Correspondence

 

5 June 2009

 

Bruce Sheppard

Chairman

New Zealand Shareholders Association Inc.

C/- PO Box 6310

Wellesley Street

 

 

Dear Bruce

 

Thank you for your letter of 21 May 2009.

 

The analysis within your letter raises a number of queries with regard to Vector Limited’s financial position as at 30 June 2008. I have summarised these as follows:

 

(a)   An analysis of certain financial metrics for Vector Limited (“the Group”) relative to your view on whether these would be acceptable to banks under the relevant lending covenants;

 

(b)   The level of foreign currency risk faced by Vector Limited;

 

(c)   The pricing relating to Vector Limited’s electricity distribution networks;

 

(d)   The level of equity capital held by Vector Limited; and

 

(e)   The rationale for the ongoing share buyback.

 

You have also specifically requested a response to the analysis in your letter, together with disclosure of the Group’s financial covenants to its bankers and the trustee of the capital note issue and underlying ratios as at 30 June 2008.

 

You have further requested for disclosure of the cost of funds for each of Vector Limited’s foreign denominated borrowings, together with disclosure of the hedging arrangements in place.

 

The company does not and has no plans to disclose either financial covenants in place with any of our bankers or other financiers as we consider these to be commercially sensitive and confidential between Vector and its financiers. However, I would note that Note 26 to the financial statements disclose that the lending covenants in place for borrowings had all been met at 30 June 2007 and 30 June 2008. Any breach would be disclosed to the market immediately to maintain full disclosure.                             

 

In terms of the analysis of financial metrics outlined in your letter I would note the following.

 

The carrying value of borrowings as at 30 June 2008 of $3,163,573k, as disclosed in Note 26 to the Group financial statements, represents the total indebtedness of the consolidated Group at that date. This includes debt funding relating to the Wellington electricity network, which was subsequently sold on 24 July 2008. The consolidated financial statements as at 30 June 2008 also disclose the cash and cash equivalent balance to be $53,581k.

 

As this network was classified as available for sale at 30 June 2008, the EBITDA result from this network was classified as a discontinuing operation.

This EBITDA figure was $92,089k (as disclosed in Note 1 to the financial statements).

 

Accordingly, for a valid financial metric to be calculated for the purposes of your analysis, the EBITDA figure utilised in the calculation of the Debt to EBITDA metric should be $547,922k plus $92,089k ie, $640,011k. The Debt to EBITDA metric calculated using this EBITDA figure would be 4.94.

 

If the Debt figure were to be netted against the cash position of the Group, as I understand many financiers calculate debt related covenants, this would give a net debt position as at 30 June 2008 of $3,109,992k. Recalculating the metric based on net debt and total EBITDA figures as at 30 June 2008 gives a figure of 4.86.

 

With regard to the other metrics calculated in your letter, these underlying figures have been correctly extracted from the Group’s consolidated financial statements as at 30 June 2008 and the metrics correctly calculated from a mechanical point of view.

 

Your analysis then compares the figures calculated to your view on a bank’s relative level of discomfort with regard to the absolute values for these metrics.

 

It is not clear from your letter how you arrive at the determination as to the values of financial covenant ratios that a bank would consider to be inappropriately high from the point of view of a company’s financial stability.

However, I would note the following points.

 

Vector Limited as an entity is currently rated by Standard and Poor’s. As at 30 June 2008 was rated as BBB+, a rating it still currently holds. Standard and Poor’s annual rating review includes a detailed assessment of similar financial covenants to those outlined in your letter.

 

Secondly, in the Group’s interim financial statements for the six months to 31 December 2008, the level of borrowing is disclosed at $2,783,998k in Note 7 to these financial statements. Note 8 also outlines that $560m of bank loans were repaid following the completion of the sale of the Wellington electricity network on 24 July 2008. The cash position, including amounts on term deposit, of the Group was $267,632k as at 31 December 2008. 

 

On 4 March 2009, Vector repaid $200m of NGC bonds utilising the same amount of cash funds held on deposit.

 

The recently completed retail bond issue for $150m was separately rated BBB+ by Standard and Poor’s.

 

With regard to your comments as to whether the Group has suffered the currency risk fluctuations you outline in your letter, I note the following.

 

The Group fully hedges the foreign exchange risk relating to its foreign denominated debt.

 

On page 52 in the Interest Rate Risk section of Note 27 of the financial statements, disclosure is given in relation to the hedging of all of the foreign denominated borrowings – for each of the Australian dollar, US dollar and British Pound debt issues its states that the method of hedging employed and in all cases discloses that the foreign exchange risk is eliminated through this hedging arrangement.

 

Furthermore in the Hedge Accounting and Sensitivity Analysis section of Note 27, it states that “cross currency swaps hedging the foreign currency denominated debt are hedge accounted and treated either as a cash flow hedge or a fair value hedge depending on the risk being hedged. Any changes in fair value arising from foreign exchange movements will have no impact on the profit as the receive leg of the cross currency swap exactly offsets the coupon payments of the underlying exposure.”

 

As a result of this hedging programme, the Group has not suffered the currency risk fluctuations you outline in your letter.

 

With regard to your query on the cost of funds for foreign denominated debt, on page 50 of the Interest Rate Risk section of Note 27 to the 30 June 2008 financial statements, the weighted average interest rate for each category of borrowing is disclosed. Furthermore, the

receive and pay legs of the cross currency swaps hedging the foreign denominated borrowings are also disclosed on page 52 of the same note.

 

 

With regard to your comment “you clearly operate in a monopoly environment”, I would note the following points.

 

Since 2003 Vector has been operating under a price path set by the regulator and so it is incorrect to state that “you cannot expect to continue extracting monopoly pricing without attracting regulator interest”. To the contrary, Vector has been pricing to levels prescribed by the Commerce Commission since this date.

 

The monopolistic nature of then Group’s electricity distribution and Auckland gas distribution networks is such that these activities are subject to regulatory price path control. The Commerce Commission as regulator constrains price increases to a price path of CPI-X, which ensures price increases cannot increase greater than prescribed by the Commission. In Vector’s case, the X value is zero; hence its prices can only increase by CPI. The regulator reviews and resets this price path on typically a five year period. A key factor the regulator needs to take into consideration is the need for regulated companies within this regime to earn commercially appropriate returns on investment.

 

 

The Commerce Commission is due to reset the electricity path in the next 12 to 18 months. For your reference, the graph above shows price increases in the electricity sector between energy generation/retail and network lines businesses, such as Vector. I think it speaks for itself.

With regard to the level of equity capital held by the Group, it is inappropriate for Vector to comment of the intent of any shareholder including the Auckland Energy Consumer Trust.

 

With regard to the appropriate level of equity capitalization relative to debt funding for the group, I refer you to my comments under the heading “Financial Analysis”.

 

 

As stated in Vector’s market announcement on 1 August 2008 of its intention to conduct an on market share buyback, “Vector’s board currently believes its shares are undervalued by the market and therefore represent an attractive risk-return proposition for its shareholders”.

 

As at 26 May 2009, 4,244,923 shares had been purchased under the buyback.

 

 

I trust this response addresses the queries and concerns raised in your letter of 21 May 2009. If you would like to discuss this, please feel free to call me.

 

 

Yours sincerely

 

 

Chairman