Keith Woodford explains how Fonterra’s capital shortage has now got a great deal worse, with no easy answers

Keith Woodford explains how Fonterra’s capital shortage has now got a great deal worse, with no easy answers

The forthcoming asset write downs of more than $800 million announced on 12 August by Chairman John Monaghan are clearly damaging to Fonterra’s balance sheet. It also means that Fonterra will now make a loss for the year of around $600 million. However, the implications go much further than that.

The losses mean that Fonterra will need to sell more assets to bring its ‘debt to asset ratio’ under control. The losses also ping back to the balance sheets of its farmer members, where the Fonterra shares are assets against which these farmer members have their own debts. Many dairy farmers are already struggling with their balance sheets, with banks now requiring debt repayments on loans that used to be interest-only.

If these write downs are the full story, then Fonterra will survive. The big question is whether these are all of the write downs, both for now and the foreseeable future.

It will be no surprise to those who have been analysing Fonterra that asset write downs would wipe out this year’s operating profits. For analysts, the surprise will be the extent of the losses and where they have come from.  

In contrast, most of Fonterra’s farmers had no prior insight as to the emerging situation.

One of the worries is that Fonterra has made no comment about its Chilean endeavours with Soprole and Prolesur.  There is a risk these may prove to be considerably overvalued.

There is also concern that we have only seen the first stages of necessary Australian rationalisation. Not only is Australian dairy production in decline, but Fonterra has been losing market share to its competitors. It would be remarkable if the $70 million Australian write down, which includes the $50 million loss associated with closing Denniston, was the end of that story.

Beingmate is another worry. This is currently in Fonterra’s books at around $244 million. However, based on current share-value of around 5 RMB, a value of around $190 million looks more appropriate.

I don’t know anyone who foresaw the announced loss of around $200 million for DPA Brazil. That would have been well below the radar for most of us who try and figure out what is happening at Fonterra.

Similarly, the overall projected write down of $200 million for New Zealand consumer-based activities seems totally remarkable. This figure is net after allowing for Tip Top having been sold well above book value.   The other consumer-based activities in New Zealand must be in big trouble.

There are now increasing questions 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 Cooperative 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 come 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.

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 for which there is now definitely no dividend, but in the immediate years ahead. It is easy to see a further weakening of the price of units and hence also farmer-owned shares as this reality dawns on the retail unit investors. Why would any non-farmer investors want to retain units in the present environment?

Farmers have a right to be angry at being blindsided by these losses. There was no hint from Fonterra that these losses were likely until now. Rather, Fonterra has been resistant to the perspective of a range of commentators that things were not all well at Fonterra, and that Fonterra’s challenges were greater than had been admitted. In these situations, farmer instincts have been to trust the leaders of their company.

Fonterra has also now announced that the Board is looking again at its capital structure. Serious attention will need to be given as 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 now has is that it needs more capital but there is no obvious source. This is not a new problem but it has now got worse.

I have always been sceptical as to whether the current capital structure, implemented in 2012, would be long lasting. Until now, it has not really been tested given the benign environment of the last few years.  It certainly is going to be tested now!

Currently, there is not enough information to make any further definitive judgements. We will have to wait until September when Fonterra publishes its annual accounts. Even then, there are likely to be more questions than answers. I expect that farmers will be much more demanding of both Chair John Monaghan and CEO Miles Hurrell than they were at the last AGM.


*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. Previous article on Fonterra’s challenges can be found at https://keithwoodford.wordpress.com/category/fonterra. You can contact him directly here.

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The real reason for the OCR cut is to keep income up for farmers by lowering the dollar!

Certainly is. I see a lot of debt distressed farms teetering on the brink...this will help keep foreclosure at bay for a while. How long till the debt mediation legislation thats in development comes into force...it will be needed!

I could only wish that the connection between the RBNZ and my cowshed was that close!!

Its been proven time and time again that this doesnt work, especially when the rest of the world is trundling down the same slope in their economic trolleys.

