Examination of Witnesses (Questions 620
- 639)
WEDNESDAY 6 JANUARY 2010
MR ANDREW
COOKSEY, MR
ROB KNIGHT
AND MR
PHILIP MOODY
Q620 Chairman:
In terms of the Rabobank position, what you are saying is that
the Rabobank bankers were on board, but the Rabobank bit that
was giving you the advice, was not.
Mr Moody: No, I am not saying
that at all.
Q621 Chairman:
Come back to what your minutes say. The minute perhaps did not
make the distinction between two parts of the same bank. It is
pretty clear to me that Rabobank, a part of it, had said that
the final bid price that you were going to put in was too high.
Is that factually correct, or not?
Mr Moody: At the meeting of the
ASG on 6 April 2004, Rabobank presented the information that I
have just talked you through about the potential value of the
business. We then came on to a discussion about what their opinion
was of the people who would bid for the business, and what they
thought those parties would bid, as opposed to what they thought
they might ultimately pay. They advised a strategy to the ASG
of bidding at a level that was materially lower than the level
at which the board ultimately chose to bid. So I suspect that
is what the minutes are that you are referring to.
Q622 Chairman:
It seems to me, as a layman in these matters, quite a central
point. A bank, which has very considerable experience in European
agricultural funding, which is continentally based and understands
the co-operative model in some depth, seems to have given an opinion
that was at odds with the ultimate decision that the board made,
viz. the level that it chose finally to bid for ACC.
Mr Moody: The opinion was based
around bidding strategy, rather than value.
Q623 Chairman:
My recollection of the minutes seems to be fairly clear that it
was recorded in your minutes, and I always stand to be corrected
so if I have not remembered because I have not got them in front
of me, but when I read them through it caught my eye. There seemed
to be a clarity of expression that indicated that Rabobank basically
thought that the price was too high.
Mr Moody: Rabobank thought that
we did not need to bid at the level that we chose to bid.
Q624 Chairman:
Are we not having a little bit of linguistic semantics here?
Mr Moody: No, I do not think we
are, Chairman.
Q625 Chairman:
The Rabobank said—you just used the words "you did
not need to bid at the level you did".
Mr Moody: When I provide you with
the information in writing privately, which I have agreed to provide
to you, perhaps the comments that I am making will make more sense.
The only way in which I can adequately address your challenge
here and now is to quote those numbers, which I feel unable to
do in a public session. What I am trying to say to you is that
there were two sets of numbers. There was a set of numbers that
it was advised the businesses were worth to the bidders, and then
a separate set of numbers that were judgments about what one needed
to offer for the business. Obviously, one would not seek to offer
more than the business was judged to be worth but there might
be a perception that you did not need to offer as much as the
business might be worth in order still to acquire it. That is
where there was a difference of opinion. There was a difference
of opinion between what Rabobank believed we needed to offer,
i.e., less than what they thought it was worth, as opposed to
what the board of Dairy Farmers of Britain believed it needed
to offer in order to be competitive in the bid process. Dairy
Farmers of Britain's belief in its opinion was based around the
fact that its competitors had greater value to derive from the
acquisition from industrial and commercial synergies than the
DFB itself could not benefit from. Therefore, if DFB offered materially
less than the advice that the company was worth to DFB, then it
risked being left out of the short-listing process because it
may have misjudged the level at which its competitors might have
sought to bid.
Q626 Chairman:
Let me just remind you of what Mr David Messom, who is the director
of food retail at the Co-operative Group said in front of this
Committee, "My personal view is that you could argue that
they [DFB] paid too much for the ACC business originally which
they acquired from the Co-operative Group."
Mr Moody: If you are asking me
whether, with the benefit of hindsight, I think Dairy Farmers
of Britain paid too much, my answer is, yes, unquestionably. But
whether you are asking me, does that imply that there was a flaw
in the evaluation process, then I would say, no, there was not.
I think other circumstances led to that conclusion.
Q627 Chairman:
That process fully took into account all of the costs of rationalisation,
further investment and the in-fill acquisition, which Mr Cooksey
alluded to earlier in the evidence. In other words, it was a total
picture that led you to bid £81 million that ultimately you
paid for it.
