Fools rush in where bankers fear to tread

Friday 5th July 2002

Shoeshine never ceases to be amazed by New Zealand punters' appetite for high-risk yield investments.

While the share prices of strong, growing mid-sized companies languish for lack of interest the newspapers are full of advertising for fixed-interest junk instruments offering a few percentage points above the risk-free return on government stock.

Scarcely a day goes by, it sometimes seems, without someone who can neither raise equity nor persuade a bank to debt-fund their scheme, running to the retail market where a horde of mum-and-dad investors stands eternally ready to part with its cash.

These are the people who bought Skellerup bonds with now-famous consequences.

They fronted up to finance Andrew Krukziener's Metropolis apartment development and are still waiting to see a penny of their money back.

They backed Reeves Moses contributory mortgages and a host of other failed CM schemes.

They're piling into two-year term deposits with obscure finance companies at 8.5% when the High St banks are offering 5.8%. Scarcely any, Shoeshine is confident, bother to examine these companies' financial strength or to find out where the money is being lent.

The current high-risk, high-yield fad is capital notes, or junk bonds issued by companies.

There's no doubt these have a place in a balanced fixed- interest portfolio.

Of the 15 companies that have issued notes of some sort Fonterra and Telecom stand out as the pick of the bunch. Their notes have an investment-grade credit rating and the risk of default is, well, rather remote.

In the second tier are companies such as Fletcher Building, Sky TV, Sky City and GPG Finance. While unlikely to go belly up these companies are not as substantial as Telecom or Fonterra and the yield margin their notes were offered at was appropriately higher.

And so we come down to the silly end of the market.

The latest company offering investors a slice of unsecured, subordinated debt is Advantage Group, a down-on-its-luck technology company.

Advantage is seeking up to $10 million at a coupon rate of 10% pre-tax. The notes run until April 2006, when holders can opt to roll them over or to convert them into Advantage shares.

The offer is underwritten by McDouall Stuart Securities, the investment bank set up in January by former Forsyth Barr sharebroker Andrew McDouall, and was originally scheduled to close on June 28.

The company has extended the close date to next Friday, citing "adverse weather conditions in the South Island" and, mysteriously, "requests from shareholders."

Shoeshine will be fascinated to see how much is raised.

Prospective investors have to ask themselves why Advantage has no bank debt but is offering a margin of around 3.8 percentage points above 2006 government stock.

Since banks' (secured, first-ranking) business lending rates lie somewhere in between this suggests the banks showed Advantage the door.

To understand why this might be you need to take a look at Advantage's past performance and its current financial standing.

The company listed in 1993 and did well enough for a while from its core but maturing business of selling eftpos terminals, except for a bad year in 1998 when it lost $7.3 million.

From 1999 it started buying up big, investing in internet retailer Flying Pig, technology investor Strathmore, software maker Viatx and web developer Glazier Systems, among others.

The party ended with the April 2000 "tech wreck."

In the June 2001 year Advantage had to write off $60.3 million of goodwill and $6.2 million of restructuring and other one-off costs and booked a $65.9 million bottom-line loss.

Since then, it has changed management and sworn off growth by acquisition, restructuring into four divisions aiming for organic growth.

Whether all this will work or not remains to be seen.

The company is forecasting a $2.16 million profit for the June 2002 year. It plans its resurrection off an asset base that is as diaphanous as a Bond girl's nightie.

According to the prospectus the $9.05 million, after issue costs, raised through the notes issue will represent nearly 40% of total capital funds of $22.8 million.

Total assets are $39.22 million, of which $9.14 million is intellectual property and $27.95 million is "current tangible assets."

These comprise receivables, cash and inventories - working capital, in other words.

In short, Advantage owns virtually nothing of any substance against which the banks could secure a loan.

The notes are accounted for as "capital funds" because they're convertible into shares, but at a 5% discount to the April 2006 share price, not at a strike price close to the current price (a price that reflects the risk equityholders bear now).

Until then noteholders will have plenty of exposure to Advantage's downside risk but none to the upside.

Nor is there likely to be much of a market into which to sell if things go wrong.

For an investor looking for a home for $10,000, risk-free 2006 government stock will bring in around $621 of annual interest pre-tax.

Advantage notes will bring in another $379, or about a dollar a day.

Is this worth risking $10,000 for?

If investors believe the company can get its act together and make money they'd be better advised to buy the shares.

Sadly there will be plenty of "investment advisers" who are more interested in shifting this product than in advising clients on appropriately structured portfolios.

And there will be plenty of clients who will take their advice.

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