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Well I'm calling this the NZ version of the Lehman Brothers. The next thing that you will see at Fonterra is a hand being held out asking for a taxpayer bailout. Which they will get due to Fonterra and the dairy industry's privelaged position in the NZ economy. My closing comment is this; Fonterra is essentially the NZ economy when you follow the degree to which it permeates the entire Country, for better or as I have been saying for several years...for worse. If this is the best our Country's titans of commerce can produce then we are screwed. Ferrier, Speirring, Key, Collins and the rest of the National Party supporters club who drove the China trade agenda that has failed so spectacularly on several fronts now need to be held to acccount. I see Luxon being bandied around as a future National Party leader...well whats he acheived. Running a partly Government owned regional airline is hardly nation building stuff is it...but Kiwis love a well spun fallacy don't we!

If there is to be a handout given to farmers I can only hope that it is means tested. Giving taxpayer money to entities that might have assets in the 10s of millions would be obscene. Nobody twisted their arms during the good times to take on crazy debt s where all farmers intelligence seemed to stop at "they're not making any more land eh"
The subsidies given to sheep farmers in the late 70's is now seen as wrong and history will probably show the same for what will happen here. Nearly a billion dollars in 70s money was given to wealthy cockies while almost nothing was allocated to welfare for low income families so sheep were being looked after better than small children.

Yes government largesse for the corporates knows no bounds. Who will stand up to it? I was lamenting this with a friend who operates in the not for profit sector helping needy people get on their feet. He was analysing the money thats been given to the NZ Americas Cup team and associated infrastructure since the late 90s and its just heartbreaking to consider that virtually everyone who participates in that sport comes from high networth backgrounds they could pay for their own campaign! Yet they get government handouts courtesy of the taxpayer while there are people living under bridges all across the country. I know I don't approve of my tax dollars paying for a yacht race!

Don't forget the other God, Peter Jackson, who too got millions in subsidies and other benefits.

Anyway, if government bails out Fonterra and/or the farmers, then the general public also has a right to demand tax cuts, which will dovetail into RBNZ's 'spend and boost the economy' mantra.

You forgot Clarke n Co. Helen oversaw Fonterras inception did she not. Which then threw the rural community into a fizz. Convert or die. By 2008 and Keys election, most of the conversions were done. It all happened from the very late 90s to 2008 and the gfc. With the overcapitalisation once converted there was no going back.
Please 4th estate dont put this on John Key. Yes he ran with it but ya kinda had to after the gfc.

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I think you are a bit wide of the mark and I do believe Key etal are highly culpable in all of this, his smiley face never fooled me. Fonterra was created by legislation the dairy industry basically wrote took to wellington and handed to the clark government. It was enacted more or less to keep the conservatives happy under a leftish leaning government. As for conversions being done before the gfc, no way, they're still happening today.

Sorry 4th you are just plain wrong. I know I lived it. It all happened in the late 90s up to 2008. Yes their have been more conversions since then but bugger all compared to the early 2000s.
The likes of Landcorp in the Broadlands Wairakei Estate era were late to the party in the 2008 to 2011 period. Ata Rangi south of Tokoroa were also very late to the party in 2015/16. The main guys, the likes of Maxwell was flat out in 2006, 2008gfc was such a kick in the guts he sold up after that. Colin Armor was pretty well all done by 2009.
Most of the smaller converted farms were done late 90s early 2000s.
A small fortune was made by fencers in those years. After 2009 the good jobs were few and far between. The likes of Wairakei Pastoral and Ata Rangi were coveted. Many fencers were out of work.
What you think you know and what really happened are two different things. And most of it was before 2009. Part of my business is in contract fencing. Believe me, it was tough for a good while after 2008. And now its sheep and beef or deer farming where its at. Or conversion to hort.

What Helen Clarke allowed to happen around Lake Taupo was shocking. While giving away our most attractive bits of the high country to farmers in the south island she allowed Landcorp to sell out of the central plateau. And guess who bought in. Colin Armor. What could have been the less polluting sheep farms of Landcorp became converted to dairy. Landcorp knowing nitrogen restrictions were coming bolted. Armor bought up N units and poured on the cows.
Whatever you think of Key and National, under Helens stewardship things were worse.

