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Dairy Valuation - Full Text Of Directors Letter

Joint Statement from:
New Zealand Dairy Group and Kiwi Co-operative Dairies

Embargoed Until 0100 Saturday 27 January 2001


Dear Directors
Proposed Amalgamation of New Zealand Co-operative Dairy Company Limited and Kiwi Co-operative Dairies Limited
1. Arthur Andersen Corporate Finance (“AACF”) has been engaged to advise the Directors of Kiwi Co-operative Dairies Limited (“Kiwi”) and New Zealand Co-operative Dairy Company Limited (“Dairy Group”) on the proposed merger of both companies by way of amalgamation (the “Merger Proposal”) with effect from 1 June 2001. This proposal was embodied in an agreement between the parties (the “Merger Agreement”) a copy of which has been circulated to all shareholders of each company.
2. In broad terms, we have been engaged to:
 Update the ‘MergeCo’ estimates of merger benefits under the direction of management of both companies.
 Determine, on the basis of historical and current-year information provided by both companies, the likely range within which the relative difference in the equity values of the two companies falls, when expressed in terms of kilograms of milksolids forecast to be supplied in the year to 31 May 2001.
 Provide an opinion on whether a merger under those terms is commercially reasonable and in the interests of all shareholders.
3. Our advice and opinion have been given in a detailed 60 page report to the Directors of both companies, and the Directors have asked us to prepare this summary letter (which does not provide an exhaustive analysis of the proposed merger) to be sent to shareholders in connection with the Merger Proposal. Our Terms of Engagement are attached to that report. The terms deal with disclosures of interest and AACF’s qualifications, and contain disclaimers and limitations of liability as well as restrictions on the use to which the report and this summary can be put. The Terms of Engagement incorporated in our detailed report are deemed to apply to this summary letter.
Our Approach
4. Since our instructions require us to focus on the relative values of both companies, we have excluded the value of their respective investments in the New Zealand Dairy Board (“NZDB”), to the extent that we have analysed the revenues of the two companies exclusive of NZDB’s marketer’s surplus.
5. We have assessed the respective value ranges of the companies on the assumption that, under the status quo, both would continue to operate within the existing industry structure and that each would, for FY2001, continue the typical practice of fully distributing earnings to shareholders. However, to assist the companies give effect to the detailed terms of the Merger Proposal, we have also:
 provided results that take into account the proposed equalisation of FY2001 milksolids payout of both companies that was agreed as part of the merger terms, and
 converted the results to values per share based on each company’s forecast number of shares on issue at 31 May 2001.
6. We assessed the range of base-case valuations based on the two valuation approaches we were instructed to use, namely a “capitalised EBITDA” approach and a “limited DCF” approach. Ranges were derived by reference to values common to both the DCF and EBITDA approaches.
7. Under the capitalised EBITDA approach, we assessed the value ranges of each company on the basis of the following formula:
where‘EBITDA’ is our assessment of future maintainable earnings before interest, tax, depreciation and amortisation for each company, based on historical data and forecasts for the year ending May 2001 adjusted as necessary for one-off items, differences in accounting policy and agreed post-balance date items; ‘M’ a multiple determined by examining the relationships between EBITDA and market value for a range of companies that are comparable to Kiwi and NZDG; and ‘D’ the forecast value of each company’s debt at the end of May 2001.
8. Under the ‘limited DCF’ approach we assessed each company’s value on a discounted cash-flow basis, using as inputs into our analysis information provided by the companies on each company’s actual 1999/2000 results, adjusted for differences in accounting policies and one-off factors, and each company’s forecast 2000/2001 results, adjusted for differences in forecast assumptions and one-off factors. Under the direction of management, we compiled projections of each company’s future performance using this base financial information, adjusted for known changes, and a consistent set of assumptions provided by the companies.
9. Of the options available to assess the respective value ranges of both businesses, we consider the approach we have been asked to take is reasonable in the circumstances, having regard, in particular, to:
 The complex organisational structure that links both companies and the New Zealand Dairy Board. Of particular relevance in this context is the dynamic nature of the transfer pricing arrangements that are employed which means that we will inevitably need to rely to a large extent on judgements of industry experts on the likely apportionment of New Zealand Dairy Board revenues between the companies.
 The dynamic nature of the sector, where forecasts are dependent on assumptions about commodity prices which are subject to fluctuations and milk production levels that are subject to seasonal variation.
 The different accounting policies with respect to depreciation between the companies, which means that the capitalisation of EBITDA approach (in conjunction with a limited DCF approach) rather than the capitalisation of EBIT will give a more reliable indicator of the relative values of the two companies on a per kilogram of milksolids basis.
