• About
• Publications
• Exemptions
• Notices
• What's new?
• International
• Speeches
• Information for investors
• Contact us
• Site map
• Home

Report on aspects of the initial public offering of Vertex Group Holdings Limited in 2002

THE DUE DILIGENCE PROCESS

51. The DDC comprised the following people:
    
    
    • Simon Pillar (Chairman of the Due Diligence Committee);
    • Doug McKay (Vice-Chairman of the Due Diligence Committee);
    • Paddy Boyle;
    • George Clark;
    • Jim Bini;
    • Sarah Roberts;
    • Carl Rowling (Partner, Buddle Findlay); and
    • Frances Allan (Senior Associate, Buddle Findlay, Secretary of the DDC).


52. Observers to the DDC were:
    
    
    • David Goatley, Andrew Robertson and Mark Greene (JBWere);
    • Leo Foliaki and Ian McLoughlin (PwC); and
    • Blake Lovelace (PEP).


53. A Due Diligence Planning Memorandum prepared by Buddle Findlay and adopted by the DDC on 12 April 2002 set out the objectives of the due diligence process as being to ensure that:
    
    
    1. the [offer documents] make full and fair disclosure of all facts which are material to enable investors to make a properly informed decision in relation to the offer contained in those documents;
    
    
    
    2. the [offer documents] do not contain any material statement that is false or misleading;
    
    
    
    3. there are no material omissions from the [offer documents];
    
    
    
    4. there is evidence to show that those involved in the preparation and issue of the [offer documents] made reasonable enquiries to ensure that all material statements included in those documents were true and not misleading and that there were no material omissions from those documents;
    
    
    
    5. there is evidence to verify the accuracy and completeness of all material statements contained in the [offer documents] such as to provide reasonable grounds for the belief that all material statements in those documents were true and not misleading and that there were no material omissions; and
    
    
    
    6. the [offer documents] comply with the information disclosure requirements of the Securities Act, Securities Regulations and Listing Rules."


54. DDC meetings were held weekly between 8 April and 27 May 2002. On 3 April 2002, before the first DDC meeting, Vertex management gave a presentation to the DDC to provide an understanding of the activities and main issues within each business unit, to demonstrate the basis of the proposed forecasts and to provide an explanation of the key assumptions underlying the budgets of each business unit.



55. Initial issues were identified from that session, and a "due diligence information request list" was created. This was a running list of material issues to be considered in the due diligence. The list was reviewed and updated at each DDC meeting.



56. The Commission was told that the DDC reviewed the 2002/2003 budget prepared by Vertex. This included details of the assumptions underlying the budgets for each business unit. The budget was the starting point for the forecasts in the offer document.



57. A key issues log was created to record the issues raised by the DDC and the responses to those issues. Some issues were dealt with by way of further presentations and reports provided to the DDC. Much of that information was packaged together in a "drill-down pack" and provided to the DDC members.



58. All of the due diligence information was kept in a "data room" at Buddle Findlay's offices, which was accessible by Vertex management, directors, prospective directors and advisers. The Commission understands that the room was used regularly, particularly by incoming independent directors Jon Hartley and Doug McKay. Vertex's solicitors, Buddle Findlay, have also advised the Commission that Board members and advisers carried out plant visits and that substantial interrogation of the due diligence information was undertaken.



59. In their evidence before the Commission Vertex's directors expressed the view that the due diligence procedure adopted was of a very high standard relative to others they had known.



60. Instead of the regular DDC meeting on 20 May 2002, a lengthy questions and answers session was held, which was open to the DDC, other interested parties and management. That session was used as a forum to test the reasonableness of the information provided throughout the due diligence, and any other information available at that time.



61. The DDC required the preparation of due diligence reports by its independent advisers, Buddle Findlay (legal), PwC (financial, information technology and tax) and Kingett Mitchell (environmental). These reports were based on the due diligence information request list.



62. As noted above, PwC was appointed to carry out a due diligence role and to perform its statutory role as auditor in respect of the financial information to appear in the offer document. PwC's engagement letters to Vertex clearly separated the two functions, and defined the scope of the work to be undertaken by PwC in respect of each. Copies of these letters are attached as Appendices B and C. In its engagement letter of 20 March 2002 relating to the due diligence, PwC listed the sections of the due diligence information request list that it was engaged to report on. This did not include questions relating to the prospective financial information.



63. Vertex's solicitors advised the Commission that the questions in the due diligence information request list relating to the prospective financial information were not contained in a due diligence report as such, but were addressed by the DDC and recorded in the key issues log where relevant.



