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Keith Woodford explains some complexities of Fonterra’s capital structure, and how this plays out both over the short and long term

Keith Woodford explains some complexities of Fonterra’s capital structure, and how this plays out both over the short and long term

Fonterra’s shares have been on a steady downward slide for the last 18 months. In January 2018 they were selling at $6.60 dropping to $3.86 at closing on 30 June 2019.

Then this last week things suddenly turned volatile, dropping at one point on July 4 a further 10 percent to $3.45, before rising by six percent to $3.69 at close of trade on 5 July.

The causes of the long-term drop are well understood. Very simply, Fonterra made a loss of $196 million in financial year 2018 largely because of write-down on assets. Fonterra is also now in asset-selling mode to strengthen its balance sheet. Non-farmer investors are coming to understand that, with family silver having to be sold as well as some rubbish disposal, any turnaround is likely to be long-term rather than short-term.

However, the recent increase in volatility is due to more than these issues. There is emerging concern that perhaps some of the asset sales are not going as well as hoped. Tip Top was easy; some of the others are taking longer. Markets hate uncertainty.

The situation is complicated by Fonterra’s unique company structure. This is because there are two separate capital entities tied together like conjoined twins.  These are the Fonterra Co-operative Group (FCG) for farmer members and the Fonterra Shareholders Fund (FSF) for non-farmer investors.  In terms of pricing, where one goes the other also goes. Left to themselves, they would often go in different directions.

The FCG price is driven by the demand for new shares by farmers who have to share-up in line with production, whereas shares for sale come from departing farmers. In contrast, drivers for non-farmer investors are the estimated capital value of future company profits.

The price-linking between the entities occurs through a custodian who buys and sells shares in FCG, and also buys and sells units in FSF backed by these same FCG shares that it has bought.  The custodian does this in such a way as to keep the price of FCG shares and FSF units aligned.  I cannot find any other co-operative company anywhere in the world that does things this way.

The total number of shares held by farmers and the custodian remains fixed at just over 1.6 billion, but how those are allocated between the farmers and the custodian can change. Hence the number of units in the FSF can also change, and it does.

What I have just said here is only the bare bones of the system, but it contains the essential elements necessary to understand something about both the long-term decline and recent volatility.

In January 2018, there were approximately 140 million dividend-earning units within the FSF. At the end of June 2019, the number had declined to approximately 102 million shares. So, how did this happen?

The answer is that farmers purchased 36 million additional shares in the FCG. Most of these purchases were by farmers who were required to ‘share-up’ to balance historical production increases resulting from dairy conversions up to five years previously.  This net sharing-up in the FCG led to an equivalent reduction of 36 million units sucked out of the FSF by actions of the custodian.  The FSF is like a bladder that can both expand and shrivel.

Without the custodian buying back these units, the unit prices at FSF would have dropped considerably further over the last 18 months. It has allowed disgruntled unit holders at FSF to exit from Fonterra without the need for new unit-holders to come into the market.

Conversely, if it were not for the activities of the custodian, there would also have been a shortage of shares available for purchase in the FCG, and the price of FCG shares would have increased rather than declining.

Now, some people are going to say this all sounds very complex. There is some truth to that judgement. However, the role of the custodian and the transfer between the entities lies at the heart of Fonterra’s capital restructuring back in 2012. The aim of that system was to reduce Fonterra’s redemption risk and thereby transfer the risk away from Fonterra and back to its farmer members.

Some people might also ask as to whether this system, inaccurately called ‘Trading Among Farmers’ or simply ‘TAF’ was the right structure for Fonterra. I was one of those who from the outset thought that it might end in tears. I still do. But that end is not where we are at right now.

There are two possibilities as to what caused the sudden collapse of the price on 4 July, when both FCG and FSF shed over ten percent in a few hours. It could have simply been that multiple non-farmer investors got cold feet from recent media speculation, including the suggestion that Westland’s fate might be the prelude to a similar fate for Fonterra. It is also possible that some farmers departing Fonterra decided to sell their shares on that day and there were no other farmers wanting to buy them.  Digging in the data, I think I can see some evidence for the latter.