10. Sensitivity testing undertaken around these valuations indicated that flexing most variables (such as the EBITDA multiple, terminal growth rates and WACC) alters absolute values but, as might be expected, has a much smaller impact on the relative value difference.
11. Changes to assumptions regarding the relative sharing of industry revenues under the Commercial Pricing Model (and the gross margins applicable to them) proved to have a greater impact. The difficulty of forecasting these particular revenues (or of establishing any clear pattern in them over the short time the Commercial Pricing Model has been in operation) has been a significant problem in the course of this valuation exercise.
12. After considerable dialogue with the two companies on this issue, we favoured the view that, over time, NZDB revenues would be shared more or less according to industry market shares in the longer term.
Respective Values of Each Company
13. The single range for each company from the application of the approach summarised above is as follows (per kilogram of milksolids forecast to be supplied to 31 May 2001) if no account is taken of the proposed equalised FY2001 payouts;
 Kiwi $4.52 – 4.96 with a mid-point of $4.74
 Dairy Group $4.63 – 4.95 with a mid-point of $4.79
14. The difference between the mid-points of the assessed value ranges for Kiwi and Dairy Group is therefore 5 cents in favour of Dairy Group. This difference is less than the 20 cent threshold agreed between the parties in the Merger Agreement and, as such, we note that no compensating or equalising payment is necessitated as part of the Merger Proposal. When expressed in cents per share the difference between the mid-points is 1 cent in favour of Dairy Group.
15. If account is taken of the proposal to equalise FY2001 payouts, the range for each company is as follows (per kilogram of milksolids forecast to be supplied to 31 May 2001):
 Kiwi $4.61 – 5.05 with a mid-point of $4.83
 Dairy Group $4.63 – 4.95 with a mid-point of $4.79
16. The difference between the mid-points of the assessed value ranges for Kiwi and Dairy Group if account is taken of the proposed FY2001 equalised payout is therefore 4 cents in favour of Kiwi. When expressed in cents per share the difference between the mid-points is 3 cents in favour of Kiwi.
17. The differences in the respective value per kilogram of each company are small – approximately plus or minus 1% of Dairy Group’s capital value, for example. Given the inevitable uncertainties relating to forward-looking forecasts, particularly in the context of the complex organisational structure that links both companies and the NZDB, and the dynamic nature of the environment in which the sector operates, our view more generally is that no material difference exists in the respective per kilogram values of both companies.
18. This outcome is unsurprising given the existing structure of the industry under which:
 the export production of both companies is almost exclusively marketed through the NZDB; and
 the two companies account for almost all export dairy production, and each faces strong incentives to monitor and respond to the strategies of the other to ensure that factors like the Commercial Pricing Model do not lead to permanent differences in relative shares of NZDB surpluses.
19. Accordingly, each company could be expected to track the performance, investment and payouts of the other over the medium term, on a per kilogram of milksolids basis.
Assessed Commercial Benefits of the Merger
20. We have also been asked to consider whether the valuation aspects of the Merger Proposal (many other terms not having been determined at this point) are commercially reasonable and in the interests of all shareholders.
21. In forming our opinion, we have had regard to the merger benefits identified by the management of Kiwi and Dairy Group. The projected benefits are tabulated below and are explained in more detail in a business case prepared by the chief executives of Dairy Group and Kiwi.
22. We have confined our advice to a review of the likely position of shareholders in Kiwi and Dairy Group if a merger proceeded under the Merger Proposal relative to the likely position of those shareholders if the current industry structure were to be maintained. We have not considered other possible counterfactuals.
23. We note that the potential commercial benefits of the merger have been projected to be in the order of $310 million annually by the management of Dairy Group and Kiwi. In broad terms, these comprise three categories of benefit – cost reductions (category 1), productivity improvements (category 2) and strategy gains (category 3). Even if we confine our analysis to the Category 1 benefits – those which derive from identified, tangible cost savings – these have been quantified as $120m per year (albeit offset in year one by one–off costs) or some 12 cents per kgms. These savings arise annually and convert to a capital value (on a DCF basis) in the vicinity of $1b, or $1 per kg (compared, for example, to the assessed value differences of between plus or minus 4-5 cents per kilogram noted above). The total benefits identified (including the less certain Category 3 benefits) are significantly greater than this amount (though also progressively less certain).
24. In the light of the minor differences in the value of each company on a per kilogram of milksolids basis which are far outweighed by projected benefits of the merger, it is the view of AACF that the terms of the Merger Proposal as they relate to valuation issues are commercially reasonable and are in the interests of all shareholders of both Kiwi and Dairy Group.

Yours faithfully

Alex Duncan, Director
Duncan Wylie, Director

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