Mr Moody: The basis of our financial
evaluation of ACC was based on information provided by the management
of ACC through CWS and CWS's advisers, HSBC IB. What they presented
to us was historical financial information together with financial
projections of the business, covering the financial years 2005
through to including 2007. We took those financial projections
and applied over them a Dairy Farmers of Britain overlay, so we
added to them the existing DFB business, then we applied to it
any changes that we were intending to bring to the business post
acquisition. That created in aggregate an acquisition plan around
which the evaluation and funding capability of the business was
considered. That business plan was subject to review by the banks,
it was subject to review by PwC, who reported both to the banks
and to the board of Dairy Farmers of Britain on it, and it was
also subject subsequently to due diligence, which no doubt we
are going to come on to discuss. But that plan supported the price
of £75 million.
Q628 Chairman:
But I presume that it was also totally underpinned by an assumption
that there would be no material change in the newly-formed enlarged
customer base that you were hoping to serve.
Mr Moody: It was underpinned by
the assumptions that were inherent within the financial projections
that were presented to us.
Q629 Chairman:
You retained Barclays, HSBC and Rabo as the three finance banks
for the project and you then embarked on your due diligence. When
Lord Grantchester gave evidence to the Committee, he said that
all of a sudden you subsequently discovered what he described
as a potential huge tax liability of some £6 million, which
you managed to avoid only after spending £1 million on advice.
He also went on to say that you discovered a number of commercial
contracts that were uncompetitive. He finally noted, "We
even began to question how they put the due diligence together
as to where the profit of one division stopped and the next division
started." That does not sound like a ringing endorsement
for the due diligence process and yet, if that was the case, Mr
Moody, as somebody well versed in these matters, you believed
all of it in the first instance, did you not?
Mr Moody: The vendors chose to
operate what is called a vendor due diligence process. A vendor
due diligence process is where the vendor engages a firm of financial
advisers, instructs them to carry out due diligence on its own
numbers and then presents that information to the purchaser. Whereas,
in the case of a transaction that is prosecuted without a vendor
due diligence process, the purchaser would normally appoint its
own agents to go in and carry out its own review of the numbers.
Vendor due diligence is a process which, at the time, was frequently
used by major corporates in auction processes where they believed
there would be strong interest, and particularly in circumstances
where potential bidders would be competitors. It was an intent
to control the exposure of the business, which they then still
owned, to commercial risk and exploitation by competitors. Dairy
Farmers of Britain, of course, was not a competitor in that sense
but, nevertheless, it was required to agree to participate in
the vendor due diligence process or withdraw from the process.
As an experienced corporate finance professional, I have an inherent
dislike of vendor due diligence processes because I personally
believe—I am not suggesting in this case it was so—but
I personally believe there is an inherent conflict of interest
for the firm being invited to carry out the vendor due diligence,
because it is engaged by the party selling the business and not
the party buying the business. However, that is the set of circumstances
in which we found ourselves.
Q630 Chairman:
It was take it or leave it, basically?
Mr Moody: It was take it or leave
it, yes. The financial due diligence was prepared by a firm called
KPMG. KPMG provided extensive DD reports on the historical trading
data but did not provide, initially, commentary on the financial
projections. The financial projections were, of course, of acute
interest to Dairy Farmers of Britain and its bankers.
Q631 Chairman:
Would I be right in saying, because I am not an accountant by
training, but I had a quick look at the due diligence report,
and I struggled to find anything where it was—easy perhaps
is the wrong word—but none the less I shall use it, nothing
that seemed to be an indicator of what the worth of the business
was going forward.
Mr Moody: No, that is not the
purpose of due diligence. Due diligence is not there to express
an opinion on value. It is there to provide information and express
opinions on information to enable somebody to understand whether
the information that is being reviewed is reasonably based or
financially accurate.
Q632 Chairman:
But it does have a significant part to play, if not in terms of
the financial projections to which you yourself mentioned a second
ago, as to what the real worth of the business is. In other words,
are there any skeletons in the financial cupboard?
Mr Moody: Absolutely, without
question. As we proceed with this discussion it will become clear
where the problems of Dairy Farmers of Britain began to emerge.
