You Can’t Blame the Government for SPC

Greg CanavanJanuary 31, 2014

We’ll try and ignore markets for today…they need a little time to themselves. Are they happy about strong rear view mirror economic growth in the US, or worried about the Fed’s continued taper and its effect on emerging markets?

They don’t really know, but it seems like the Aussie market can’t get excited about too much these days. We’re clearly on the emerging markets side of the fence in the eyes of foreign investors. Our proximity to China now looks detrimental, rather than beneficial.

You might think this is another bearish sign for commodities, but don’t be disheartened. These events could just be setting up gold and commodities as a tremendous long term buy this year. We won’t go into it now, but check you inbox this weekend for details.

Today we’re going to leave this confused market to work things out for itself. It needs some time alone. Instead, we’ll ask the question: Is it government’s role to protect jobs?

We ask because the issue of handing fruit processer SPC Ardmona a lazy $50 million to keep its Shepparton based plant running has become a major talking point. If you’re not aware, owner Coca Cola Amatil [ASX: CCL] has asked the State and Federal Governments to chip in $25 million each to modernise its Shepparton fruit processing plant. CCL will invest $90 million.

Why won’t CCL put in the whole amount? Because it’s return on invested capital won’t make the investment worthwhile. Only $50 million in ‘free’ government money will reward shareholders enough for the ‘risk’ they are taking.

The Federal government yesterday rejected the request, a decision that has drawn plenty of criticism from parts of the mainstream media, and obviously, unions. Why it’s not CCL copping the brunt of the criticism is strange.

Maybe it’s because people instinctively realise profit seeking organisations won’t invest money when they know the returns are sub-standard. Which is why they turn to the government. Apparently the government has a bottomless pit of money and can provide subsidies when there are jobs on the line.

We don’t think it’s the government’s role to subsidise every (or any) inefficient plant or factory in Australia. But where it becomes tricky is when you’re dealing with the actions of other governments, or industries that are not regulated in the same way as Australia’s.

Then you get arguments of ‘cheap imports’, ‘not a level playing field’ etc. But it is what it is. The market is clearly voting by buying products that are cheaper than SPC’s. The regulations, whatever they are, that dictate SPC’s production clearly do not add enough value in the eyes of the consumer to make them switch to a higher priced product. Fruit is a commodity…and when it’s in a can it’s pretty much all the same…so price wins out.

We reckon the over-arching problem is prolonged underinvestment by CCL. From memory CCL bought SPC around 10 years ago. It paid a decent price, but the fruit processor has struggled ever since. A stronger dollar and rising labour costs since that time no doubt contributed to its woes.

If the return from the initial investment was low, CCL would not have rushed to invest more to improve productivity. It’s likely that CCL simply used the business as a cash cow, running it for cash flow while avoiding additional capital expenditures that would have only generated a below average return.

Don’t forget, CCL is a highly profitable company…any capital it had to invest was much better off going into the main soft drink distribution business.

But it obviously got to a point where CCL had left a major capital upgrade too long. And after doing some due diligence, they realised they needed to invest nearly $150 million to get the place in order.

‘That’s a lot of money,’ the board says.

‘But if we don’t invest now, things will continue to deteriorate…we’ll have to walk away and write off our investment; shareholders won’t like that,’ says management.

‘Well, ask the government to chip in,’ says the board, ‘they won’t want to see jobs in the areas go. Actually, ask state and federal government, we’ll get both to chip in.’

That’s all speculation on our behalf, of course. But it makes sense to us.

And in this case, we think CCL has managed the business poorly. They failed to invest and take some short term pain to improve productivity. They were beholden to the share market, who would’ve pushed their share price lower on news of any major capital expenditure.

But if you really want to go back to the source of the blame, give Ben Bernanke a call. His QE policy helped set off a boom in China, which set off a terms of trade boom in Australia. This pushed our currency and wage rates to record levels and made things like locally produced canned fruit pretty expensive.

See what easy money does? It enriches the bankers at the expense of the workers.

But the good news is that the dollar is coming back down. Meaning canned fruit import prices will get more expensive. It’s all thanks to China, which is slowing and will slow much more rapidly than most people think this year.

And because the rest of the world views Australia as an appendage to China, such a slowdown will see our currency continue to fall against the majors like the US dollar and the euro.

As we said yesterday, news from China will be pretty quiet for the next few days, as everyone is on holiday. That’s probably why gold took a beating overnight. There’s no one around in China to buy the hedge fund selling-induced dip…making the short sellers’ profits that much easier to collect.

But no news is not good news on the China front. That being the case, we’ll leave you with something to ponder for the weekend. It’s what investment bank BNP Paribas, calls ‘perhaps the most dangerous misconception concerning the Chinese economy‘.

From Alphaville:

…(it’s) ‘the self-limiting argument that, because the Chinese authorities have been able to exert an impressive degree of control over cyclical volatility for many years, this will necessarily continue to be the case. This argument manages to conflate bad economics, poor history and unsound logic. The key lesson of the global financial crisis is that long periods of stability actually sow the seeds for bouts of future instability: the greater the apparent degree of control and stability, the greater the build-up of hidden vulnerabilities.‘

Regards,

Greg Canavan+
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Greg Canavan

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing.

He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’.

Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors.