no rice in favour of alternative crops such as cotton in pursuit of potentially higher profits. This would clearly be detrimental to shareholders if SunRice ends up having little or no domestic rice to sell and is forced to buy rice in the open market with the working capital and price risks that this would entail. However, what makes the situation challenging for SunRice is the competing objectives cannot easily be resolved in a commercial setting where SunRice is the only buyer and is under a statutory obligation to achieve the best possible returns for growers. Growers will feel rightly aggrieved if they receive a less than full price for their crop and shareholders will be aggrieved if they achieve a lower return on their investment due to high payments to growers. Page 13

14 4.3 How can the Governance Dilemma be resolved? In our view, this Governance Dilemma can be resolved by replacing SunRice s statutory obligation to achieve best possible returns for growers with a clearly defined commercial obligation. While SunRice would be free of the statutory obligation, it would still have a commercial imperative to support growers to ensure their continuing participation in rice growing. A greater level of transparency is required in relation to the paddy price determination process and outcomes so that both growers and shareholders better understand how paddy rice proceeds are divided between these key stakeholders. Options for better transparency are beyond the scope of this report but, in our view, would require the introduction of a paddy price charter setting out how paddy prices are determined. Transparency would also be achieved by introducing some form of competition to SunRice. However, due consideration would need to be given to ensuring that Australian rice exporters do not compete against each other, forcing prices down. In due course, new entrants may emerge to compete with SunRice to buy rice from growers for export, giving growers freedom to deal with any party (including SunRice) to achieve the best outcome for them. SunRice would then be judged by growers on its ability to generate good paddy price outcomes and by shareholders on its ability to generate acceptable earnings, dividends and return on capital. SunRice, as a well established incumbent with over 80 years of heritage in the industry, is very well placed to compete with any new entrant into rice marketing. It has strong relationships with all growers, an extensive infrastructure in the Riverina and access to markets for rice both in Australia and globally. Any new entrant would start a long way behind SunRice given its experience in marketing Australian rice for export. 4.4 Review of Rice Marketing Act to consider SunRice export monopoly We note that the Strategic Policy & Economics Division of the NSW Trade and Investment Department is currently conducting a Review of Rice Vesting under the Rice Marketing Act 1983, submissions to which were required by 3 August The Department is scheduled to report to the NSW Government by the end of September with the Government expected to announce the result of the Review before the end of the year. Page 14

15 5 Paddy Price Analysis 5.1 What does best possible returns for growers mean? SunRice s statutory obligation to deliver rice growers best possible returns is not defined anywhere in the Rice Marketing Act or the monopoly export licence. While various reviews into the Rice Marketing Act have discussed the term, no specific or measurable definition has been given to it. Submissions to these reviews have referred to data showing SunRice s paddy price outcomes in comparison to international prices or in comparison to outcomes in the absence of a single desk. However, there has been no publicly available, rigorous and quantifiable assessment of SunRice s performance on this metric. 5.2 SunRice paddy price performance: 1994 to 2009 The lack of transparency on such an important metric is totally unsatisfactory. We also note that the lack of transparency is contrary to the recommendations of the 2010 Review. We interpret SunRice s announcement of its own review into its governance and capital structure as an acknowledgement that this is not an ideal situation. In this regard, we note that the 2011 SunRice Scheme Booklet issued with the Ebro bid had a detailed assessment of SunRice s paddy price performance covering the crop years from 1994 to This assessment compared SunRice s paddy prices against Californian pool prices. The relevance of this comparison was because the Ebro bid offered growers a price formula based on Californian paddy prices. We note that SunRice was quite clear during the Ebro bid not to offer growers a similar pricing mechanism, or, indeed, any form of price guarantee. Nevertheless, it is worth studying the paddy price analysis in the Scheme Booklet as it remains the only publicly available analysis to this day. The analysis in the Scheme Booklet concluded that SunRice had achieved paddy prices broadly comparable with Californian pool prices over this period. The Booklet states that the correlation between SunRice medium grain paddy return and the average Californian medium grain pool return was 85%. This is illustrated in the chart below. Figure 6: Californian average medium grain pool returns vs SunRice medium grain paddy price Page 15