So, the custodian came to the rescue by purchasing FCG shares and then created balancing units in FSF.  However, the process dragged down the price at FSF to make the transfer stick.

As to why the price then rose some six percent on 5 July, it could have been that other farmers needing to share-up decided this was the time to do so, or alternatively, investors responded to soothing words from Chief Financial Officer Marc Rivers on the evening of 4 July that Fonterra knew no reason for the price decline.  I think it was a bit of both.

In coming weeks, the market will remain nervous until there is more information from Fonterra on both their asset-sale program and the operational profit for the season just ending. Fonterra has a balance date of 31 July. It will be a nervous wait.

Here is what Fonterra CFO Marc Rivers said on 4 July.  “…our performance is not where it needs to be. We’re doing everything we can to turn that performance around and are undergoing a full strategy review. We know there are going to be some bumps along the way.”

It is this acknowledged outlook for “more bumps along the way” that will have both investors and farmers wondering.

The biggest test for the Fonterra capital structure will occur much further into the future should Fonterra’s milk supply ever drop. Linked to any production drop, farmers would be selling their shares. The same drop in milk supply would also threaten profits and create risk for stranded assets. Non-farmer investors would also therefore want to exit.

The above scenario, with the conjoined twins now wanting to run in the same direction, would be the real test for the Fonterra capital structure. The Government might then have to decide as to whether Fonterra was too big to fail. But that scenario is still way over the horizon.

Right now, the reduction in share price does not affect Fonterra itself in any direct way. It is simply a sign that investors are unimpressed. However, the reduced value of Fonterra shares does affect farm balance sheets. Hence, rural bankers have less security for their farm loans. With the current tightening of the rural-credit screws, this is where it is hurting farmers right now.

Fonterra share price

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The 'FCG' chart will be drawn here.
FCG Daily
Source: NZX
The ' FSF' chart will be drawn here.
FSF Daily
Source: NZX

*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. His articles are archived at You can contact him directly here.

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Next there will be articles trying to convince us how smart a move it will be selling Fonterra to foreign hands, I won't say which particular hands, I think we all have a fair idea just which.
Won't be long before I will be checking my watch rather than my calendar for when.

Yes indeed. The same ideologues who are happy to see the World Bank issue low cost NZD debt to facilitate NZ banks hedging their foreign USD borrowing via cross currency basis swaps - which amounts to nothing less than paying tribute to Northern Hemisphere banking conglomerates, thus keeping us colonised.

The share price dropped because Fonterra wiped out a huge percentage of the value of the company as a result of long term mismanagement. Valuation of foreign assets also didn't match reality. Management needs to not get suckered into expansion to meet neoliberal ideals into markets that they do not understand.

Selling off Tip Top because of stupidity makes Fonterra look like it was run by pawn shop customers. Typically you see this in poverty psychology. Where someone borrows money for a rip off deal, then end up losing whatever asset they bought and still holding the debt. The only other organisation in NZ I've seen operate this way and on this scale is the National Party,

Thanks, I understand this more now.

I really hope Fonterra can get it's act together from now on.

Is it 'conjoint twins' or 'conjoined twins'?

You are correct. Mea culpa

On closer inspection, both conjoint and conjoined are correct terms, but conjoined is more common.

Conjoint? That'd be a prison, wouldn't it?

Yes, both joints and cons can lead in that direction

Keith. Intelligent Fonterra investors reacted to the sale of Westland. Fonterras business is built on WMP and China. When your biggest customer becomes your biggest competitor your business model is very vulnerable. Especially when they control the supply chain.

Yes, but Westland failed because of poor management and poor governance over a prolonged period. Of course Fonterra has had the same problems but at least so far not quite so disastrous. Chinese dairy consumption is about 50 billion litres per annum. About 15 billion litres equivalent of this is imported (in various forms). The imported volumes seem to be increasing, including from NZ. To some extent they are importing the milk (in various forms) rather than importing the animal feed from America. Yili is the biggest company, from memory about 10 billion litres of fresh milk produced and purchased in China, plus unknown quantities of WMP imported from NZ. Their Oceania production this year should be around 600 million litres (converted to powders) and incorporation of Westland will take them up to around 1.2 billion or a little more. This is about the same as Open Country. NZ total production is around 20 billion litres. I provide this information for context, not to argue about what you are saying.