It bugs me that I still can't dig it up off the interweb, but I remember reading an article in a Target Taupo mag back in the early 90's which referenced some studies on the underground bow wave of nutrients slowly on it's way into lake Taupo. Goodness knows how much that has been boosted in the last while. And the full effects not to be seen for decades yet.

you also had all the CHH forests that were cleared turned in dairy then sold off by NZ richest man, back then milk was the new gold
https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=106...

CHH dairy farms were all underway before Key came in in late 2008. But they were also late to the party as that was also hit by the gfc.
Then of course we cant forget Crafars. He or I should say they, had 14 farms, most were conversions. It was late 2009 they were seized by the banks. Two not far from here were already at least 6 years in by that stage. And they were the newest of the conversions. Taharua had been converted mid 00s at latest.
Helen overlooked the greatest change in NZ farming in our history.
Key didnt fix it, denied the damage it was doing. And I think it was Key and crew that masterminded the Canterbury debacle.
But for all the blaming and shaming I well remember rural NZ before the white gold rush and Fonterra. It was a pretty sad broke place.

Thanks for clearing that up for me in such a collegial fashion, I guess I don't know what I do know or as you say as I think I know. Is that what you were saying? I'll just disregard what I have observed first hand, it couldn't possibly be factual.

Then feel free to give examples. Times dates go for it. Hubby n I went for a zoom around the south island in 2002. We were absolutely shocked at Westland. It was mostly dairy. We went back in 2005. What wasnt dairy in 2002 was now in 2005.
My daughter moved to Queenstown in 2005, a sharemilker she used to work for had preceeded her the year before and gone to Southland where it was all happening. Sheep to dairy. Helens watch. He converted, but the weather beat him down. He gave up and came back up north. There was a flood of Waikato dairy farmers heading south then. Its a long time ago now.

That shift started in the 80s, Auckland and South Auckland farms being chopped into 10 acre blocks, the farmers moving to the Waikato, the Waikato farmers moving to Southland.

Thanks. I'll go on to say that I recall a former workmate from southland who I worked with in the early 90s lamenting how the dairy conversions where he had grown up had ruined the pristine streams he used to swim and fish in. Not a Labour govt in sight in those days...

Boys and Girls I think that during these difficult times that we can all agree to disagree that both Parties ran with the Dairy Boom for one thing - the mighty dollar - the question we all now need to focus on is how does the future look considering the environmental issues and Fonterra sick balance sheet and that of a large number of its highly indebted shareholder/suppliers?

Jacinda has now idea of the damage shes caused!!!!

Boys and Girls I think that during these difficult times that we can all agree to disagree that both Parties ran with the Dairy Boom for one thing - the mighty dollar - the question we all now need to focus on is how does the future look considering the environmental issues and Fonterra sick balance sheet and that of a large number of its highly indebted shareholder/suppliers?

Jacinda has now idea of the damage shes caused!!!!

I lived in Invercargill from 95-97 and dairy was really taking off then. Waikato farmers could get twice as many acres for the same money, so were selling up and moving down.

Fonterribles share price on the NZX has risen 6 cents today , to $ 3 63 .. unfortunately this is still one half of their peak $ 8 in May 2013 ...

.. from May 2013 till today , A2's SP has ballooned from 70 cents , to $ 16 ..

Now... who amongst us still reckons the Fonterrible co-op model is the best way to run a business ?

As a supplier, I'd take the co-op model GBH ;-)

I second that CO. Let’s hope we can regain such a model.

If you are right about Fonterra being the New Zealand economy then the outcome of this is scary. Colin Ridden has been through the books and knows they have never made a profit, it is all financial trickery based on debt.

Thankfully, given the weekends events they missed out on purchasing Sancor.

Give it another 2 to 3 years, it will be clear whether selling Westland to Yili was a good decision for farmers, which I am confident that it was.

Perhaps, this can be replicated for Fonterra's farmers for another win-win.

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Indeed, we should progress by selling all our most productive land into the ownership of foreign public-private entities. This will surely secure our prosperity and security in our own land.

Can't you find that sarcasm key on your device, again?

to be fair the farms have not been sold to Yili - why not have a processor who has access to a large market? Westland was the architect of it's own demise. Having said that - I do wonder the future fortunes of suppliers to Westland and do lament the offshoring of valuable foriegn exchange.

Thankfully interest rates are low and Fonterra has enough scale to dig itself out of it's stinking mess but at the cost of a lot of wasted production.

RickStrauss - I totally agree. Why not? We sold majority control of PGG Wrightson to Chinese interests who then onsold the seeds business to European control, the seeds operation was probably one of the most valuable IPs ever created in NZ. We sold effective control of our biggest meat company SFF and the remaining shareholding in ANZCO another major meat company. Our pine trees are owned by American and European interests. We have sold 100% of Westland Co-op. A2 is going to end up in Australian hands. We could swap Fonterra for a couple of Tuppaware containers. Or maybe a musket and three blankets.

Make it a AK47 and three electric blankets...

That group have a poor record of decision making.
What makes you think they suddenly made a good decision?

well we know one thing for sure,
farmers are not going to inject capital into fonterrable, the best they can do is forgo dividends which will hurt many especially those just starting out that rely on that payment for capital improvements

sharetrader - On the flip side new entrants will be able to buy in at a much lower capital cost. The farmers most affected will be those looking to retire. They will be hit with a double whammy of falling land and share prices.
And the poor public who bought shares for the dividends and not fully understanding the hybrid nature of their investment.

Keith - your article touches on an interesting conundrum (my new word for the week). The FSF units are rightly valued by the investing public on their current and potential dividend return.
However I believe farmer suppliers, given an option, would value the shares differently. The main purpose of holding a share is the right to supply milk to Fonterra. Therefore the bulk of the value to a farmer is confidence/faith in Fonterra continuing as a going concern business that can collect, process and then sell their milk while providing a return on that milk that allows the farmer to stay in business. However every Fonterra supplier's balance sheet has been influenced by the price paid by unconnected investors view of dividend levels and lately sentiment is all in a negative direction. Your comments infer ( in addition to Craigs ) further downside to come. But as a supplier my view of the value of a share has not changed - it allows me to supply 1kg of milk solids - so how do we reconcile these differing views of value?

The first thing Fonterra need to do is make announcements. There should have been a substantial earnings warning, instead there's a "surprise" loss. The way the board is currently operating is deceptive and incompetent. The result is a much lower price and people questioning the existence of Fonterra. Perhaps it's time to separate all the questionable investments in illiquid shares from the core operations of the coop. Some of the debt would need to be assigned and just hope that the shares pay enough dividends to counter the debt. After that the real position of Fonterra could be determined.

While the shares may be useful for farmer supplying milk the actual value behind the shares appears to be an illusion.

Dictator - they did make announcements - see down (about 3) from the CFO Marc Rivers a month ago - "Company is doing great ......."

This isn't the milk powder you are looking for, move along.

The public sentiment is negative because the situation at Fonterra is negative, thats how it works if you are publically traded. Usually it results in the directors being removed and new business strategy or...a takeover from a competitor or bankruptcy. I looked at buying shares when they first floated but I couldn't settle my dis-ease at the lack of control shareholders would have. The company structure is kafkaesque in nature and as we have seen to date answerable to no one....yet. Whats more, I cannot reconcile the sheer complacency of farmers who haven't so much as driven a tractor or herd through the offices at corporate hq in protest. If this was France there'd be barricades and smoke bombs! Which is something I find quite odd given how the sector noisely reacts to things like h&s or methane emmissions. Perhaps thats because the real source of farm wealth these days is not so much milk fat but capital gains so failure of the cooperative is unimportant when a farm can simply be rezoned and subdivided for millions in profit...

Flipping houses, Flipping farms...the great NZ pastime of the last few years.
Benefited some clever operators.
The results are showing now, when the government has to exhort people to spend more to pull the economy out of the mess.