16 SOURCE: 2011 SUNRICE SCHEME BOOKLET The table below summarises the chart to show that the average SunRice price was within 4% of the Californian price over this period. This has been calculated as a simple average, assuming that a grower provided an equivalent volume of paddy rice every year throughout the period. Figure 7: Average medium grain paddy price: SOURCE: 2011 SUNRICE SCHEME BOOKLET 5.3 SunRice paddy price performance: 2010 to date We have conducted our own analysis on SunRice s performance on paddy prices, using the data in the Scheme Booklet and extending the period covered to incorporate the most recent harvests up to and including the April 2012 harvest. The chart and table below replicate the Scheme Booklet chart above extended to the 2012 harvest. It shows that SunRice has underperformed the Californian price in recent years and is on track to achieve a similarly weak result in FY13 for the 2012 crop based on initial payments to growers compared with current Californian prices. Figure 8: Average Californian medium grain pool price v SunRice paddy price (A/Tonne) 800 AVERAGE CALIFORNIAN MEDIUM GRAIN POOL PRICE v SUNRICE PADDY PRICE (A/TONNE) F SunRice Paddy Return Californian Pool Average SOURCE: 2011 SUNRICE SCHEME BOOKLET Page 16

17 Figure 9: Paddy Price Rice Analysis SUNRICE: PADDY RICE PRICE ANALYSIS Note Crop year to 30 April Unit F Paddy rice harvest kt Paddy price (Crop year +1) A$/t California Pool Average US$/cwt Conversion to metric tonnes x California Pool Average US$/t A$/US$ x Net California paddy price A$/t Aust/Calif premium/(discount) 1% (36%) (19%) Source: 2011 SunRice Scheme Booklet, SunRice, Creed Market Co, Bell Potter Research Notes 1 Sourced from SunRice disclosures 2 Rice harvested in April is sold in the following financial year. SunRice paddy price is after storage and drying costs. (a) Crop year 2010 (FY11) paddy price based on a weighted average of two pool prices of $550 and $320 (b) Crop year 2012 (FY13) paddy price of $245 is an estimate based on initial 60% payment to growers of $145/t 3 Sourced from SunRice and is based on Californian average pool prices in line with 2011 SunRice Scheme Booklet (a) Average pool prices declared in October to December relate to prior Californian crop year (1 September to 31 August) (b) These prices have had a deduction for storage and drying costs to make them comparable with Australian paddy prices (c) 2012 Average pool price is a SunRice estimate. Other estimates (Creed Market Co) suggest a higher price: US$17.50 pre storage and drying cost of US$1.60 = US$15.90 (California medium grain #2 58/69 (California #1)) 4 Price is per cwt FOB; cwt = hundredweight = 100 lb. 1lb = kg, so 1 tonne = 2,204.6lb = cwt 5 California price (US$/cwt) x = California price (US$/t) 6 Average exchange rate for the Australian crop year 7 California price (US$/t) x A$/US$ = California price (A$/t) We believe that a proper analysis of SunRice s performance in terms of paddy price premium to California requires an assessment of both price and volume as it is the overall revenue that growers receive. To the extent that SunRice achieves a premium in years when the crop is lower due to drought, this is much less valuable for growers than when it produces a larger crop. While a larger Australian crop will generally produce lower prices, it is against an international price comparison that SunRice should be judged. This issue will become much more important in the next few years given: 1. the strong harvest in 2011 (which generated the FY12 result) 2. the stronger harvest in 2012 (which will generate the FY13 result) and 3. high levels of dam water, the very limited watering of the 2012 winter wheat crop and carry over water entitlements from this year indicate a very large 2013 harvest. Page 17

