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Southern Capital Executive Chairman's Review

Executive Chairman's Review

The 2002 year end result is Southern Capital’s fifth year of operation and third as an NZSE listed public company. Our investment activity this year has been conditioned against a background of an uncertain international economy, volatile and generally weaker equity prices and some easing of the strong domestic economy that has prevailed over the last couple of years.

Overview

The profit for the year of $5.15 million had been earned by the first half and the second half yielded a loss on the sale of Flight Centre and general overhead expense. The sale of Flight Centre provided us with a strong balance sheet and enabled the Hirequip investment to be consummated after balance date.

Highlights of the year were:

- Winning planning approval in the Environment Court for the re-zoning of the Pegasus Bay Town site from rural to a special town zone. This has been a lengthy and difficult process but ultimately justified as a number of precedents have now been set which are useful for other developments.

- Stage 3 development at Omaha was committed and sales to date within this new subdivision area are more than twice the cost of development. Titles are expected to be ready for settlement by April 2003.

- Stage 2 construction at the Canterbury Supa Centa is nearly complete. Woolworths Supermarket opened 13 April and several other smaller tenants are now settled as well. The development has an ideal mix of tenants ranging from bulk retail and a supermarket to smaller specialty retail outlets.

- Since receiving the large distribution payment $17.5m pursuant to the liquidation of Tasman Agriculture, SCL’s balance sheet has been strong and we have been looking for new assets to buy. It has taken 6 months to reinvest the funds from Tas Ag but patience in an uncertain environment is best. Due diligence was completed on four prospective investments between December 2001 and May 2002 before we started working on Hirequip.

The Hirequip deal sees SCL enter into a 50:50 partnership with the McKinlay Family Trust. Stuart McKinlay is the founder of Hirequip and has been the Managing Director throughout its growth from a single branch in Dunedin until today – 36 branches nationwide.

We are very pleased to be able to partner Stuart and initiate new growth strategies for Hirequip.

Financial Accounts

The SCL Group generated net profit after tax of $5.15 million for the year. This compares to a surplus of $1.36 million for the previous financial year and $6.14 million at half year.

As highlighted in our interim report, a significant part of the profit was attributable to the unlocking of value within the former Tasman Agriculture Limited (Tas Ag). This occurred upon the liquidation of Tas Ag in November 2001.

Profitability was also derived from the successful completion of the Villa del Lago development and the on-sale of the Gorge Road development property in Queenstown.

In the second six months, the Groups net profit was negatively impacted by the $1.56 million loss on sale after selling costs of the Flight Centre building situated at 48 Emily Place, Auckland.

From a cash flow perspective, the distribution from Tas Ag in November 2001 generated a surplus of $1 million after the repayment of all debt raised to undertake the investment. The settlement of all the units of the Villa del Lago development and the Gorge Road property in Queenstown repaid almost all of the Queenstown project-related debt. Upon settlement of the Flight Centre building in May 2002, the Group was left with cash on hand of $4.1million, after all the Group’s core borrowings were repaid.

Since 30 June the Group’s balance sheet has been re-geared to undertake the purchase of 50% of Hirequip Holdings Limited for $17.35 million.

Equity Investments

Tasman Farms Limited (21.75% owned)

Tasman Farms (TFL) owns all of the Tasmanian farming interests previously held by Tas Ag.

The final liquidation of Tas Ag has not yet been completed but we still expect a final distribution of 5c per share. Nearly all assets are either cash or near cash and the issue to be resolved before final payments to shareholders can be made relates to finalising water supply on a farm sold last year.

As all shareholders will be aware of by now, the forecast dairy payout from Fonterra is projected to drop to between NZ$3.50-$3.70/kg milk solids compared with the record payment of NZ$5.30/kg MS in 2001/2002. In Australia, the majority of TFL’s farms supply milk to Bonlac, which has indicated a similar percentage fall in payout for the current year. This outlook has been driven by falling dairy commodity prices and stronger currencies in both NZ and Australia.

Commodity prices appear to have stabilized now but there is no clear view that a recovery is imminent.

