Solid Energy’s recent problems highlight once again the issue of corporate governance.

Who is responsible for the company’s difficulties? Why did its borrowings soar from just $15 million in 2007 to $295 million in June 2012 and nearly $400 million at present? Why have the company’s costs nearly doubled over the past five years?

Solid Energy’s recent history begins and ends with Don Elder, the company’s ambitious chief executive from May 2000 until early last month.

Elder was born in Christchurch and educated at Christ’s College and University of Canterbury where he obtained an engineering degree. He then attended Oxford University on a Rhodes scholarship.

Elder worked for 20 years in the United Kingdom, United States, New Zealand and Canada.

He was vice-president of a major Canadian engineering firm before he was appointed head of Solid Energy nearly 13 years ago.

The company’s coal sales grew from 2.8 million tonnes to 4.6 million tonnes under Elder’s tenure, revenue surged from $186 million to $978 million and total assets from $136 million to $1.17 billion.

Most of this growth was financed by retained earnings and borrowings as no new shares were issued to the Crown during this 12-year period.

Elder had a big vision for Solid Energy and believed it would play a major role in New Zealand’s energy development, in addition to coal.

The company’s 2009 annual report noted that the New Zealand economy “depends on energy to survive and thrive” and “Solid Energy is committed to making these energy resources available to support New Zealand’s increased economic prosperity and standard of living”.

However, the company had to make a $26.7 million impairment charge that year because some of its earlier non-coal investments were unsuccessful. These impairments included investments in biodiesel and coal seam gas.

In 2010 there was a big step up in capital investment with the company spending $191 million.

As the accompanying table shows nearly 40 per cent of this was financed through borrowings, which increased from $62 million to $137 million during the year.

The 2010 report also noted potential lignite developments in Southland, a feasibility study for a coal-to-fertiliser plant and a $34 million wood pellet fuel plant in Taupo.

The 2011 report commented on a $22 million underground coal gasification plant in the Waikato and a $25 million lignite briquette plant in Mataura.

Total capital expenditure that year was $115 million, mostly on the Stockton mine and processing plant but large sums were also spent on coal seam gas, lignite gasification, briquetting and renewable energy.

The 2012 result was dominated by a massive impairment charge of $149 million which was taken below the gross profit figure in the accompanying table.

As a consequence, the company reported a net loss of $40 million yet paid a $30 million dividend to the Crown.

The biggest disaster was the Spring Creek Mine which attracted an impairment charge of $64.3 million.

Solid Energy bought back the 49 per cent owned by its joint venture partner in February 2012 and one month later the mine, near Greymouth, was closed for safety reasons.

The other major 2012 year gross impairments were: Huntly East Mine ($33.8 million), wood pallets ($24.5 million), coal seam gas ($18.5 million) and biodiesel ($9 million).

Solid Energy also experienced a massive increase in the cost of sales in its June 2012 year, from $655 million in the previous year to $821 million.

The annual report noted that the Spring Creek and Huntly Mines “have been undergoing development phases requiring significant expenditure while facing increased regulatory scrutiny in the wake of the Pike River disaster”.

That is true but staff numbers have surged from 728 to 1658 over the past five years with the average revenue per employee falling from $764,000 to $590,000 over the same period.

Meanwhile, the number of employees paid $100,000 or more has soared from 130 to 472 over the same five-year period. The highest paid employee, presumably Elder, received $1,345,000 in the June 2012 year compared with $745,000 five years earlier.

Thus the problems at Solid Energy can be summarised as follows:

Costs have increased dramatically, especially wages and salaries which rocketed from $53 million in 2007 to $156 million last year.

The company has made a large number of unsuccessful non-coal investments.

A high proportion of capital expenditure has been financed through additional borrowings.

The company has also committed itself to substantial off balance sheet operating lease commitments, mainly mobile plant, offices, office equipment and vehicles. These lease commitments have soared from just $5 million in June 2007 to $137 million at the end of the June 2012 year.

It is difficult to understand why Solid Energy, with its huge exposure to volatile international coal prices and the New Zealand dollar, could adopt such a high-risk expansion strategy, mainly funded by debt and off balance sheet operating lease commitments.

In addition it has allowed costs to soar, particularly production and employee costs, while productivity, in terms of revenue per employee, has declined.

Who is to blame? Is it the Government shareholder, the board of directors or Don Elder and his management team?

The politicians have been firing mud at each other over the past few days with Prime Minister John Key blaming Trevor Mallard and the previous Labour Government because they encouraged state-owned-enterprises to expand in 2007.

Key also claimed he had stopped Solid Energy’s plans to become a multibillion-dollar energy giant based on coal seam gas, lignite and other new energy areas.

The reality is that the Crown has had no influence over the huge increase in staff numbers and salaries, the company’s numerous small investments in alternative energy or the massive increase in operating leases. The responsibility for these must rest with the board and/or management.

From the outside it looks as if Solid Energy was dominated by chief executive Elder and his big vision for the company.

The board of directors must have either endorsed his vision or allowed him to dictate the strategy.

Therefore the blame for Solid Energy’s problems must rest with the directors – as it always does – because they sit at the top of the corporate tree.

Shareholders appoint the directors and the latter are ultimately responsible for the major decisions, particularly new investments, debt levels and the mix between new borrowings and operating leases.

However, Solid Energy’s main problem is that it is a flawed business model. Fully owned Government organisations should not be run by entrepreneurial chief executives who promote high-risk investment strategies in non-core activities.

This is because politicians and public servants do not have the expertise to monitor these activities, executives have no shareholdings at risk and lenders may be too accommodating because there is an implied government guarantee.

Politically controlled, but sharemarket-listed companies are far better business models as demonstrated by Air New Zealand and Port of Tauranga in recent years.

These companies are subject to market scrutiny, executives have equity at risk and lenders are less likely to believe there is an implied government guarantee.

Air New Zealand announced large profit and dividend increases this week and Port of Tauranga continues to substantially outperform Ports of Auckland, which is now 100 per cent owned by Auckland City.

In light of this the Supreme Court’s decision on Mighty River Power is very welcome.

The electricity generator’s proposed business model, namely government control with a sharemarket listing, offers a great opportunity for the company to produce good investment returns and sustainable dividend increases for the Crown and private shareholders.

Solid Energy; Rapid expansion funded by debt & operating leases:  (June 30, years)

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Brian Gaynor

Portfolio Manager

Disclosure of interest: Milford Funds Limited holds shares in Air New Zealand and Port of Tauranga on behalf of clients.