Keith, my comment was more about the recent volitility (downwards) in Fonterra's share price and possible causes.
Yili will become the number 2 milk processor in NZ, with a huge war chest and the distribution channels in China. What investor would want to bet on Fonterra and retain their Fonterra units?
The only other potential driver of an increased price is farmer driven demand based on increasing milk production. If anything, the opposite will become true in the next couple of years as enviromental and regulatary impacts become stronger and farmers keep getting older.

"Yili will become the number 2 milk processor in NZ, with a huge war chest and the distribution channels in China."
Precisely, and they have the ability and wherewithal to put the foot on the throat of Fonterra and keep it there till Fonterra expires. They are not true competition, not one little bit, they are on an agenda and so far it looks to me to be going to plan.

Sounds like exactly the sort of sale into foreign public-private ownership that should not be signed off on because of its potential negative impacts on New Zealand. If (when) Yili executes the plan to take down Fonterra, what will NZ's response be?

that's is why the government should release Fonterra from the take all milk provision so if they need to downsize quickly they can
there is plenty of places for farmers to go now to supply open country, synlait to name two.
also farmers need to split Fonterra in two WMP and the rest so they can run business on the same footing as their competition within NZ which is growing very quickly
if farmers want to hold shares in the rest they canit will give Fonterra the ability to raise more capital.
knowing a lot of farmers they wont take up the second parcel of shares their focus is milk and price at the gate that is one of the problems with Fonterra the owners have let bad management run it for years making bad decision after bad decision ( example the many investments in china) with no consequences

Yes, the two company model, with one of those focusing on value-add and buying the milk from the co-op (the other company) is something I advocated more than ten years ago. That was the time to do it when Fonterra was in a relatively strong position. It would be much more difficult now, with very few assets to go into the value-add company. Any investor now going into value add would be very cautious without having their own processing plant and farmer suppliers, which of course is the way that Synlait has done it.
As for the take-all provisions, Fonterra needs and wants every litre it can get. Loss of supply will inevitably mean stranded assets.

Wilco, It seems that Fonterra will drift back to being a producer of commodities and ingredients, plus some butter and cheese. At that point Fonterra's profits will come from clipping the ticket on processing activities. This is a low risk activity and should produce a profit each year, with milk payout subordinated to this. The big question is what would their balance sheet look like having divested themselves of Beingmate, China Farms, and Soprole, and taken a further hit in Australia. If they want to differentiate themselves, then the way forward is to rattle their dags and get farmers to convert to herds free of A1 beta-casein asap. If I were Fonterra, I would also be looking in the current climate to converting some debt to bonds, which currently have very low yields and hence are cheap capital that is not at the whim of banks. I am sure Marc Rivers will be looking at this as an option.
Yili will have no interest in seeing the demise of Fonterra. It is possible that Yili may expand further, starting at Rolleston, but the last thing they would want to do is take over a Fonterra dinosaur. They are smart enough to realise that taking over Fonterra is not only politically impossible but would also be totally non sustainable from their perspective.

Thanks for a most Interesting perspective and comments, Keith. Seems that Fonterra is caught in a structural trap, perhaps not quite of its own making, and that it will simply have to ride whatever waves break its way (to switch metaphors) and not go permanently seawards on the inevitable rip.....