TFL Statistics YE (31 May) 2002 2001

Number of farms - Van Diemens Land 10 10

- Other Tasmanian farms 12 13

Effective Ha - Van Diemens Land 4,293 4,266

- Other Tasmanian farms 1,795 1,897

6,088 6,163

Milking cows - Van Diemens Land 9,069 8,465

- Other Tasmanian farms 4,424 4,733

13,511 13,198

Production (Kg/Milk Solids (m)) - Van Diemens Land 2.311 1.214

- Other Tasmanian farms 1.235 1.348

3.546 3.562

Farm valuation at book value ($/effective Ha)

- Van Diemens Land A$6,001

- Other Tasmanian farms A$7,259

- cf. NZ South Island average sales NZ$17,000-$18,000

For the 12 months to 31 May 2002, TFL produced an excellent result reflecting buoyant commodity prices and low NZ and Australian dollars. Reported net profit after tax was NZ$6.13m and shareholders funds, after revaluing farms to independent valuation, were $44.2m or NZ 66c per share. Although TFL shares have recently traded at or below 40c, this is an unduly pessimistic view of value. At this share price the implied value of the dairy farms would be discounted significantly below levels which are already low relative to NZ farm values.

In order to maximize profitability in times of reduced revenue, TFL has instituted a number of measures:

- Bring forward calving as early as possible in order to maximize production and reduce reliance on end of season production when climate is sometimes prone to dryness.

- Reduce expenses where possible.

- Adopt hybrid forms of sharemilker/manager agreements which differ from the traditional 50:50 sharemilker or 100% owned management agreements. In some instances TFL owns the dairy herd but still provides some revenue and cost sharing with the manager to provide incentivisation.

BLIS Technologies (10.5% owned)

BLIS has continued to meet commercial milestones and notwithstanding a weaker share price we are happy with progress made. Key events were:

- BLIS K12 Throatguard was launched during the winter with a very high penetration into pharmacy outlets. Sales have been ahead of expectations and although this is not significant financially in a NZ context, it is significant if extrapolated on a per head of population basis to overseas markets.

- Launch of K12 in Germany is expected in January 2003 with a distributor signed up. Potential distributors are also being screened in other large markets.

- Successful pilot trials have been carried out on a product which helps prevent tooth decay and large scale trials are now underway at the University of Otago School of Dentistry. This product contains BLIS-producing bacteria that inhibit the re-growth of Streptococcus mutans, one of the key causes of tooth decay. This is a product with large scale international potential.

- BLIS cash position is $1 million better than forecast in its listing profile due to savings made in product development.

- The research team has moved into a new laboratory in the Centre for Innovation at Otago University.

The company is also working on other products for bovine mastitis, middle ear infections, as well as screening for further opportunities amongst the extensive collection of BLIS-producing organisms owned in its portfolio.

A2 Corporation (8.9% owned)

The company has commissioned a series of scientific experiments to independently verify the claims made about A2 milk as compared to A1 milk. Whilst the final test results have not been published it is understood that the results received to date confirm strongly the proposition of A2 milk and will provide the impetus for its commercial production.

Other Biotech Investments

SCL holds shares in Botry-Zen 4.3% and Pharma Zen 5.6%. Both stocks were purchased upon IPO at 10 cps. Botry-Zen currently trades at 20 cps and Pharma-Zen at 14 cps. Both companies have management appointed and Botry-Zen is considering a full listing on the NZSE.

Biotech Stocks Market Value vs Cost

Stock Market Price Cost % Gain Years Held

BLIS 44c 10.7c 311% 2.0

A2 22c 3.1c 610% 2.5

Botry-Zen 20c 10.3c 100% 1.0

Pharma-Zen 14c 10.0c 36% 0.8

Hirequip (50% owned)

After balance date, on the 20th August, SCL announced the purchase of 50% of Hirequip for $17.3 million. The other 50% is being retained by the family of Mr Stuart McKinlay, who is also the Managing Director.

A private company based in Dunedin, Hirequip is New Zealand’s only nationwide general and specialist equipment hire company, operating from 36 locations throughout the country.

