Waikato Times, Sept 2009 - Dairy Industry Restructuring

Dairy Industry Restructuring

Wind back to 2000 and 2001 and the expectation was that the formation of a mega co-op would ensure the future of New Zealand’s dairy industry.

Ten years on and questions remain as to whether the future of NZ dairying is still through a variant of Fonterra. That shouldn’t be the case after eight years of Fonterra effectively calling the shots for the industry.

The question of Fonterra’s restructuring should be put into the context of whether it will make a material difference to saving the NZ dairy industry.

That question is not being considered – rather it is being deflected by interest in redemption risk and capital restructuring. Neither of which are amongst the two most important issues facing diary farmers.

Many dairy farmers have a massive problem servicing excessive debt. Farm debt to farm GDP will average in excess of 500% this season.

The debt is compounding and by June 2010 will have increased by about $2.50 per Kg of milk solids to average around $27.00. Those levels of debt are simply not serviceable at any combination of payout and interest rates in prospect.

Fonterra has its own issues with excessive debt, but is now proposing shareholders find more capital in expectation of higher future payouts.

The industry’s most important issue is that of high and increasing industry costs: assets, finance, and operating. These costs are where NZ dairying has lost its international competitive advantage in producing commodities. Only some of those costs are under producer control.

So to the relationship between New Zealand milk producers and Fonterra – the processor providing payout to the vast majority of dairy farmers. Some producers, politicians, and service providers are looking to Fonterra in expectation that it can increase payouts enough to save stressed farmers.

Others – a minority at this point – look at Fonterra’s size and status as part of an industry model that is the problem: in crowding out research, analysis, innovation and competition, and with effects flowing into other sectors of agriculture - providing instead a consistent but unrealistic message of a golden future for the industry led by Fonterra.

Has the mega co-operative model delivered the NZ dairy industry so many expected back in 2000? Comparing the dairy industry in 2001 against 2009 suggests the industry has changed from being confident to being in crisis. Massive inflation of asset values has led to a huge increase in debt. Profitability and international competitiveness have been severely eroded by increasing costs.

Something to consider is whether that is the fault of the industry model, Fonterra, farmers or a wider New Zealand culture?

Has Fonterra delivered on its narrower role of significantly increasing dairy payouts over prevailing world commodity prices? It appears not – payout has remained very closely tied to international commodity prices.

Data rebased, 2003=100

Data Source: DairyNZ

Fonterra has not in the past been capital constrained. Assets increased $3.7 billion in the five years between 2003 and 2008 - liabilities $4.1 billion. What are the prospects of Fonterra significantly improving payout/farm profitability on acquiring more capital in the future?

Where that $3.7 billion went over those five years is useful information. The biggest component at $1.181 billion is intangibles including $828 million of goodwill. Other major components are: Equity accounted investments (subsidiaries) $592 million; Inventories $537 million; Property, plant and equipment $436 million and; Cash and receivables $980 million.

Let’s suggest Fonterra increases its equity with another $2 billion from shareholders (roughly a 50% increase). Shareholders are going to have to borrow most of that money and pay interest on it.

And lets say Fonterra does much better than it has in the past and delivers a 10% return on that extra equity (I am assuming that it isn’t used to reduce debt or provide working capital). That return would provide an extra $200 million for payout or an increase of only 16 cents per Kg of milk solids. That is hardly going to save the industry, especially when considered against increased farm debt.

Putting that 16 cents increase in return into the perspective of changing dairy commodity prices, a NZD $400 per tonne change in dairy commodity prices is worth about 50 cents in payout per Kg of milk solids.

Dairy payouts are going to be dictated by global commodity prices, and nothing Fonterra has done in the past or is likely to do in the future can significantly change that.

The dairy industry’s most important issues remain increasing costs and debt. The lack of an industry body responsible for such issues is a major design fault of the current industry model.