18 The chart below shows the SunRice paddy price performance contrasted with the harvest in that year. The insight from the chart is that SunRice has typically underperformed the Californian price in years when it has had a strong harvest to sell, but outperformed in years when the harvest has been weak. Figure 10: Paddy Price Performance vs SunRice Premium '000 tonnes 6000 PADDY PRICE PERFORMANCE: PADDY PRICE v SUNRICE PREMIUM 60% % % % 2000 (20%) 1000 (40%) F Australian Paddy Rice Harvest (LHS) Aust/Calif Premium/(Discount) (RHS) (60%) SOURCE: 2011 SUNRICE SCHEME BOOKLET The point is illustrated in the following table which compares the average price SunRice has achieved on a simple average basis (assuming equal paddy tonnes delivered every year) and on a volume weighted basis using actual paddy tonnes delivered. Note that we assume that the Californian weighted average is similar to its simple average based on our understanding that California generally produces a more consistent crop due to greater certainty around water availability than is the case in Australia. Figure 11: SunRice Average Paddy Price Average (A$/t) Average (A$/t) Average (A$/t) Simple Weighted Simple Weighted Simple Weighted Australia California Aust/Calif premium/(discount) (A$/t) (12) (57) (65) (104) (20) (65) Aust/Calif premium/(discount) (%) (4%) (19%) (18%) (28%) (7%) (21%) Source: Bell Potter Research SUNRICE: AVERAGE PADDY PRICE The table shows that even in the period covered in the Scheme Booklet, SunRice significantly underperformed California on a volume weighted basis in other words, Australian growers received 19% less (or $57/t) for their crop than their Californian counterparts when both price and volume are factored in. It was only a grower who could theoretically have delivered an identical quantity of rice in each year from 1994 to 2009 who could have been within 4% (or $11/t) of his Californian counterpart. In recent years (2010 to 2012), the underperformance on paddy price has widened to $65-$104/t or 18-28%, depending on whether simple or weighted average price is used. Page 18

19 5.4 Why has the SunRice paddy price underperformed the California price? The obvious question to ask in this analysis is what is causing the discrepancy in pricing. We understand from industry participants that there are several reasons for this: 1. Domestic v export sales: Californian rice is sold into a much larger domestic market than Australia. We understand that around 50% of Californian rice is sold in the USA and 50% is exported, compared with Australia at around 20% domestic and 80% exported in a normal crop year (at least 800 kt). Given that export sales are typically at lower prices than domestic, this does explain at least in part lower Australian prices; 2. Australian drought helps Californian prices: In recent drought affected years, California has been able to sell rice with very little Australian rice competing for export sales in the same crop year. By the time Australian rice has been available to sell, the most lucrative export markets have likely been filled, leaving only lower value bulk commodity export sales for Australian rice. Although FY12 was the first year in which Australian rice exports recommenced in size, these sales could not commence until after the harvest in April 2011, by which time California had been selling rice since its harvest in October 2010; and 3. Californian pool prices exclude cash market sales: Californian pool prices do not include all rice sold by Californian growers. There is a substantial portion of Californian rice sales outside the pool system (up to 50% of volume in some years) typically sold into export markets which may or may not be as high as the pool prices. Accordingly, the pool price may overstate the actual return to a Californian rice grower in years where these excluded sales are at prices lower than pool prices. Page 19

20 5.5 Conclusions on paddy price analysis We draw three conclusions from the above analysis: 1. SunRice should be more accountable and transparent about its paddy price performance: Growers should be better informed about paddy pricing outcomes than they currently are. At a minimum, SunRice should disclose to growers its paddy price performance relative to international prices for medium grain paddy rice and explain to growers reasons behind any deviation each year. It is worth noting that this was a recommendation of the 2010 Review which states on page 16 that it would be appropriate for the [Rice Marketing] Board, at a minimum, to consistently monitor... performance indicators relating to one of its primary objects, that of obtaining price premiums on behalf of growers in export markets.... Other business indicators surveyed could include cost containment and exchange and interest rate performance on crop financing.... Such target metrics could be made available to growers and government to enable more informed judgments about the ongoing sustainability of the present licence arrangements. 2. Ebro offer was a good deal for growers: The formula Ebro proposed offered growers a transparent pricing formula compared with the zero transparency SunRice currently offers growers. In addition, the Ebro formula gave Australian growers some indirect access to domestic US rice pricing which typically is at a premium to export pricing which is the main market for Australian rice; 3. SunRice should continue efforts to grow value added export opportunities: Australian paddy price outcomes will benefit from lesser reliance on bulk commodity export sales. While this is self evident, increasing sales of consumer branded and packaged rice is a challenge for SunRice given the unpredictability of the Australian rice harvest. In this regard, we note that SunRice has developed its global sourcing and trading activity in recent years to ensure reliable supply. Page 20