LOL! If we did put a herd through Fonterra HQ it would probably be the first time most had seen a live cow! The Fonterra staff are recieving more money in the hand than farmer shareholders. The board seems to have lost the pedals in N.Z milk product share as well. If the company cant keep the home fires burning it deserves to be put out of its misery...

Wilco,
It is impossible to reconcile the role of service capital in a traditional co-operative with the profit-maximising thrust of an investor-oriented firm. Hence the reason that the current Fonterra capital structure was and is destined to be a journey to somewhere else. In my experience, hybrid co-ops always eventually become unstable. In some cases they revert to a more traditional structure (this is not always possible) and in other cases they convert to genuine investor-oriented firms. Whichever way they go, it is always strssful. It's better not to go hybrid in the first place, unless it is a puroseful step along the journey to somewhere else.
KeithW

If Fonterra's worth book, I'm Chris Hemsworth.

Welcome to interest.co Mr. Thor

TK - Well this guy disagrees with you.
https://www.rnz.co.nz/news/business/393713/no-reason-for-share-drop-font...

6th july 2019 - Fonterra's chief financial officer Marc Rivers said there was no explanation for the fall.

"The fundamentals of our business are strong; the world wants more dairy and we make great products.

Mis Direction much? Apart from obviously having no idea about the state of his company I think he must come from the Theo Never Here School of Economics.

Good pick-up. What shred of credibility can you retain as a CFO when you go on record as saying there is no explanation for a fall in the share price and then take a $800m write down and print a $600m loss 4 weeks later? I must admit, I'm no expert in the in's and out's of their capital structure, but I have seen enough to know Fonterra has the whiff of death about it.

Is there any possibility/whiff of insider trading in Fonterra ? Just wondering...

What then is Mr Rivers salary

Great article, Keith. It's clear that most of the offshore ventures have been a collective fustercluck. I was gobsmacked to learn that Venezuela was in the mix - because it had been running on fumes for a decade and investing there was always gonna end in tears as the OPM ran out. 'Difficult' doesn't begin to describe it.

But the comments thread has, as usual, attracted drive-bys which show all too clearly the animus which has now built up towards F in particular, but also to farming in general. This is a worrying trend, because there are only around 12,000 dairy farms; they are a large part of our landscape so are highly visible; and are easy targets for urbanites' projected guilt. There needs to be a more moderate tone to the conversations, because we are, after all, talking about somewhere between 15 and 30% of export income. But, like the light bulb that has to want to change, this reduction in confrontational rhetoric needs to come from them urban types......

Fonterra are a high profile NZ enterprise whose core competency in recent years has been to destroy shareholder value.The dairy industry is high in negative externalities - polluted waterways being high on the list. Fly up and down NZ and invariably you are looking at grass - industrial deforestation. Personally, I'd like to see more horticulture and less dairy.

What sort of horticulture Te Kooti? I have a foot in both camps and I am not convinced a significant increase in some types of hort isn't jumping out of the frying pan and in to the fire, with regards the environment. So am interested in hearing what sort of hort you would like to see and which regions.

From my involvement in hort, it still has high input requirements and an alarming level of pesticide use to consider. If it were me I'd say woodlotting in native hardwoods would be my pick of the bunch. Graze stock through the plantations during the day and home them overnight in a barn like they do in Europe.

I really don't have a strong view, clearly Avo and Kiwifruit have done well - there are plenty of options. What I do know is that a dairy farm has to be the single worst aesthetic use of land I can think of. Also, no effluent to deal with.

Obviously you've never had to follow a pruning gang into a orchard. Never walk behind the shelter belts

Fonterra deserve all the negative comments they are receiving. I want dairy farmers to do well and Fonterra has been too busy flushing money down the toilet buying into useless or scam investments instead of productive investing instead of handing money back to both farmers and investors.

Running up hundreds of millions in debt then declaring over $500 m in losses in a surprise announcement is unacceptable. None of that benefits farmers like a coop should. As other commentators have pointed out farmers should be protesting, if this was France they'd be spraying liquid fertiliser over their building.

