Restructuring NZ Dairy

Dairy Restructuring
Colin Riden

The question of Fonterra’s equity position arose in discussions about 12 months ago. Many dairy farmers were facing rising costs, high debt, low payouts and some only remaining solvent borrowing against rising asset values. The word on future payouts was that farmers should get used to $4.00 per Kg of milk solids. The average farmer wasn’t aware, but they would have been more profitable by producing less. Conjecture was that reasonable numbers of North Island farmers would exit dairy farming altogether at the end of the season by moving to beef or some other form of land use. Dairy farms were harder to sell, but it was not polite to mention that many of those for sale were losing money.

Before Christmas the issue was spun to the media that aging farmers presented a problem to the dairy industry when they withdrew from the industry - putting Fonterra at risk of losing supply and equity. Although the issue of redemption risk was still some years away, restructuring of Fonterra was needed now.

Dairy co-operatives have somewhat mythical status in NZ. The stated assumptions behind the need to restructure weren’t challenged. Aging farmers aren’t the problem. There are always aging farmers who retire and normally sell to other usually younger farmers.

Restructuring is only needed when the current structure is not working. The issue was not years away but immediate - Fonterra needed capital but already had debt ratios exceeding governance guidelines.

Fonterra has made no retentions from surpluses, and in some years the payout has been kept up only by scraping together every last dollar of surplus. Since its inception Fonterra surpluses have found their way into farm capital asset expenditure rather than being retained to develop processing innovation, marketing, or adding value and effectively improving the industry’s co-operative assets to give better future payouts.

What is clear is that the NZ dairy industry – at least Fonterra and its suppliers – have high levels of debt, are unable to fund opportunities in international markets and looking for equity from outside the industry.

Today, 12 months later some things have changed:

  • World events have significantly increased payout prospects for at least this season and next
  • Confidence in dairying is again high and it is seen as a boom industry by those seeking to share in increased returns
  • From the security of an apparent boom it is now O.K. to mention that dairy farmers were making losses in the past

But much has remained the same:

  • NZ dairying is still not the cheapest supplier of milk to the international market
  • Rising costs, increasing debt and asset values, and more corporate and/or foreign ownership of farms and dairy production
  • The average farmer would still be more profitable by producing less
  • The intention to restructure Fonterra, but a slightly longer time frame for making a decision is apparent

The primary issues for the dairy industry today are not Fonterra or its restructuring, but:

  • Getting a reasonable income from farm investment. Costs are high, asset values are high, and payouts even at a projected $5.50 per Kg MS are in real terms less than those in 2001 and 2002
  • Indications that a lack of competition for milk is leading to inefficiencies beyond the farm gate
  • The industry’s dated production orientation and attitudes, combined with a tendency to myopically look backward to successes of the past. These include:
    • An unwillingness to accept and adapt to increasing local and world demands for lower resources use, emissions and pollution
    • A reported stream of dairy farmer opinion along the lines of ‘the NZ economy is dependent on dairy farming, and by the way don’t expect us to pay for environmental or resource use costs'
    • Assumptions that NZ farm management is world class and the rest of the world’s dairying will benefit from its application there - despite the rest of the world’s dairy farmers having much greater resources to research technology for their own environments
    • Confidence in asset values continuing to strongly increase while the fundamentals suggest there is a greater need for correction than that required for the residential property market
  • Unrealized market power from scale as a commodity supplier. Having more than 30% of cross border trade in milk does not appear to improve the industry’s ability to add real value to milk production
  • Industry leadership, and a lack of ideas or concern about where a continuation of current trends are going to take the industry long term

All items which significantly impact on Fonterra, its performance and supplier confidence, and highlight the need for detailed consideration of what direction shareholders should take given this opportunity for restructuring.

Some of these issues can also be associated with the drive for the formation of the mega co-op in the late 1990’s. Fonterra was eventually formed in 2001as a political solution to mitigate some of the industry’s structural issues. But bypassing the commerce commission also created some of these issues - particularly of inefficiencies from lack of competition for milk supply.