21 6 Review of financial statements for FY05-FY12 A key consequence of the Governance Dilemma is that financial analysis of SunRice from the perspective of an investor is a fraught exercise given that profit in any year can be seen merely as a function of paddy price paid to growers. This is demonstrated by the statement by Chairman Gerry Lawson on 19 June 2012 with the release of the FY12 financial results. In referring to an overall retention of $21.8m (being FY12 NPAT, after minorities, of $31.8m less FY12 dividends declared of $10.0m) he noted that this was including $11.2m in after tax profit from our Australian Rice Milling and Marketing business, equivalent to $20 per tonne before tax. Based on 800,000 tonnes of FY12 paddy harvested, $20 per tonne equates to $16m pre tax or $11.2m after tax. In our view, financial analysis for the Company in its current form requires a critical assessment of its paddy price outcomes for growers as this is the key metric that determines returns to growers and shareholders alike. If SunRice can achieve higher export prices for rice and lower operating costs, this will lead to a higher source of funds to distribute to both growers (as paddy payments) and shareholders (as profits). Accordingly, we believe that our review of the financial statements of the Company is less relevant than it is for a traditional company which does not have the Governance Dilemma that SunRice faces. We have reviewed the financial statements of SunRice based on Annual Report disclosures since FY05 (eight years to FY12 inclusive). Our review is limited to this period as complete financial statements (profit, cash flow statement and balance sheet) are not available for prior years. The period under review is short and dominated by poor drought affected harvests. We note, however, that SunRice has broadened its business activities over the last decade to be less reliant on Australian rice milling and marketing and has developed extensive global sourcing and rice trading capacity. Testament to the Company s success in these activities is the record FY09 result (representing almost triple the average NPAT of the period under review) which was struck on a record low 2008 crop of only 19,000 tonnes driven by higher international prices. Accordingly, we believe that the period under review is broadly representative of its financial performance. In any event, it is the only period for which sufficient data is available and meaningful analysis can be conducted. Page 21

22 6.1 Return on capital In our view, the return on capital achieved by SunRice has been weak over this period. Assuming that 10% is an acceptable return on equity for an industrial company (which implies ~15% pre-tax pre interest return on funds employed), SunRice has rarely achieved this benchmark. We understand that in determining paddy prices, SunRice applies a 10% pre-tax asset financing charge to ensure shareholders achieve some return for the use of their capital for the service it provides to growers. This is an entirely legitimate charge although the quantum of it can be argued over. It would be among the matters to be considered if a paddy price charter was to be implemented. Figure 12: SunRice Return on Capital SOURCE: BELL POTTER 6.2 Circularity of profit versus paddy payments Another factor to consider in this analysis is that SunRice by its own admission has achieved a higher profit in FY12 by retaining $20 per tonne from the paddy price paid to growers. If this amount had been paid to growers, the result is that EBIT and NPAT would have been $16m and $11.2m less respectively. The effect on returns is set out in the table below: Figure 13: SunRice FY12 Financial Analysis SUNRICE FY12 FINANCIAL ANALYSIS PROFIT ANALYSIS Reported Adjusted Difference EBIT NPAT EBIT NPAT EBIT NPAT % 35% RETURN ON CAPITAL ANALYSIS Reported Adjusted Difference ROFE ROE ROFE ROE ROFE ROE 14.5% 10.9% 11.2% 7.0% 3.3% 3.8% SOURCE: BELL POTTER While the $20 per tonne reduction in paddy prices represented only a 7.3% difference ($255 cf $275), the effect on reported profit is substantial. From the table, EBIT and NPAT would have been 23% and 35% respectively lower than what was actually reported, with a commensurate decline in return on capital. The above analysis highlights the circular nature of SunRice profit v paddy payments. Page 22