Keith, I disagree - foreign ownership of Fonterra is not politically impossible - remember Murray Goulburn? Australian dairy industry icon, farmer co-op loved by it's suppliers, made bad management decisions, now in foreign private ownership. Remember Silver Fern Farms? - farmer co-op now under effective foreign ownership. Remember Westland? Going the same way.
With the ongoing fragmentation of NZ's dairy processing industry all those intangible assets on Fonterra's balance sheet may have questionable value.
I don't want to kick a dinasour when it is down but I cant see any upside in Fonterra.
No/low dividend, no/low financial capacity for innovation, no/low capital growth, no/low growth in supply.
And as for A2 production, what a joke. I asked if I should be converting one herd to A2 as a start. The official advice from Fonterra was to not bother as there were no plans to differentiate milk for the forseeable future outside the small catchment they currently collect from.
What will be interesting is how much of the money ANZ indirectly receives from the Westland sale via its farmer clients that they recycle back into the NZ economy and how much they take back to Australia.

I think one key difference is that Murray Goulburn was only about one fifth the size of Fonterra and in an economy five times as large.
I also remain of the view that neither Yili or any other company would want to take over Fonterra - too big and too clunky, and too many non commercial politics to deal with. Also at that scale not aligning with their overarching food company vision. And far too risky. But they might be open to buying a modern factory here and there. Or even an old one at fire sale prices with consents in place allowing rebuilding.
I am also open to the notion that at some stage in the future Fonterra might decide it has to retain a dollar or two from the milk price to build its capital. But I am waiting to see what it can sell its key overseas assets for before looking at that as a serious possibility.
Did Fonterra give you that advice about A2 in writing? Would love to see it.
In 20 years time I expect that those of us still here may well look back and say that the way Fonterra continued to mishandle the A2 issue was their biggest mistake of all. I see that in Australia A2 cows are now selling for a premium of $A400.
I remain of the view that this year's milk price looks promising but it all depends on China. Similarly, milk prices look OK further out, but with the same caveat.
Until tonight, I had understood that ANZ was Westland's banker. But tonight someone who should know has said that it is HSBC.

The comment on ANZ was regarding them being the largest farm lender on the West Coast and the expectation that they would be demanding some capital repayment from those farmers from the Westland sale proceeds. Will they reinvest the money or take it home.
The answer will be a strong indicator of ANZ's committment or not to our rural industry going forward.
Regarding potential A2 supply, not in writing but verbal advice given by their area manager that the costs and effort in testing, segregating and managing a separate A2 herd would not be justified in the forseeable future. There is no realistic competitor for Fonterra on the horizon in our area so what they say basically goes.

Milk differentiated by grass fed provenance may be a better bet than A2. A2 is able to be produced by any dairy processor anywhere in the world. Not so grass fed; why Fonterra hasn't promoted and marketed this more heavily is very disappointing.
Yili may not want to 'acquire' Fonterra, but they couldn't care less if it collapses.

re grass fed- Ah..., but this is where the lack of co-development of water/environment/GHG policy/regulation is going to potentially make an ass of either one or the other, or both. Grass has a higher protein content than say PKE, so from a water quality perspective, if you are in a N limited catchment you are better off putting PKE in to your system than having a fully grass fed system. But if its greenhouse gas emissions you are concerned about you are better to feed grass.

Interesting presentation by Hans Johr, Head of Corporate Agriculture, Nestle, Switzerland at the Primary Industries Summit. He showed a video promo they use in Sth America which probably covered off similar to what you are referring to, and then went on to say that if you used that in Switzerland it wouldn't resonate the same with the Swiss. The offshore consumers don't all have the same personal/cultural values/wants. You need to understand the markets you are selling in to. One only has to look at the various versions of acceptance standards for 'organic' and 'grassfed' among countries. Food safety is very high on the list of priority wants for offshore consumers.

Food safety is a high priority for every consumer CO, but the discernable ones prefer milk with grass fed provenance, without a doubt. I realise its a threat to farmers with a traditional focus on maximising undifferentiated production, but if we could capture the value that discernable consumers place on authentic nutrition, then perhaps we could reduce stocking rates to help offset nutrient loss to waterways.
I think it would be a great story to differentiate and add value to our milk, whilst reducing pressure on the environment.

Hi Keith, wonderful article. What entity is the custodian
of the variance between FCG and FSF shares?
I lease to 2 ex fonterra suppliers , now Open Country. I guy still has the fonterra app on his ph. Constantly reminding him of the Fonterra share price.He got out in the $6.00 range!