64. The Commission is of the view that the scope of the activities undertaken by the DDC was appropriate. However, there was a confusion about the role of PwC and the directors in relation to the prospective financial information. This is commented on later.

65. On the evidence presented to the Commission, it appears that Vertex has a comprehensive budget process that is followed each year. The process commences in December, at which time a high level review of targeted sales, EBIT and capital expenditure is carried out. Detailed sales plans are then prepared for each business unit, based on historical data, trends, and anticipated new product development projects.



66. Assumptions are made in relation to raw material costs, including associated foreign exchange rates. Overheads are budgeted on the basis of historical data, known changes and latest wage and salary costs.



67. When the business unit budgets were complete for the 2002/2003 financial year, George Clark (Chief Financial Officer), Jim Bini (Chief Operating Officer) and Paddy Boyle (Managing Director) and the business unit managers reviewed the budgets, and checked whether all the assumptions underlying the budgets were reasonable. They also checked the alignment of the business unit plans to the strategic plans for the company. Mr Bini took primary responsibility for the review of the core business unit budgets, while Mr Boyle took primary responsibility for the review of the Securefresh and Technical Injection budgets. This review took place in February 2002, following which changes were incorporated into the business unit plans and the first draft of the consolidated 2002/2003 budget prepared.



68. The budget was considered by the Vertex Board in February 2002. Mr Pillar told the Commission that the board undertook a "risk assessment" based on the relative volatility of each business. He also commented that changes were made as a result of this assessment, "on the basis of conservatism". The most significant change was a reduction in budgeted operating earnings before interest, tax, depreciation, and amortisation (EBITDA) from $18,056,000 to $17,627,000.



69. A copy of the final budget adopted by the Vertex Board, including the business unit budgets, was given to the Commission.

70. The budget for Technical Injection anticipated significant growth in revenues over previous years, with a large proportion of budgeted sales coming from new product development (targeted at existing customers), and large increases in revenues from existing customers. The majority of budgeted sales revenues were expected to be derived from Technical Injection's four main customers. Because Technical Injection was anticipating significant growth compared to the previous year, the budget was not based on the prior year's figures, but on Technical Injection's business plan prepared in September 2001.



71. Vertex used information provided by customers about their intentions to budget sales revenues. However, for the purpose of its budget Technical Injection discounted Prima's own forecasts by 50 to 60%, as it considered that Prima was over-optimistic about the sales it expected to achieve. Vertex's directors told the Commission that overall, and particularly in relation to the growth businesses, Vertex adopted a conservative approach to its budgeted revenues.



72. The Commission heard evidence from the directors and from a Technical Injection customer that, as part of the due diligence and budget processes, Vertex tested the sales projections provided by customers. This included a visit to Prima in the USA.



73. The budget identified risks faced by Technical Injection, and indicated that there were some production quality and capacity issues within the business unit. It also identified the possibility of Prima losing over the counter volumes and of Fisher & Paykel not achieving market share. Reliance was placed on Fisher & Paykel Healthcare's sleep apnoea product launch in the USA occurring on time and growing rapidly.



74. The capacity issue was addressed by the purchase of additional machinery, which was approved in May 2002. The approval of the purchase of the machinery at that time indicates to the Commission that no significant drop-off in orders was expected in the near future, rather that business was expected to increase. The internal quality issues were addressed with the introduction of a new member of staff responsible for production planning.

75. The budget for Securefresh anticipated significantly higher revenues and EBIT from the previous year, based on planned growth in sales of Securefresh machinery and packaging to Australia, and tray sales both domestically and to the USA. Planned sales for case-ready were based on the assumption that the machine trials would be successful, and that certain key contracts would be signed with customers. No issues in relation to the primal cuts segment of the business were identified at the time of the budget. Post-budget events



76. In early May 2002 Technical Injection lost the contract to manufacture one of Fisher & Paykel's sleep apnoea products, representing around 25% of its business from Fisher & Paykel. At that time, new business was being acquired from Zee Tags, which offset the lost revenue. The launch in the USA of Oracle, another Fisher & Paykel sleep apnoea product referred to in the Technical Injection budget, was also deferred in May for three months, and deferred again after that. Prima also continually deferred orders from May, but information provided by Prima indicated that the orders would eventuate.



77. Prima did not indicate to Vertex until August that there would actually be a significant reduction in volumes ordered. Until that time, Vertex was confident that the orders would be received, and that revenues would simply be deferred until later in the year. Vertex witnesses indicated to the Commission in December 2002 that more orders were starting to come through by late 2002, and that the situation might be one of deferral rather than cancellation.