Established in the early 1950s, the company acquired Projex in September 2000. This saw Hirequip become New Zealand’s largest hire company at around twice the size of its nearest competitor. Its revenues now exceed $50 million annually.

Hirequip’s product catalogue is diverse with over 100,000 items for hire from one to 30 tonne excavators, front-end loaders, road rollers, nine tonne trucks, generators, compressors, DIY equipment, right through to a party and function division that provides marquees, toilets, crockery and lighting equipment.

Hirequip’s size brings significant economies of scale in equipment purchase as well as enabling the company to provide specialist equipment for the larger construction projects being undertaken at any one time.

The company has increased its focus on the Auckland market over the last two years and is well poised to benefit from increased infrastructure expenditure planned for the region, given that it is the preferred equipment provider of major roading contractor, Fulton Hogan.

Given the very fragmented nature of the equipment hire business in New Zealand, there is also potential to further grow the company through the acquisition of small providers with a strong local presence.

Whilst it is still “early days”, the current financial year’s trading is shaping up well given the first two months sales and we expect Hirequip to perform well as long as the economy maintains its current momentum. Further, we expect to be able to help initiate new strategic growth strategies in partnership with Stuart.

Long Term Development Projects

Omaha Beach (42.2% owned) www.omahabeach.co.nz

As they say quality property always sells! We have now sold over $54 million worth of property at Omaha since marketing began. This covers titles settled as well as pre-sales contracts on sites currently under development.

Stage 3 development has commenced. This will see bulk earthworks completed for the balance of the site and infrastructure completed for 68 titles to be issued on the front of Neighbourhood 2 (N2) and N3. Sufficient pre-sales have been contracted to cover about twice the cost of the development work.

The nine-hole golf course has been completed within budget and will prove to be an excellent addition to the amenities at Omaha. In addition the stage 1 wastewater upgrade has been completed and a formal monitoring process is in place to measure performance against specification and also volume demands placed on facilities. This information will be used to provide input to stage 2 wastewater expansion.

Subsequent to balance date, Manapouri Developments Limited repaid shareholders’ advances and accumulated interest. On a historical cost basis, SCL now has no funds invested in Omaha albeit the book value has increased through equity accounting.

Goldsworthy Bay (50% owned)

This 41 Ha property was purchased in December 2001. It is located about 15 minutes from Omaha and is an elevated site overlooking the coastline with extensive views.

The property has been subdivided (on a non-notifed basis) into nine country life style blocks ranging in size from 1.28 Ha to 4.05 Ha. Drive-on access has been completed and marketing is underway. Titles are not yet to hand as telephone and power still need to be installed.

One property has been presold. A residual 16 Ha property is being held as one lot as it has been identified in the Proposed Rodney District Council Plan as “Future Urban”. If this is zoned urban in the future then a residential subdivision will be possible.

Canterbury Supa Centa

Stage 2 development is structurally complete and largely leased. Woolworths supermarket is open, as is Smith City Market Power Store and Profitness Gym. A further tenant from a national chain has signed and a further two tenants are in the process of negotiating final terms. If this is successful, all retail space within Stage 2 will have been let. There is some residual first floor office space as yet unlet.

The Centa is trading well and will be cashflow positive after financing costs. Further development opportunity exists for more than 10,000m2 of retail space. We are in discussion with large scale retailers, which could see a significant portion of this committed.

CBD Building – The Flight Centre, 48 Emily Place, Auckland

This last building carried over from the merger with CBD was sold during the year for $7.85 million. This produced a loss on sale of $1.56m. In the final analysis we were unable to add much value to this building in a competitive office leasing market within the Auckland CBD. We took the view that releasing the funds for more productive reinvestment was the best decision, and with the benefit of hindsight this has enabled us to finance the Hirequip investment.

Queenstown

During the year the development at Frankton Road was completed with all units being sold prior to completion. The development comprised 18 units being a mix of single and three bedroom apartments. The sale of the Gorge Road property was also settled during the year.

The remaining property is a 1 acre block, comprising 4 individually titled sections, situated on Vancouver Drive in the area of Queenstown known as the Commonage. The value of the property has continued to appreciate while development options are being evaluated.