Hi Keith, off topic a little. I read yesterday MPI have fronted up at last with the Autumn milk tests. 155 more positives. Where does this lead us to now with mbovis.
There was a lot of comment on a social media page from dairy farmers having had enough of it. As someone put it, with mbovis hanging over everyones head you cant plan for anything. Any chances they are going to kick it to touch yet?

Belle,
The 155 positives are bulk milk tests from autumn calving cows, so it does seem a high number. MPI thinks most will be false positives, but around 10 will be found to be genuine infections. Each will have its own fan of traces. My best guess is that it will be about next February when the program is canned. They will wait to see how may of the autumn bulk milk positives are genuine positives, and apply this ratio to the forthcoming spring testing of all farms.
KeithW

Thank you Keith. Yes it does seem a lot coming from just the Autumn calving crew. Pity the poor buggers getting phone calls.

Farmers have no right to be angry with Fonterrible .. they've consistently demanded high pay outs , all the co-op could afford to pay .

.. this co-op model has not grown and innovated ... it's just bought out or bought into other companys ...

And the massive losses this year don't even include their disastrous foray into Beingmate . . Moo hoo .. .

Gummy - while I always enjoy your unique view I don't agree this time.
There was nothing wrong with demanding high payouts - this is one way to ensure a business doesn't get fat and complacent. Make it work hard.One measure of a poorly run business is excessive capital being under utilized.
And logically - if the milk payments had been too high - where the hell did Fonterra get all these funds to invest (and then lose) overseas. They in large part got them from retained earnings which they then leveraged. Normal business practice - except Fonterra screwed up with poor investment decisions.
I agree with Jones - massive egos got in the way of a good business.

Credit where credit is due..
Let's remember the double double debt.

The farm. Where gross margin treats interest as an operating expense. Where loans are on top of revaluation reserves. Where loans often start as conversion, read development loans against a feasibility study. Where shares in coop are lent against. Where stock are bailed.
Remember the investor syndicate conversions, for when borrowers in short ss.
Farm service providers made a killing, bc the cash came from the bank.
Everything is basis the milk price payment + dividend.

The coop then borrows (as shareholders unable to buy bonds), secured against the fact that the coop loan payments have priority over the milk price payment and dividend....

At the farm level folk are saying if the bank will lend it, they are backing me.
The bankers, able to create money & money supply, shown by Oz r commission, not good folk, & now making customer remediation payments there.
Bank regulators weren't, more waved & cheered everything through.

"farmer instincts have been to trust the leaders of their company" some of us lost that faith years ago and became resigned to being part of a ship of fools

I've been (agricultural meme alert) Ruminating about how it could have come to pass that F invested in the known TWS of Venezuela. And then (mining meme alert) This little 2014 nugget washed up in the pan....

Fonterra said it would, together with a local partner, acquire Nestle’s share of DPA Venezuela. Lukas Paravicini, who joined Fonterra as chief financial officer in 2013 after 22 years with Nestle, said the moves would increase the co-operative’s strategically important markets of Brazil and Venezuela on the consumer side of the business.

So, to an outsider's eye, the sequence is reasonably clear:

  • Ex-Nestle wallah joins F
  • Nek minit a JV with Guess Who is hatched
  • Less than half a decade down the track, the thing goes Udders Up
  • Unexpectedly

Gotta laugh, otherwise you'd Cry.....

My advice to dairy farmers since 1993 has always been, " Never ever ever ever ever let non farmers become shareholders in Fonterra." There are 3 ways to use Fonterra's profit. Pay it to farmers in terms of butterfat, I mean milk solids payments. Pay it to shareholders as dividends. Use it, with borrowed money to invest in stuff to make more money. However, it is common sense to only invest in places one can keep an eye on. China and South America do not spring to mind as such places. The only people who would invest in these places are people who are not using their own money, and can run away from problems which may crop up, at the right time, as, of course happened. Fonterra has to get back to being a Kiwi farmer owned Co-op which exports stuff overseas. As soon as that happens, they will be back in business, providing great payments to their owner suppliers as in the past.