78. Securefresh began to experience problems in its established primals business in May, as a result of a shortage of lambs for export due to the drought in Australia and an increase in the use of live exports into the Middle East. Miles Patterson, Securefresh's business manager, gave evidence that Progressive Enterprises and Woolworths had told Securefresh that they would be implementing case-ready operations in 2002. Those sales were included in Securefresh's budget, but in May, deferrals of orders for case-ready machinery and packaging began to occur. However, communications from customers prior to the IPO indicated that these were short-term deferrals only. Securefresh was not advised until September that the orders would not be made at all.



79. Evidence provided to the Commission indicated that there were difficulties with Richmond's early trials of the Securefresh system, which resulted in additional delays of planned sales.



80. Mr Patterson stated in his evidence that the delays with the case ready business were very important in relation to the budget, because of the impact on sales revenue, and the impact on EBIT. He noted that although there is not a large profit made on the machines themselves, the lost profit on the accompanying packaging sales is significant.



81. Mr Patterson advised that in July, Securefresh reviewed its sales plan and it was evident to Securefresh management at that time that budgeted sales would not be achieved.



82. The evidence provided to the Commission indicates that the directors were first made aware of the extent of the issues facing Technical Injection and Securefresh at a board meeting held on 25 June 2002. That meeting focused particularly on the problems in Technical Injection, revenues for which were $377,000 below plan at that time, and for which the EBITDA was $456,000 below plan on a year to date basis.



83. Vertex made adjustments to its internal sales forecasts on 28 June 2002 to defer sales revenues in Technical Injection and Securefresh from the first half of the year to the second. The Vertex board held a telephone meeting to discuss the impact of these revised sales forecasts, in light of the forthcoming allotment. The board determined that Vertex's forecast EBIT was still on track.

84. The Commission heard that an important factor for the Vertex board in reaching this conclusion was a "margin of safety" that had been built into the forecast EBIT when it was developed from the budget.



85. The starting point for preparing the prospective financial information in the offer document was the Vertex board-approved budget. Forecast EBITDA for the year ended 31 March 2003 in the offer document was the same as in the Vertex budget. The forecast EBIT figure in the prospectus for the year was $800,000 lower than in the budget. That $800,000 was included in the prospective financial statements on the basis of an assumption stated in the notes to the prospective financial statements that "Vertex Group will incur an additional NZ$0.8 million in project management costs in the six months ending 30 September 2002 associated with the completion of Project New Age." Effectively this represented a reduction of budgeted earnings to provide, as seen by Vertex's directors, a "margin of safety" between the EBIT of $12,008,000 in the budget and the EBIT of $11,208,000 forecast in the offer document.



86. A further adjustment was made for the forecast EBIT for the first six-month period. Forecast EBIT for the period April to September 2002 in the offer document was reduced by a further $800,000 against the corresponding amount in the budget. Forecast EBIT for the period October 2002 to March 2003 increased by $800,000 against the corresponding amount in the budget. The change was effected by transferring $800,000 of budgeted operating expenditure from the second six-month period into the first six-month period.

87. Jim Bini prepared a memorandum to the Vertex directors on 2 June 2002, for consideration at the 3 June 2002 board meeting. Jim Bini included in his memorandum actual results for April and a forecast for May based on the preliminary sales for May, and extrapolated from that a forecast for FY 2003. He noted shortfalls in Technical Injection, Securefresh and Hastings Food Trays. However, he also noted that these shortfalls were partially offset by strong performances in other business units. Jim Bini's memo concluded that the prospectus revenues were achievable and that there was still a significant "EBIT buffer" available. This buffer existed on account of lower actual Project New Age project management costs against the amount included in the prospective financial statements ($800,000) and the existence, at the time, of a further "EBIT buffer" from expected and actual positive variances against various budgeted provisions and foreign exchange items, and also unbudgeted sales price increases.



88. On 25 June 2002, after the offer document was registered, but before the shares were allotted on 1 July 2002, changes were made to Vertex's internally reported sales forecasts. These changes took account of deferred sales in the Technical Injection business that had come to light at the Vertex board meeting on 25 June 2002. It was apparent at that time that Technical Injection and Securefresh were not going to reach their revenue forecasts for the first six months. The Vertex board met by telephone on 28 June 2002 to discuss the possible implications of the changes, and confirmed the forecasts appearing in the offer document, as there was a strong "EBIT buffer" between the internal forecasts and the forecast EBIT figure in the offer document, and results were still ahead of plan for the company as a whole.