Financial commentary

Review of financial statements: holding the line through recession

A dull glow at the end of the tunnel?

The Marlborough Lines Group recorded earnings after tax of $2.040m for the 2011 financial year and $12.917m inclusive of revaluation gains. The operational result is – on the surface of it – a 63.6% decrease over the net income recorded for the previous year and a more significant reduction (81.3%) over the target figure for the year. In reality the reported Group net result includes the effect of a goodwill write-off in one of the equity accounted investment companies which impacts the bottom line by $6.274m. Thus, without this non cash charge, the Group would be reporting a net operating surplus of $8.314m – a much healthier result.

Total comprehensive income for the year was boosted by net revaluation gains totalling $10.877m added ‘below the line’ to give a total of $12.917m. The revaluation gains arose from cyclic revaluations of infrastructure assets in Nelson Electricity and the OtagoNet Joint Venture.

The profitability comparisons included in this report are made against the first set of company estimates from January/February in the preceding year, rather than the revised estimates adopted by the Company as the year progresses.

With the later arrival of the recession into the Marlborough region the Company has had an opportunity to reassign contracting staff into maintenance work as the flow of private customer work has reduced. This has allowed for additional catch-up work in relation to vegetation control (trees/line clearances) and the reprogramming of some capital renewals. In maintaining a contracting workforce of about 90 staff in the Marlborough area there is always a fine balance between satisfying external demand for construction of private lines and maintaining the Company’s core infrastructure asset. The allocation of more staff into maintenance work during the year meant that by year end the original profit forecast had been reduced by approximately $1.050m.

In addition to this reassignment of resources, the Company also faced additional unbudgeted expenditure from one significant storm event on 28 December 2010. This storm caused disruption to supply over a wide area, blocked roads and damaged lines. Coming as it did in the holiday period this storm brought significant additional costs through overtime payments, travel through other regions to access faults and the provision of temporary generation in a number of rural areas. We also provided assistance following the Canterbury earthquakes at no cost.

Following a decision by all network companies within the greater Marlborough Lines Group to hold network charges for the previous financial year as a measure to assist during the recession, charges in all areas rose again in the 2011 year. Marlborough Lines increased prices by an average of 5.7%, whilst OtagoNet and Nelson Electricity both being subject to the Commerce Commission’s ‘default price path’ (DPP), increased prices by 12% and 7.5% respectively. The winter of 2010 brought mild conditions with electricity consumption for the year being reduced in all three areas. Network revenue in the Marlborough region still increased by $1.260m, as a result of the price increase.

Operating earnings after tax for the Parent company increased by 23.7% over the previous year but fell short of target – see table on

Turnover for the Group and Parent at $48.056m, was 2.7% ahead of target and 8.62% ahead of last year. Turnover for the Group and Parent is the same, and any net surplus available to the Group from the investment companies is equity accounted rather than taken as a share of revenue and expenses, as would happen in a conventional consolidation. (See section on Accounting for investments – page 74.)

Interest costs for Parent and Group increased ($1.552m this year compared to $666,000 last year) as a result of an increase in net borrowings from $22.5m to $38.1m and as a result of taking up further interest rate hedges over the next two to five years. As at 31 March 2011 the Company had moved to apply interest rate hedges against $25.0m of the $38.1m total debt. (See note 22.2 Interest rate risk on page 108 of the financial statements.) As with any interest rate hedge the main intent for the Company is to fix a proportion of the interest rate exposure going forward. The Company will look to maintain interest rate hedges on a similar proportion (about 65%) of its term debt going forward given the current upward outlook for interest rates.

Interest cover for the Group at 7.25 times, was lower than in recent years but predictable given the increased loan quantum and move to hedge interest rate risk going forward.

The Directors are satisfied with the financial results and in particular the returns from investment companies. (See Review of investments section page 71.) There are some signs that the economic recession might be easing with firmer primary produce prices nationally, and signs that Marlborough’s principle industry – the wine industry – is stabilising after a period of uncertainty. (See later section on ‘The trading environment’.)

