When break-up means bonus

Friday 1st June 2001

Splitting Fisher & Paykel into healthcare and whiteware companies is the best idea since refrigeration. So why has it taken so long, asks Unlimited's new investment columnist, Roger Armstrong

It was the best of companies, it was the worst of companies. That's how Fisher & Paykel will be remembered once the company is split in two later this year.

On one side, there's the F&P Whiteware division, a household name in washing machines, fridges and dishwashers - albeit fancy ones like the DishDrawer. On the other is the rapidly growing Healthcare division, a household name in hospital wards with products like its humidifier, a hit with intensive care patients. F&P's management has long argued that the two divisions have technological common ground. Whatever. Financially, they are at opposite ends of the performance spectrum. F&P Healthcare is a superstar, growing fast, making huge returns on capital and spitting out cash for shareholders. F&P Whiteware is a financial dog, making spluttering profits, below-target returns on capital and, worst of all, sucking in dollops of cash as F&P has, somewhat heroically, continued to expand the company in the face of intensifying competition.

Some question the wisdom of listing Healthcare on the Nasdaq, given the market's plunging fortunes. But it doesn't change the fundamental reason for the split - F&P Healthcare's strong profits have to be prised away from the expansionary and under-performing Whiteware group. In investment parlance, this is called eliminating the "reinvestment risk" of F&P Healthcare's cash flows. In plain English, it's called a good idea.

You've got to congratulate the board for its decision to split. It is never easy to carve up the company you have created and nurtured. But why has it taken so long? F&P should have split years ago, maybe as early as 1998 when Healthcare first overtook Whiteware in terms of profit (see graph).

The delay reflects, I believe, the structure of the F&P board. It is dominated by management and former management (six out of nine directors), it is old (average age 64), it is full of "whiteware guys" (there are no F&P Healthcare representatives) and it is stale (the board has remained the same for a decade). It is a board that you would expect to move cautiously, to favour the status quo and to be very protective of the Whiteware operation. On the positive side, most directors have a sizeable F&P shareholding (six out of nine directors have at least $1 million in F&P stock). But still, the board has simply been delaying the blindingly obvious.

Healthy figures

So, how good is Healthcare? Spectacular, if you look at the numbers. In the last decade its earnings before interest and tax (EBIT) have grown at a compound rate of 35% a year, to an estimated $2 million this year - over twice what Whiteware is predicted to earn. Over the past four years it has earned over 60% return on capital employed, miles above its estimated pre-tax cost of capital of around 16-17%.

Because of its high return on capital, Healthcare has been able to grow fast and spin out cash at the same time - an unusual combination. Over the past decade it has produced $172 million of after-tax profit, but only needed to inject about $80 million of that back into the business to finance this breakneck expansion.

When separately listed, F&P Healthcare will be in the super-premium category of New Zealand companies, to be judged alongside The Warehouse and Baycorp. And the way I see it, Healthcare has better investment characteristics than these two companies, with a similar predicted growth rate (around 20%) for the next two years, but better return on capital employed and a larger potential market. It's no exaggeration to say that Healthcare may be the highest quality company to list on the New Zealand share market.

By comparison, Whiteware is a washout. It has innovative products, superb marketing (judging by the market share it achieves at premium prices) and an outstanding team culture. But in a very tough industry - the Koreans have been merciless competitors - Whiteware has not been able to convert its premium prices into premium profit. Judged against its fellow Australasian producer, Simpson, F&P has performed poorly. The dumb decision to start manufacturing in Australia in the late 80s exacerbated its already poor economies of scale.

Over the years management has given a number of excuses for its poor performance: manufacturing line commissioning problems, poor currency hedging strategies, marketing costs in the US, blah, blah. Many of these excuses have been valid, but the facts remain. F&P Whiteware will probably be about $50 million EBIT away from earning its keep in the 2001 financial year. It is so far short of the mark that you have to conclude it has deep-seated problems.

Dirty dishes

But that's not the worst of it. Investors can accept the industry is tough, and a slipping currency is not management's fault. What is unforgivable is that F&P has expanded Whiteware when it is demonstrably a value destroyer. Companies not making their cost of capital - or without a clear path to doing so in the near future - should not expand, they should contract. The buck for this action stops with the Whiteware-dominated board.

F&P's accounts show that its "appliance division" has increased its capital employed by close to $200 million over the past decade. Given the divestment of non-Whiteware appliance businesses in areas such as telecommunications over the past few years, it is likely that close to $300 million of extra capital has been put into Whiteware in last 10 years - more than the after-tax profits of the division through that period.

I am being a bit tough on the old Kiwi icon. Whiteware is not a hopeless case. In the DishDrawer, F&P has a world-beating, high-margin product, which also has the ability to open up distribution channels for other products in the US and Europe. Whiteware's economy of scale will be strengthened if the company can exploit high-margin world markets using existing factories. F&P Whiteware has capacity to burn (it can expand production by about 50%) and the current management team has shown a willingness to license its technology as a way of expanding without using capital, a major value-adding possibility. The company has also embarked on a large cost-reduction programme.

To date, F&P Whiteware has mucked around in the US, pricing the DishDrawer at about twice the New Zealand level and, not surprisingly, capturing less than 0.5% of the market. With a new model now hitting the US at lower prices and a European model to be out by the end of the year, Whiteware will have no excuses if it can't lift its performance.

Management is making the right noises, but the market has been disappointed by this side of the business too many times to give the company any credit until the results are on the board (show us the money!). Failure could lead to a takeover by an international firm with the distribution to exploit the DishDrawer and other Whiteware technology stock. Another Kiwi icon lost?

Roger Armstrong is an independent financial analyst.
Disclosure of interest: Roger owns shares in F&P

Roger Armstrong
rogerarmstrong@clear.net.nz

The old firm

F&P board in 1992 ...
Maurice Paykel, 78
Sir Colin Maiden, 58
John Gilks, 50
Gary Paykel, 50
Norman Geary, 53
Lindsay Gillanders, 42
David Henry, 40
Don Rowlands, 66
Julian Williams, 55

... and in April, 2001 (spot the difference)
Maurice Paykel, 87
Sir Colin Maiden, 67
John Gilks, 59
Gary Paykel, 59
Norman Geary, 62
Lindsay Gillanders, 51
David Henry, 49
Don Rowlands, 75
Julian Williams, 64

How it works

Shareholders get to vote on the F&P split in August or September. Assuming the necessary 75% of shareholders approve the scheme, all the necessary court approvals and paperwork should be completed in time for shareholders to receive an early Christmas present. Current shareholders will automatically become Healthcare shareholders (representing 60% of the company). A new company, F&P Appliances, will be "spun out" (the shares distributed free to existing shareholders), including whiteware operations, the finance company and a 20% stake in Healthcare. A 20% stake in Healthcare will also be sold to US investors concurrent with a listing on the Nasdaq, and some proportion of the proceeds will be given to shareholders.
Investors will be hoping for a very fresh look on the new Healthcare board and a bit of new blood for the Appliance company board, too.

Roger Armstrong
rogerarmstrong@clear.net.nz

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