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.