23 6.3 Balance sheet and gearing The SunRice balance sheet has carried significant debt since FY05. The most significant acquisition the Company made was the Storage Sheds in June 2006 for $125.8m, although SunRice already had substantial debt prior to this acquisition (see table below). Figure 14: SunRice FY12 Financial Analysis RICEGROWERS LIMITED Year to 30 April Gearing analysis Ex retention Net bank debt RMB Equity Certificates Total net debt Equity Gearing ratio 219% 318% 343% 258% 168% 118% 102% 66% 72% Net debt/ebitda Net interest cover (EBIT/Net interest expense) This acquisition was funded by bank debt and the assumption by SunRice of RMB Equity Certificates. RMB Equity as a form of funding has been interest free and was initially loaned by growers out of paddy payments. Repayment to the RMB for the Storage Sheds to meet maturing RMB Equity has been funded through the issue of B Shares, SunRice cash flows and bank borrowings. While the conversion of RMB Equity into B Shares has improved the capital structure of SunRice, it has expanded the share base (diluting existing shareholders) and increased dividend outflows in short the cost of capital has increased. SunRice has acknowledged that it has a suboptimal capital structure and needs to reduce gearing. While this has been occurring in recent years, in our view interest cover metrics are still too high. FY12 was the first year in which net interest cover was above 3x and net debt/ebitda was close to 2x (which we regard as a minimum acceptable rule of thumb benchmarks for industrial companies) excluding the exceptional FY09 year. However, after adjusting for the $16m EBIT ($11.2m NPAT) retention payment (essentially retaining operating earnings at the expense of growers), net interest cover fell to 2.5x and net debt/ebitda rose to 2.7x as per the table above. We note that much of the interest expense relates to financing the working capital investment in paddy harvest and is included in the costs to arrive at paddy payments. Accordingly, SunRice is less financially vulnerable than its low interest cover would suggest as growers essentially pay for the interest cost associated with funding the paddy harvest. Recent efforts by the Company to raise additional capital have yielded lacklustre results (e.g. only $0.9m raised in the last capital raising offer in 2009). While the Governance Dilemma remains, accessing fresh equity capital will be a challenge. Page 23

24 6.4 FY12 Australian Rice Milling and Marketing result FY12 was the first year in which SunRice disclosed its key Rice Milling and Marketing profit segment split between its Australian and Global businesses, with a comparison for FY11 on a similar basis. The significance of the split is that it shows the revenues achieved by SunRice for its paddy rice, allowing some insight into its cost structure for this business. Below we set out our analysis of this result. Figure 15: SunRice Australian Rice Milling and Marketing Segment Result Year to 30 April % change Gross revenue % Paddy payments to growers % Gross margin % Operating costs Centralised corporate costs % Other % Total operating costs % EBITDA NM Depreciation and amortisation % Operating EBIT NM Non operating costs % Reported EBIT NM Net interest expense % Net profit before tax NM Result analysis on a $/paddy tonne delivered basis Change on pcp A$/t % Paddy tonnes delivered kt % Gross margin analysis Rice price received A$/t % Paddy payments to growers A$/t % Gross margin A$/t % Operating cost analysis Centralised corporate costs A$/t % Other operating costs A$/t % Total operating costs A$/t % Net profit before tax A$/t NM Source: 2012 SunRice Annual Report Segment information note 35, pp NM: Not Meaningful We make the following broad observations on the analysis above: 1. Gross margin: Despite the near quadrupling in paddy tonnes delivered (205kt to 800kt), revenues only tripled ($146m to $452m) as sales per tonne declined by $143/t or 20% ($708/t to $565/t). However, the decline in paddy payments to growers was larger than the decline in sales per tonne at $160/t ($415/t to $255/t) leading to an increase in gross margin per tonne of $17 ($293 to $310). However, all of the gross margin per tonne increase is attributable to the $20/t retention withheld from growers referred to above; and Page 24