Frank Newman: Interest rate rises and Meridian

It should come as no surprise that interest rates are likely to start rising from about April next year. Last week the Governor of the Reserve Bank, Graeme Wheeler, reaffirmed that outlook but was more specific about the size and speed of interest rate rises.

Radio New Zealand reported, “The Reserve Bank says the official cash rate could increase by 2% from 2014 to the beginning of 2016, which could mean interest rates on first mortgages of 7 - 8%. The central bank says if the Loan Value Ratio restrictions do not slow house price inflation, larger increases in the benchmark interest rate would be required.” In other words, expect interest rates to rise by 2% over the next two years, and more and faster if the property market (in Auckland) continues to charge ahead at 10% a year.

Property investors and homeowners (in fact any borrower) would therefore be wise to factor 2% higher interest rates into their budget estimates.

Besides the increased interest cost, there is a further downside. Higher domestic interest rates are likely to attract overseas investors into our money market and cause the Kiwi dollar to rise. Farmers and foresters (and any exporter) will not be very happy when they convert their overseas currency into New Zealand dollars, and that loss of income is likely to be felt in the provinces. Again, it will be provincial New Zealand paying for Auckland’s problems. That’s why planning regulations are important and why policies like “Smart Growth” which is being promoted by council planners and certain councillors are naive and downright foolish. (So called Smart growth places limits on urban boundaries on the ideological premise that commuting is bad for the environment.)

Meridian

The Meridian share offer is now in full swing. The Government will be hoping it goes better than Mighty River Power, which is still trading at 20 cents below its $2.50 issue price. My view at the time was that the issue price was a bit rich, especially given the political sabotage from the Greens and Labour. The market too has taken that view and is still factoring in political risk, and more so now that Labour has made some recent gains in the polls.

If a general election where to be held today, it is likely that we will have a Greens/Labour government. National remains the most preferred party but that counts for nothing under MMP. National does not have any support partners, and that’s its problem.

As a consequence political risk remains very real, and is probably the biggest risk associated with the Meridian offer.

The offer itself is more attractively packaged than Might River. The issue price will be between $1.50 and $1.80. Private investors will pay no more than $1.60 and the money is payable $1 now and the balance in May 2015.

Dividends paid between now and May 2015 however will not be discounted to reflect the part payment so the initial dividend yield is a very attractive 13%, although that is a bit of a mirage as it will fall to about 8% once the shares are fully paid.

On an earnings basis the shares are being offered at about 21 times earnings per share.  That’s anything but cheap, especially for a company that carries the risk of:

- Drought affecting the supply of electricity,

- Politicians regulating the wholesale price of electricity, and

- An oversupply of generation in the foreseeable future and greater competition between retailers.

The fact that an electricity retailer recently offered consumers a scheme to fix their current electricity rate for five years is a reasonable indication that electricity retailers do not see a lot of price growth ahead.

Despite these risks, most analyst are valuing Meridian shares at between $1.51 and $1.81. One suggests the fair value would drop to $1.39 should the Labour/Green proposal to reform the electricity market be introduced.

All factors considered, it looks likely that the shares will list at a premium, but there is enough uncertainly about the future to be less sure about returns over the next year or two.