Short memories suggest the analysis done at the time may have been forgotten. In brief it was known but possibly not widely understood that:

  • The formation of Fonterra was a political trade off that would need fixing later
  • There would be short term industry and political gains
  • A long term decline in dynamic efficiency was to be expected and affect Fonterra’s performance
  • There would be minimal or no benefit from market power
  • The formation of a mega co-op would have benefits and detriments, but the detriments would outweigh the benefits in the order of five to one and not be in the national interest

The shorter-term industry benefits were widely advocated, and shareholder suppliers voted for the formation of the then Global Dairy Company. The graphs showing merger benefits and reducing levels of debt last appeared in Fonterra annual reports in 2003 and 2004 respectively.

When there were many dairy co-ops, and even when it got down to two major ones in Kiwi and NZ Dairies, their relative and absolute performances were closely scrutinized. The Dairy Board was of course incomparable being one of a kind.

Sound comparative data on industry processing, supply, and marketing performance is essential to assessing any restructuring proposal, or subsequent investment decision. The industry’s decision will be much poorer if this data and analysis is lacking in the decision process.

A look at Fonterra’s comparative performance in Australia where it has to compete for milk supply with both co-ops and investor owned companies should be quantified and rated.

What strategy does having most increase in demand for fresh milk being produced within each country’s borders, and no longer being the world’s cheapest producer of milk suggest for NZ dairy farmers, for Fonterra and for investors? How can these strategies best line up in a single entity? Or would separate entities be more effective?

There is a view circulating that Fonterra is following a very smart strategy in working with joint ventures, exporting our technology, lifting production in lower cost countries, and bringing their prices up to world best price performance. There is more than one way to interpret this depending on how you view the effects of competition over time, and our current industry performance.

Competition theory probably has something to say on the likely outcomes, and it is unlikely to suggest they are sustainable. Questions exist as to why a monopoly processor/supplier will be able to compete more effectively than those currently operating in competitive supply situations.

Restructuring Fonterra is an unenviable task. Issues include:

  • A requirement for 75% shareholder approval
  • Modifying the unreasonable expectations around market power still persistent from the formation of Fonterra
  • Attracting outside equity to an organisation controlled by shareholder suppliers used to all returns being taken in milk payout
  • Establishing fair market prices for NZ supplied milk
  • A possible need for, but reluctance by, government to approve legislative or regulatory changes to the Dairy Industry Restructuring Act

There is an issue as to whether restructuring will be aiming to correct issues inherent in the original formation of Fonterra, or more simply to mitigate the symptoms. It could be that a return to a less corporate type of co-op is an option, but more likely are moves towards a more corporate one. Each may be appropriate depending on the strategy being followed. The more economically effective strategies may require splitting Fonterra.

If the proposals for restructuring are all predicated on accepting the single existing mix of strategies rather than including a choice of new strategies, then an option should be to decline all options if the existing strategies are not accepted.

There will be more or less appropriate structures to match the strategy of the business, but it is having the correct strategy and management to perform in delivering the strategy that matters far more than whether the delivery vehicle is a co-operative or not. Again, depending on the strategy being followed, some models of cooperative will be better than others.

There are no simple answers, and shareholders require detailed information on their cooperative and sufficient time to make the best decision on its future structure. The decision on the initial formation of Fonterra was conducted under pressure by shareholders who were poorly informed and poorly lead.

Some of the questions aren’t simple either. Has the dairy industry supplying Fonterra invested returns heavily into farm assets and retained none to develop the business relied upon to add value to milk production?

Why would outside investors put money into a hybrid investment controlled by shareholder suppliers when the same suppliers prefer to invest elsewhere?

Will any of the proposed changes still work for dairy farmers and investors when commodity prices next cycle down and the payout before any dividend or value add is under $4.00 per Kg milk solids?