Pegasus Bay Town (100% owned)

I informed you in the last Interim Report that we won our plan change application, after 4½ years of hard slog. We have filed an application for costs, which has not yet been heard. The Judge’s decision, whilst approving the plan change in concept, required the precise wording of the plan change to be resubmitted to the Court once it was agreed amongst the parties. This is because the wording needed to incorporate not only the Court’s decision but also the decisions from the earlier Commissioner hearings. The task has been complicated because the District has two plans that require amendment – the transitional plan and the proposed plan. At present, we are in the final throes of finalising the required documentation.

Pursuing the plan change application was the right economic decision to make, notwithstanding that the cost of doing so consumed a substantial portion of our expected profit. The difference between the land zoned for a new town and the land remaining zoned as rural is a factor of 4-5 times. Thus, the win not only ensured that we would make a profit but it also removed a substantial degree of downside risk from our balance sheet.

With the documentation that will enable development of Pegasus Bay Town almost in place, we face important decisions as to when, and/or under what circumstances, we will physically commence development. This is not a decision we will take lightly because we are acutely aware that, once development is embarked upon, valuable options are lost and changing direction for a project of this size becomes like turning a supertanker. We face an example of this at present, where we are discussing with Waimakariri District Council options for supplying potable water and waste water treatment, which include providing these services ourselves (as the plan change requires) or developing them jointly with Council.

Moreover, actual development of Pegasus Bay Town will involve a substantial commitment to capital expenditure and we are cognisant of the potential effects of this on our own balance sheet. For that reason, our preference is to share some of this risk with an equity partner. We are continuing to identify potential partners.

Waimakariri Employment Park & Motorway Service Area (100% owned)

We are cautiously optimistic that we can obtain the plan change that enables both the Employment Park and the Motorway Service Area without the need for an Environment Court hearing. A positive spillover effect from the Pegasus Bay Town decision and several other cases recently decided by the Environment Court in Christchurch, is that some of the issues surrounding the Employment Park project have been clarified; particularly those concerning versatile soils and transportation. This has led to Environment Canterbury withdrawing its reference to the Environment Court against the proposal. The remaining parties, Kiwi Property Management Ltd and Christchurch International Airport Ltd have indicated a willingness to resolve their respective concerns by way of a Consent Memorandum, rather than hearing the case in Court. Also helping the situation is Waimakariri District Council’s decision to take a neutral stand on the plan change application, in light of the last Commissioner’s recommendation to reject it (and the original Commissioners’ recommendation in favour). We hope to be able to make further announcements on this project in the near future.

Clifford Bay Mussels (22.6% owned)

Progress towards obtaining the two permits necessary to develop the mussel farms at Clifford Bay has been frustratingly slow, due in large part to the Ministry of Fisheries’ failure to provide input into a proposed research programme. Despite a successful capital raising within the Clifford Bay group of companies we have decided not to commission the required research until we have surety that:

1. Hectors dolphin is the only matter of concern to the Department of Conservation and Ministry of Fisheries; and

2. The proposed research design is acceptable to all parties with a statutory interest (i.e. DoC, MFish and the Marlborough District Council).

An Environment Court fixture date has been set to hear the appeals on the coastal permit (resource consent) in late February 2003. We continue to work with Ministry of Fisheries in addressing some of their issues relating to the grant of a marine farming permit.

The Future

With the benefit of hindsight, I said in last year’s annual report:

“Today’s business environment is probably more uncertain than this time last year and so new buy-side deals will unquestionably present themselves. Shareholders should see new deal inactivity on our part as good (not bad) because your directors and management will be waiting for high returning investments qualified by acceptable risk.”

I would reiterate that patience in waiting for deals rather than simply doing the best deal available at any given point in time, is an important principle in our investment strategy. Having said this we expect to be able to devote more management time in the next 12 months towards transactions compared with the last period when, for a large part of that time, we had three major projects enmeshed in planning processes.

We will be looking to release some further value from our balance sheet and once this is achieved will review our position as regards investment opportunities and strategy, capital requirements and/or share buybacks.

Graeme Wong

Executive Chairman

12 September 2002


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