Within this process, having been presented with vendor DD on historical
information, it was made clear to CWS and its advisers that Dairy
Farmers of Britain would be unable to proceed with its acquisition
interest if the due diligence did not extend to commenting on
the financial projections going forwards. As a consequence, an
addendum to the vendor due diligence report was prepared by KPMG,
where they reviewed the financial projections upon which Dairy
Farmers of Britain were relying, in terms of not only arriving
at its value, but also securing its banking support to acquire
the business. In due course, that due diligence report was made
available. That due diligence report contained a number of comments
within it indicating that aspects of the financial projections
were challenging. Its overall conclusion was that the underlying
assumptions arrived at by the ACC management in setting those
projections were prudent. That conclusion gave the comfort to
Dairy Farmers of Britain; to its advisers and to the banks that
the projections were capable of being relying upon in pursuing
the acquisition. I am sure you will appreciate that with a transaction
of this size and with the credit committees of the banks involved,
those projections were given a very high level of scrutiny and,
of course, the assumptions underlying them were also given a high
level of scrutiny. There were various elements that provided that
comfort, alongside the comfort provided by KPMG.
Q633 Chairman:
Did the assessment of these financial projections also include
proper sensitivity testing, bearing in mind variations in potential
sales level, because at the end of the day, it is what you get
for selling the output of ACC, which is going to determine whether
the financial model works or not?
Mr Moody: Correct. There were
three key areas of sensitivity. The first area related to the
business operated from a plant in South West Wales called Llangadog,
which was a canning plant owned by ACC. That business was disclosed
to us as having been historically loss-making. We were aware of
that in any event because of public concern in the area of the
factory and, indeed, I stand to be corrected, but it is my personal
recollection that prior to the acquisition of ACC by DFB, concern
was expressed that led CWS to state categorically that it had
no intention of closing Llangadog. So we knew that Llangadog had
a troubled history. The financial information presented to us
stated that as a result of increases in retail prices and cost
reduction measures effected by the ACC management, those losses
had been stemmed and the financial projections demonstrated an
elimination of those losses and a modest return to profitability
for Llangadog. That was one of the key sensitivities. The second
key sensitivity related to volume being sold to its principal
customers. Volume had been declining and there was a concern about
whether that volume was going to continue to decline or whether
it was likely to be reversed as the financial projections suggested.
Ultimately, comfort was received in respect of that by the announcement
that a significant sales contract had been struck by the ACC management
with a third party, with a four-year duration, which effectively
more than supported the revenue projections contained within the
financial projections. The banks and DFB have the comfort that
its principal customer, the Co-operative Retail Trading Group,
were secured in terms of a three-year supply contract to 2007,
where the prices were specified with adjustment mechanisms specified
in the contract and that there was also a four-year contract in
respect of this other significant party. We considered that if
we were buying any other processing business without such customer
revenue contracts in place, the probability would have been that
as soon as we took over ownership of the business, retailers would
seek to use that as an opportunity to renegotiate prices and margins,
and therefore we were protected from that risk through those contracts.
Q634 Dr Strang:
We have got to August 2004 and you have acquired the ACC. It has
been suggested to us that it really took you a very long time—a
year—to really grasp some of the problems that existed within
ACC, that was after you had owned it. You have said something
about the plan you had for ACC, perhaps we could hear more about
that. But also, could you say—we are now talking about post
acquisition, leaving aside the background to it, which you have
explained admirably, if I may say so—anything about that,
given where you were once you had got this business, why did it
take so long, apparently, to get to grips with the problems, to
some extent what were the problems and what would you have done
differently looking back?
Mr Moody: Let me give a comment,
but I am sure the chairman will also want to comment on that.
First of all, it did not take us a year. I know that Gerry Smith
made that statement in his evidence, but Gerry Smith was not involved
in the liquids business until the middle of 2005, and therefore
it would have been outside his knowledge. In fact, the underperformance
of the liquids business was identified as early as November 2004,
when a formal report was written identifying that the business
was generating profits materially below those anticipated within
the financial projections that had been presented and reviewed
at the time of the acquisition. There were two principal reasons
for this. The first reason was that contrary to our understanding
at the time, Llangadog had not returned to breakeven, it was suffering
very considerable losses as a factory. Dairy Farmers of Britain
had to quickly consider whether or not that factory had a future
and, indeed, decided to close that factory, which it did at the
end of the first quarter of 2005. That was a project which Gerry
Smith very competently managed as part of the process. The second
was that we identified that the sales contract, which had been
heralded to us as a benefit for the business, was a contract entered
into to supply a competitor to Dairy Farmers of Britain with processed
products at a price that caused Dairy Farmers of Britain to suffer
losses. Those losses eroded the profitability of the liquids division
directly, but also enabled a competitor to challenge customers
of Dairy Farmers of Britain in one of its profitable sectors with
product that was cheaper than Dairy Farmers of Britain itself
could produce.