Regulation – we are currently setting our own price path

Marlborough Lines has for the last two years been categorised under the current Commerce Commission regulations as ‘exempt’. Exempt status is available to community owned networks and the most significant advantage is freedom from the price/revenue control requirements. In theory ‘exempt’ companies have a circular form of ownership which allows the consumer owners to effect changes to boards of directors if dissatisfaction exists to a sufficiently serious level. Co-incidentally, provision exists within the Commerce Act for consumers to petition the Commission to bring exempt companies back under price/revenue control.

Thus for the moment Marlborough Lines is in charge of its own pricing, a position which helps the current Board set prices to reflect maintenance requirements and which allows a revenue contribution to the current (relatively) high level of capital works.

For the non-exempt networks in which Marlborough Lines has investments (Nelson Electricity, OtagoNet and Horizon Energy), the Commerce Commission has again changed the rules; such that individual price paths could now apply instead of the one size fits all 2.5% increment initially announced as the ‘default price path’. These individual price paths could bring retrospective adjustment, impacting current revenue streams. (See Regulation section.)

All network companies remain subject to the information disclosure requirements which provide for annual regulatory financial statements – not GAAP compliant, standard regulatory asset valuations and a range of performance/reliability statistics which demonstrate the Company’s trends in service reliability. These disclosure requirements are reported on in August each year.

The trading environment – we are trying to stay +ve!

Problems in the trading environment have been well illustrated this year. This year accounting revaluations of electricity network assets were undertaken in two of the investment companies. These revaluations are based on replacement values. Whilst the country might be in an economic recession the cost of imported network components continues to rise. In the Nelson network the effect of these cost increases would have seen the network value increase by about 50% in just three years. The increase is mostly due to the escalating value of metal raw materials, increased demand for components worldwide and also the variability in the New Zealand dollar.

Companies in the Group continue to undertake currency hedging in relation to the larger items sourced offshore such as zone substation (Marlborough Lines buys 33/11kV transformers from Vietnam) and also steel poles sourced from Australia but manufactured in Asia.

The current economic recession has impacted on the level of private work (line building and maintenance) available, however as noted last year both Marlborough Lines Contracting and Otago Power Services were able to maintain staffing levels by diverting resources into maintenance and capital expenditure works within their respective associated networks. The financial result is affected through reduced profits posted in relation to external contracting work. Additionally all companies within the greater Group have been fortunate to be able to retain staff in the face of continued overseas demand for qualified engineering and technical staff.

Although trading conditions have been tight, both contracting companies have recorded good results. The emphasis in terms of infrastructure work has turned from system expansion to renewals, upgrades and reliability improvements and reducing backlogs of maintenance in both Marlborough and Otago.

All three networks within the Group experienced a reduction in electricity sold across their networks. The combination of a very mild winter, the recession and possibly an accumulating resistance to retail electricity price rises in recent years served to reduce energy sold across the Marlborough network by 2.03%. Similar percentage reductions (Otago 0.05%, Nelson 2.58%) were recorded in the investment companies.

Regional economies affect electricity networks to the extent that expanding economies demand more capacity and connections. Recession, as we are currently experiencing, has brought investment growth to a virtual standstill. This has caused an inevitable contraction in those businesses involved in development work. This will last until there is confidence to resume investment spending.

Although on a national basis commodity prices for timber, milk derivatives and meat have shown improvements over the past year, the same cannot be said for wine and aquaculture which underpin much of the economy in the Marlborough region. The wine industry is undergoing an inevitable period of restructuring whilst a system of more stable raw material pricing is established and undercapitalised players are eliminated. The emphasis for Marlborough Lines at this time must be to consolidate and ensure that there are systems in place to deal with the next cycle of growth.

Investment income – making investment dollars work

Dividend income flowing from Nelson Electricity to Marlborough Lines increased from $0.708m for the 2010 year to $0.900m in the current year. Nelson did increase network charges during the year but also experienced a reduction in domestic electricity consumption. The distribution policy adopted by the Nelson directors is that generally dividends will equate to tax paid profit but that this will also depend on immediate requirements for capital expenditure and a review of borrowing capacity.

