Tough choices for Fonterra’s farmer-shareholders – and getting them right is important for NZ’s economy

The proposed  reform  of dairy giant Fonterra’s  capital  structure  has rapidly become a  critical issue, not  just  for  the cooperative’s 10,000  farmer-shareholders, but also  for  the  country’s economic wellbeing.

The  decisions  to  be  made  have  been thrown into  sharper   focus by the  crash in the  fortunes, as  evaluated by  investors,  of  other  listed dairy  companies, A2 Milk  ( its  share price  is down from its  peak of  $20  to  just  above  $6)  and  Synlait  (down  from $7.56  to  $3.17).

Fonterra is a complex business. Its co-operative structure, its vertical integration, its sheer size in the market, the fact it is reliant on not one but several commodity price structures, all combine to make the company, as one  market analyst  put it, “like a machine with a million moving parts”.

Its  founders  20  years  ago believed it  would  rise  to   become  a  global  leader. But  there has always been  a fundamental tension within its  co-op structure between  the  need to  maximise returns  to  its  farmer  suppliers,  as  at  the  same time  as it  should be maximising funding  for   investment in  new  plant  and in R&D.

Spending  on  research  has  been relatively miserly:  where market  leader  F&P Healthcare  outlays  around  9%  of  its  revenue  annually   to  R&D, Fonterra’s  R&D spend  can be as low  as  1%  of  its $20bn revenue.

Chairman  Peter McBride,  who’s  driving the  proposal for major  structural   change,  has  a hard  row  to  hoe. The aim is to balance farmer ownership, milk supply, and secure its financial future.

Among the options put out for consideration are dual-share structures to allow outside involvement, splitting the co-op between supply and processing businesses, and different classes of shares.

McBride presents   the  case  for a capital structure review on   the  need to ensure the sustainability of the co-operative into the future.

“The co-op’s future financial sustainability relies heavily on our ability to maintain a sustainable NZ milk supply and protect farmer ownership and control.”

Capital structure options the co-op is consulting on:

  • Dual share structures, which would move from the current single co-operative share to a compulsory supply share and a separate non-compulsory investment share
  • Unshared supply structures
  • A traditional nominal share structure
  • A split co-operative model

McBride says to allow Fonterra’s farmers to have open conversations and consider all options during consultation, it is temporarily capping the size of the Fonterra Shareholders’ Fund by suspending shares in the Fonterra Shareholders’ Market from being exchanged into units in the fund.

“The decisions we’ve already taken in response to the findings of the review – like temporarily capping the size of the fund – haven’t been made lightly,” he said.

Some of the options the co-operative is asking its farmers to consider included buying back the fund.

If the temporary cap was not in place, anyone holding “dry shares” – these are shares held in excess of the “wet share” requirement linked to milk production – would have been able to exchange them into units in the fund during consultation.

That could have more than doubled the size of the fund and made the option of buying it back unaffordable in the context of the co-operative’s current balance sheet targets.

Fonterra said it believed the best option was move to a structure that reduced the share standard so farmers had greater flexibility,  either remove the fund or capping it from growing further to protect farmer ownership and control.

That would make it easier for new farmers to join the co-op and give more flexibility to existing farmers who may want to free up capital or who were working through succession.

“A key outcome of this change is that shares would be bought and sold between farmers in a farmer-only market.

“These changes could impact the price at which shares in our co-op are traded, and there may not be as much liquidity in the market. Ultimately the price for farmers’ shares would be determined by the performance of the co-op and trading between farmers.”

Fonterra said it believed that was a more sustainable proposition over the longer term than the alternatives confronting it.

 So why  is the co-op is looking at alternative capital structure options?.

Fonterra says the environment in which it is operating has changed significantly over the last decade.

It needs to be prepared for flat or potentially declining milk supply as a result of factors such as climate change impacts, regulatory changes, and alternative land uses.

Declining milk volumes or more flexibility for farmers’ shareholding requirements could cause the fund size to grow significantly, Fonterra believes.

That would mean the thresholds that were put in place to help protect farmer ownership and control could be exceeded within the next few seasons.

Over the coming months, the co-operative’s farmers are being given the chance to share their views through a series of meetings, webinars and other forums.

One  argument in  favour  of the proposed changes  is that they may suit young farmers wanting to join the co-op.

But   more  conservative  elements   within the industry   argue  that  older  suppliers who  bought   shares when  they were  relatively  high  are  confronted   with  market  prices   that  are  declining.

McBride  will  need  all  the  skill  he  deployed  when  in a  previous  life  he  reorganised the  kiwifruit’s  industry structure  to  get the  75% support required to shove any change across the line.

Some  complicating  factors  have been  cited   by Arie Dekker, head of research at investment house Jarden Securities, who says Fonterra shareholders need to think closely about scrapping the fund, which is the only avenue for non-farmer investors to have an exposure to Fonterra’s business.

“It is one of the largest sectors of the economy and Fonterra is clearly one  of the largest corporates.”

Dekker said the fund had benefits for farmers, by giving them a way to discover the value of their shares without giving up ownership of the co-operative.

He believes it would be a “shame” for retail investors to lose out on investing in one of the country’s largest companies.

Fonterra  in  his  view should be looking to sell more overseas assets to recoup capital.

It has sold much of its China investments, joint ventures in Latin America and Europe, but retains interests in Australia and Chile.

As  McBride  says,  the  compulsory  nature  of  capital  can  be  a  strength  in  a  co-op,  but it  can be a  weakness, too.

“Compulsion  is a  real issue here. When  you provide optionality  or  choice, you can’t  sustain the  model we have.

“We  would  like to provide  choice for a  diverse group of stakeholder  farmers, but  at the  same  time  we have a  framework  for  a  fund that  could blow out   and  we  could lose control of it,  or  we  could  have to be  dishing  out significant  capital  to  maintain thresholds”.

Tough  choices,  clearly,  for  farmer-shareholders—and  if  they  don’t  get  them  right, it  could be the  end of the  dream of  Fonterra  becoming a world-beating national  champion.

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