Q635 Dr Strang:
This is a four-year contract, you said?
Mr Moody: Correct. And that was
a fundamental and material undermining of the profitability of
the business. When I said earlier that we overpaid for ACC, had
we known about the losses in Llangadog and had we appreciated
the nature of that contract, then we would unquestionably not
have paid the price that we did.
Q636 Chairman:
Could you help me for a second to understand what you have said.
What was the factor that prevented you from knowing about the
implications of this contract?
Mr Moody: The sales process itself
was very much on the basis that there was not open and unrestricted
access to what the vendor regarded as commercially sensitive information.
I would point out that is quite normal when a company is selling
a business where potential bidders are competitors. So I am not
implying for one second that the process pursued by CWS was in
any way improper or in any way unusual, but it was nevertheless
very restrictive for somebody seeking to gain full and complete
information about the business it was acquiring.
Q637 Dr Strang:
Could you have done something differently to deal with these problems?
Obviously these problems were inherent, as soon as you got the
business you got these problems, could you have done something
different to sustain Dairy Farmers of Britain against that horrific
acquisition?
Mr Knight: As Philip Moody has
explained, we were landed with two issues here—one was this
long-term supply contract and the second was Llangadog. With Llangadog,
we acted very swiftly on that particular business. It was more
difficult with the contract that was set up and that we inherited.
The reasons that you are investigating, quite correctly investigating,
and the reasons also that Philip Moody is explaining in some full
detail equally reflects an accurate answer of events. That contract
was there soaking up the milk and for us at that time it was a
non-profitable contract. So the issues in the liquid division
started to emerge at that stage and we started to work through
negotiations with the key customers to try to ease the situation,
and they proved to be tough.
Q638 Dr Strang:
Given the scale of this acquisition, obviously in the context
of how big Dairy Farmers of Britain was at the time, it was a
huge decision for Dairy Farmers of Britain to take. In retrospect,
it is hard to resist a conclusion that was what it was all about,
your final demise was predetermined once you had made that acquisition.
Is that fair?
Mr Moody: No, I think that is
unfair. Had the business delivered the level of profitability
that was anticipated at the time of the acquisition, then the
acquisition would have been successful with some margin for comfort.
Bear in mind that the financing of this business was totally driven
around the profitability and the cash flow that we were expecting
to generate from it. That determined our ability to service bank
debt; it determined our ability to service the member investment
that the members had made in this business; and it also determined
ultimately our ability to influence the price that we were going
to pay our members for our milk. That was overwhelmingly the purpose
for which Dairy Farmers of Britain was created—to build
an improvement in the sustainable milk price. That was always
our criterion. We did not need to look at an acquisition on the
basis of providing an investment return, we needed to look at
it on the basis of providing a sustainable purchaser for the members'
milk and improving prices for that milk. That did set us apart
from the other bidders who obviously had shareholders and investment
returns that they needed to take into consideration. Of course,
the amount that one pays for a business is an important factor,
because whatever you pay has to be financed and has to be repaid
at some point. With the benefit of 20/20 hindsight, it was not
the price that we paid for this business that caused the problem,
it was the lack of profitability in it that we discovered once
we had bought it that was the problem.
Q639 Dr Strang:
I understand that, but there were some inherent problems there
which, with the best will in the world, you could not really tackle.
Mr Moody: No. Let me give you
a chronology of just how we tried to deal with that because it
will help you. In the period from November 2004 through to the
end of 2006, the executive management were very strongly challenged
by the board to look at all ways of seeking to drive cost reductions
and greater profitability out of the business. They came up with
a range of initiatives, which were called PIPs—profit improvement
programmes. There were a huge number of different initiatives
running within the business at any one time. In my judgment, the
executive management did an exceedingly good job in beginning
to turn the business round in that period, 2005-06. There was
a belief that as we approached the end of 2006, the business was
getting back on track and that there was an opportunity therefore
to start to derive the kind of benefits from this business that
we believed were there at the outset. Unfortunately, what followed
2006 was 2007, and two material events happened during 2007, which
fundamentally changed the financial prospects for Dairy Farmers
of Britain and, in my judgment, proved ultimately to be something
from which the business was unable to recover. Andrew Cooksey
may want to talk about those events in more detail, but I will
identify what they were. The first event was, of course, the CRTG
contract came up for renewal in August 2007.
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