Dividend income received from Otago Power Services and OtagoNet is channelled through the subsidiary Southern Lines Limited. Southern Lines then transfers the funds to Marlborough Lines either as interest on its shareholder debt or as dividends.

Dividend and interest funds received by Southern Lines from southern investments this year totalled $5.530m (2010 $5.454m) and was remitted to Marlborough Lines as interest ($5.530m) on shareholder loans.

The Marlborough Lines Parent company uses equity accounting to take up the undistributed profits of Nelson Electricity and Southern Lines must also use the same system to book its share of the undistributed surpluses of Otago Power Services and OtagoNet. In the 2010 year these equity adjustments totalled $4.784m (debit) as a result of a goodwill write-off in the OtagoNet Joint venture. This was more than offset by a net revaluation credit of $10.877m listed in the ‘Other comprehensive income’ section of the Income Statement.

Equity accounting is required to be used in accordance with the New Zealand equivalents to the International Financial reporting Standards (NZ IFrS). The use of equity accounting whilst technically correct results in Group numbers which are only marginally different in a number of key areas from the Parent company accounts. Application of the New Zealand equivalents to the International Financial reporting Standards is mandatory given the size of the Parent entity, Marlborough Lines Limited. (See separate section on Accounting for investments.)

Taxation – one of two certainties in life

Parent company tax expense for the year at $2.856m comprises current tax payable, $2.455m, prior year adjustment $36,000 and deferred tax expense of $365,000. This was lower than the original estimate due to the Government’s confirmation in the May 2010 budget of a reduction in the tax rate from 33% to 28% from 1 April 2011 and the consequential effect on deferred tax liability.

In general terms the tax liability accruing from OtagoNet (a joint venture) is borne by Southern Lines. Since the acquisition of OtagoNet, tax credits have accumulated in Southern Lines arising from the higher tax depreciation uptake in the OtagoNet Joint venture. These credits have offset the tax liability arising in the Marlborough Lines Parent. With revaluations in the joint venture to the point where accounting book values now exceed tax book values the accumulated tax credits are now steadily reducing.

The combined Group tax expense at $2.869m comprised current tax $2.427m, prior period adjustment $36,000 and deferred tax expense $406,000.

The adoption of NZ IFrS (as noted in previous years) requires the creation of a deferred tax liability equal to the tax effect of the difference between the accounting and tax values of the revalued infrastructure assets. In the first year of adoption (2008) retrospective adjustment was also required. By 2011 this ‘liability’ has increased to $43.018m in the Parent company and $50.430m in the Group.

During 2011 further asset revaluations were undertaken in Nelson Electricity and OtagoNet. At Group level this added $10.877m to the asset revaluation reserves and infrastructure asset values. The credit to asset revaluation reserves was reduced by the associated deferred tax charge (debit). A further complicating factor is the effect of the projected tax rate change such that the supposed reduction in deferred tax (from the rate reduction), is also a credit to revaluation reserves.

Financial indicators

	GROUP ACTUAL 2010 $m	GROUP TARGET 2011 $m	GROUP ACTUAL 2011 $m	GROUP TARGET 2012 $m	PARENT ACTUAL 2010 $m	PARENT TARGET 2011 $m	PARENT ACTUAL 2011 $m	PARENT TARGET 2012 $m
EBITDA	16.162	22.336	14.048	20.485	15.143	21.536	18.832	19.485
EBIT	8.911	14.828	6.461	12.726	7.923	14.028	11.277	11.726
Earnings After Tax	5.611	10.915	2.040	8.409	5.552	10.379	6.869	7.409
Shareholder's Equity	222.443	230.786	233.610	240.269	211.467	219.574	217.492	222.872
Current Assets	11.401	9.120	9.095	10.809	9.170	9.120	9.095	10.809
Non Current Assets	288.249	295.396	317.957	333.824	275.331	282.249	296.686	311.553
Current Liabilities	6.535	6.241	4.407	3.866	6.536	6.241	6.666	6.066
Non Current Liabilities	70.672	67.489	89.035	86.564	66.498	65.555	81.623	78.064