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DEAL STARTS TO SOUR

HCI frustrated at stalling of urgent capitalisation plans

The relationship between empowerment group Hosken Consolidated Investments (HCI) and dairy giant Clover Industries has soured to the point that the original black empowerment deal looks in jeopardy.

HCI holds a 34,9% stake in Clover, an arrangement that market watchers believed would give the empowerment group a meaningful foothold for further forays into the food sector. HCI also holds 44% of Clover’s preference shares.

But there have been lingering tensions between both parties over the past two years, with HCI openly critical of a perceived lack of development in restructuring and recapitalising Clover. In late 2007 Finweek’s website Fin24 reported HCI reckoned the capital structure of the unlisted dairy group was “a significant constraint to the business” and that a single capital structure was required to “free it from milk quotas”.

At that time HCI said a request was made for the Clover board to investigate the recapitalisation of the group but “that progress remained extremely slow”. It would seem subsequently that HCI and Clover have remained at loggerheads, with the former running out of patience.

In HCI’s recently released results to end-March 2009 CEO Johnny Copelyn said Clover continued to drag its feet over a necessary capital restructuring for a further year. It would now seem a frustrated HCI is ready to bail out at Clover. Last month Copelyn noted: “HCI has as a result lost confidence this (the capital restructuring) will ever happen and is contemplating reducing its exposure to the company.”

Previously Copelyn had argued that for Clover to survive and prosper in future, the group needed to adapt its business model and free its capital structure from quotas. He suggested Clover’s potential wouldn’t be realised with the current capital structure and resources.

Currently Clover – a former co-operative – has a rather complicated capital structure that ensures dairy producers (ie, farmers) effectively remain in control of the company. There are “delivery agreements” linked to ordinary shares between Clover and its producers that are claimed to be non-negotiable and integral to the dairy farmers’ relationship with the group.

Clover’s last annual report showed individuals – mostly producers – held around 34,6% of Clover’s ordinary shares and 11,6% of its preference shares.

HCI’s public hint last month it could dispose of its Clover stake certainly suggests the empowerment group – known as a dogged investor – has hit a brick wall in the Clover boardroom. No doubt HCI’s feelings for Clover have also been affected by a less-than-inspiring profit performance by the dairy group of late. In the six months to end-December 2008 Clover increased by 17,5% on the back of a 4,8% sales volume hike – thanks to inflationary pressure and an improved product mix. However, trading margins were crunched by a hefty increase in costs, which saw operating profit more than halve to R86m. Clover sunk into the red for the interim period as increased borrowings bloated its interest bill to almost R90m.

While it clearly wouldn’t be a great time for HCI to sell out of Clover, one market watcher says a frustrated HCI perhaps didn’t fully understand the risks, the cycles and the intricacies of production in the dairy industry. “They wouldn’t be the first investors to learn the hard way about the dairy sector. Just ask some of the investors who chased Bonnita when it listed in the early Nineties.”

Although HCI would probably easily source a bargain-hunting buyer for its Clover stake (PSG’s agribusiness investor Zeder springs to mind) such a development would leave Clover sans an empowerment partner. Finding a replacement empowerment partner with sufficient capital and value adding skills won’t be easy in current market conditions – unless robust entities such as Brimstone or Mvelaphanda are keen to extend their respective reaches in the food sector.

As such, maybe Clover should be pushing a little harder to placate HCI – which carries considerable financial muscle and influence throughout business, unions and perhaps even Government (judging by recent developments at Frame Textile Group).

Finweek also reckons HCI may well have a valid point about the need to quickly recapitalise Clover – an exercise the necessity of which can hardly be disputed. Clover’s interim balance sheet shows interest-bearing borrowings have ballooned to more than Rl,4bn – R868m on a non-current basis and R568m deemed current borrowings.

At 31 December 2008 Clover’s borrowings were just shy of R900m, with R359m accounted for under current liabilities. Looking at those figures you might understand why HCI is getting a tad tetchy about delays in recapitalising the group. And perhaps more worrying is that Clover’s interim operational cash flows turned negative to the tune of R186m.

But it’s not as if Clover is in denial about the recapitalisation issue and the possible hampering of performance. Clover chairman John Bredin – writing in the annual report for the year to end-June 2008 admitted that without additional capital the group wouldn’t be able to reach its ambitious growth targets. He said: “…this will not only hamper exciting returns on investment opportunities for shareholders but could also limit essential growth for producers at farm level”.

Bredin noted debt had reached upper levels and investment to improve production efficiencies and to increase production capacity was limited. Significantly, he said: “It is in everybody’s best interests to find innovative ways to introduce fresh capital into the group.”

But Bredin stressed control of Clover by its milk producers is not negotiable. Bredin reiterated the existing delivery agreements (ex-quota) that were linked to ordinary shares between Clover and its producers were perceived as an integral part of the producers’ relationship with the group. “Replacing delivery agreements with contracts that do not have such a link to their ordinary shares is not an option.”

Clover’s annual report also mentioned its management had been tasked with researching and presenting mechanisms for the raising of capital without materially altering that control structure. At that stage Bredin said: “Without pre-empting a possible solution it is quite likely that the producer shareholders would be willing to forfeit some financial return on their investment in the company in exchange for fresh capital, while retaining “It is quite likely that the producer shareholders would be willing to forfeit some financial return on their investment in the company in exchange for fresh capital, while retaining sufficient control.”

Unfortunately, it seems not a lot of progress – as intimated by HCI – has been made about finding ways of raising capital. Comments on Clover’s interim results again acknowledge its long-term future depends on its ability to raise capital “in order to reposition some of its facilities and also to create badly needed capacities”. But the bottom line is that the Clover board is still currently working on a preferred solution to restructure the group. At this point it’s unclear how much new capital Clover would require. However, Finweek would estimate anything between R400m and R800m could be needed to cull debt to more manageable levels.

There can be no doubt HCI would want to participate fully in a shares-for-cash issue, which would undoubtedly give the empowerment group a position of dominance at Clover.

The fund-raising suggestions from Clover seem to revolve around attracting new investors to the business in a way that the producers’ power base isn’t diminished. But it would be difficult to attract new shareholders – aside perhaps a specialist entity, such as Zeder – to Clover at this rather delicate junction in terms of profit performance.

It would surely also be difficult to attract significant investors with the boardroom power still residing with producers – a situation that suggests Clover hasn’t really shifted away from its co-operative days as National Co-operative Dairies (NCD).

Perhaps the way to ensure Clover embarks on a successful capital-raising exercise – with HCI’s participation – is to convince farmers that fresh investments into the group’s production and distribution capacity can only but benefit the producer base markedly in years to come. If producers don’t have the appetite for the risks associated with further capitalising Clover, they simply have to make way for those investors willing to fork out the big bucks. Clearly, Clover is petrified of losing chunks of its producer base – but that, after all, is the way of the free market. In Clover’s last annual report (released late in 2008) there was a sense the balance between operational control and economic value participation by producers was “shifting in order to accommodate future growth on their farms”.

Clover executive director Manic Roode told Finweek last week that much groundwork had been done with regard to finalising the capitalisation process. “It’s complicated – but we have approval in principle at board level. But the devil is in the detail.” Clearly, the “shifting” process needs to be shoved along… and quickly.

Source: Finweek – Marc Hasenfuss