Testing times for NZ’s dairy industry: Can its leaders find the right formula?

Dairy giant Fonterra has taken a hammering in the media in the wake of its disclosure it expects to report a full-year loss of as much as $675m and won’t pay a dividend as it slashes the value of global assets. It will be the second annual loss in a row.

Investment guru Brian Gaynor in the NZ Herald argued Fonterra’s farmers have drained the co-op almost dry in terms of milk prices and dividends and have left it in an extremely vulnerable position. Earlier another Herald columnist, Matthew Hooton, contended NZ has put all its milk in one pail – in a company with inadequate governance and capital to match its aspirations.

Fulminations like these and from other commentators underline how politicians’ claims that Fonterra at its formation by the Clark government would become a “national champion” for NZ have fallen so far short.  As Gaynor sees it, Fonterra’s high-risk debt-fuelled global expansion strategy might have worked if it had made astute investment decisions. Instead it paid out dividends of $2805m in the past six and a half years from net earnings after tax of $2740m.

Bizarre, says Gaynor.

Fonterra has embarked on a wide review that has already seen it sell a raft of assets, including the Tip Top ice cream business.

It is now increasingly difficult to see how Fonterra will be in a position to pay a dividend, not just for the year just ended but in the immediate years ahead.

So does this all affect the average Kiwi? There’s not much sympathy these days in the cities for dairy farmers, accused of polluting waterways and pumping methane emissions into the atmosphere. Climate change warriors led by Greenpeace’s Russel Norman are calling for half the national dairy herd to be culled. And in business circles, critics of Fonterra’s management say: if it is failing, why not let it go to the wall?

Yet the dairy industry is by far the country’s biggest export earner. Without it, living standards would tumble.

It doesn’t help much to boost morale among Fonterra’s 10,500 suppliers to observe other dairy companies, notably A2 Milk, earning record revenues. So there should be a path to prosperity – even if takes a management revolution to find it.

Fonterra’s losses impact on the balance sheets of its farmer members, for whom the Fonterra shares are assets against which these farmer members have their own debts. Many dairy farmers are already struggling with their balance sheets, as banks, once so generous in lending, demand debt repayments on loans that used to be interest-only.

The co-op’s two biggest shareholders – Dairy Holdings and state-owned Landcorp Farming – say the latest downgrade will weigh on their own earnings and add to farmer malaise against a backdrop of already weak confidence.

Another industry commentator Keith Woodford (who held the chair of farm management and agribusiness at Lincoln University for 15 years) says questions have to be asked about what is going to happen to the Fonterra Shareholder Fund (FSF). This is the entity where non-farmers purchase a financial interest in Fonterra, and it is this entity that determines the price of shares at which farmers also purchase and sell their shares in the Fonterra Co-operative Group (FCG).

The FSF has been shrinking in size and even more so in value over the last 12 months. The reduction in size has come about because farmers were wanting to buy FCG shares to meet their production requirement for shares, and these shares have become units in the FSF.

“This need for purchase of shares by farmers has coincided with a loss of confidence by institutional investors in the FSF. To a large extent it is now the small retail investors who have been left as unit holders. They tend to be less well informed than institutional holders, but there must surely be a limit to their patience”.

Woodford notes Fonterra’s board is looking again at its capital structure. Serious attention he believes will need to be given to whether the current capital structure is fit for purpose.  Any move to undo the current structure of farmer members and non-farmer unit holders is likely to be messy.

The problem that Fonterra has is that it needs more capital but there is no obvious source. This is not a new problem but it has become acute. I have always been sceptical whether the current capital structure, implemented in 2012, would be long lasting”.

For his part, Gaynor believes Fonterra will have to change its business model.

One option would be to become a commodity producer only, closing all its global added-value operations, slashing staff numbers and moving to Hamilton to save costs. A second option would be to separate its traditional co-op operations from its added-value activities and list the latter on the NZX, after raising capital from non-farmer shareholders. And a third option is to adopt Ireland’s Kerry Group model and list its total operations on the NZX with external shareholders.

Tough decisions confront the board, yet it is vital for the country’s economy that it finds solutions. This is an industry which has been a world leader in pastoral and bovine science. And as the world’s population rises, the need for the ingredients and food services it provides will be even greater in 2050 than now.

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