sign up log in
Want to go ad-free? Find out how, here.

Keith Woodford says the Fonterra capital proposals will make the forward journey more difficult, running counter to the intent

Keith Woodford says the Fonterra capital proposals will make the forward journey more difficult, running counter to the intent

Fonterra’s decision on 6 May to present an alternative capital structure has opened a can of worms.

The shares have dropped around 15% and investor units are down 13%. There are no immediate cash implications, but Fonterra’s capital value has declined by more than $1 billion. This transfers through to farmer balance-sheets. Given that this is just a proposal, the market response is remarkable.

There is close to zero chance that the proposals will be implemented in their present form. But the worms cannot be simply put back in the can. Fonterra has made it explicit that its current structure is no longer fit for purpose. Those are not the exact words that Fonterra is using publicly, but they are the exact words coming in on the breeze.

Prior to the proposals being announced, there was no immediate need for action. Fonterra could have kicked the can down the road for several years and left it for another governance team, but they decided to front-foot it. To that extent, their actions are laudable. But shooting themselves in both feet was not needed.

There are two key parts to the proposal. First, the plan is to reduce farmer requirements to own shares. The idea is that farmers will only need to hold one share for every four kg of Milksolids supplied, compared to the current one share for every kg of supply.  However, other farmers who have cash looking for a home can buy up to four shares as investments for each kg of supply.

The second part of the proposal is a plan to buy-out or at least cap the investor-unit fund. 

If the proposals are accepted, then the only incoming equity capital will be retained earnings plus cash from asset sales. That is the same as the current situation. However, buying up the existing investor fund would soak up funds.

Declining milk supply

The driver behind the need for change is Fonterra’s concern that its milk supply is going to decline. The key reasons are environmental regulations and urban-spread plus horticultural conversions.  Under the existing structure, this would lead to shares of departing farmers being transferred to investor-owned units. This in turn could led eventually to those investors demanding control, although there is no mechanism in law to assist them.

Although the proposals are only up for discussion, Fonterra has already cut the two-way pipeline connecting shares to units. This means that if farmers now leave Fonterra, their shares will have to be purchased by other farmers who buy them as voluntary investments. This creates a big risk that the share price will eventually crash owing to a lack of willing farmers with liquidity to buy investment shares.

There is a saying in business management theory that strategy comes before structure. Well, that is the way it is meant to be. But if strategy and structure are misaligned, then structure controls strategy like a bungee cord pulling strategy back to what is feasible.

In Fonterra’s case, the new strategy created in 2019 focuses on marketing New Zealand milk rather than also trying to dominate global trade using milk produced in other parts of the world. Fonterra still has sizeable foreign operations both in Australia and South America. Fonterra supposedly no longer has any ‘sacred cows’ when it comes to this overseas-sourced milk. 

 It makes sense for these overseas processing assets to be sold. It is a case of finding the right time to sell them at an acceptable price. At that time, Fonterra’s consumer-branded business will become considerably smaller.

At that time, Fonterra will also be much closer to having a structure that aligns with what farmers want. Their priority is to have control over the processing of New Zealand milk until that milk is in a stable form. That primarily means powders of various forms and sophistication, plus cheese and butter.

Two-company model

In email correspondence, some people have been suggesting to me that it is time to look again at the two-company model. Going back more than ten years, I saw merit in that structure and advocated for it. But those were the times when Fonterra’s strategy was to take on the world.

As long as Fonterra had a big focus on consumer brands as well as business-to-business (B2B) brands, then there were strong arguments for a two-company model. Consumer-brand companies need a different internal culture, deeply embedded in the company operational DNA, as compared to companies that focus on ingredients.

It is very hard to make consumer-focused and B2B strategies work in the same company. There lie some of the answers as to why Fonterra’s overall performance since formation has been so disappointing.

However, with Fonterra already losing much of its overseas-sourced milk plus the likelihood of losing more, Fonterra does not have a big future in fast-moving consumer brands. It no longer needs that second company.

To clarify that point, there may well be scope for a big consumer-brand company using New Zealand milk, but it needs totally separate management and governance from Fonterra. Let Fonterra focus on the things that it does well such as collecting milk from farms and turning it into long-life commodities and sophisticated ingredients, including potentially the supply of ingredients to totally separate investor-owned consumer-product companies.

If Fonterra structures itself this way, with a dominant focus on converting its suppliers’ milk to long-life products, then new capital needs will be modest. Sales of existing overseas assets can be used to further pay own debt. 

Given Fonterra’s concerns about losing supply, this low debt becomes a safety factor for Fonterra going forward.

Farmer control

Fonterra’s farmers are saying to Fonterra that they want it to remain a co-operative under farmer control. Fonterra needs to remind those farmers that a fundamental structural provision of dairy co-operatives that do not have outside-investor equity is that the farmer suppliers have to be responsible for ‘service capital’. The notion that a processing and marketing co-operative can prosper without adequate service capital from its suppliers is fanciful.

My key criticism of the existing so-called ‘trading among farmers’ (TAF) system has been that it was based on a falsehood that it somehow removed redemption risk. But that does not mean that TAF had no worthwhile features. Some alternatives are worse than the existing TAF.

Right now, there is no urgent need to buy out the existing investor fund. Having such a fund has meant that there is tension between milk price and dividend, but the proposed system simply shifts that tension elsewhere within the company. This is because the proposed system is that farmer shareholding relative to supply can vary by a factor of 16, with this being the range between the proposed minimum supply shareholding of 1:4 and the proposed maximum of 4:1.

The simplest path for Fonterra right now is to continue to sell assets related to overseas-produced milk as and when market conditions allow and to further reduce debt. In the meantime, it might also be best to consider a mea culpa and restore the pipeline between shares and investor units.  As for the notion of reducing the service capital provided by Fonterra’s farmer members, that needs to go back to the drawing board. If the current proposal is implemented, the long-term future of Fonterra will really be at risk.


*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 previous articles can be found at https://keithwoodford.wordpress.com You can contact him directly here.

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

10 Comments

So selling overseas assets when they can makes sense.
But the suggestion in this article is that domestic milk production volume is at risk of declining due to various drivers.
Would be absolutely imperative that the forecasting is well done to make sure that NZ farmers aren't left holding stranded assets here too then? Sounds challenging. And also should put some heat back on the government to give a clear roadmap on where they see land use heading to.

Up
0

Hamish
My personal view is that dairy production may decrease less than what Fonterra may be expecting. I have been influenced in my thinking by the composting moo-tel and composting shelter work that I am involved in, with this linking to duration-controlled grazing. I think these innovations can be transformational and solve key environmental problems, and do so in a way that is economically acceptable, indeed increasing profitability. But those ideas are not yet mainstream, and so in this article I decided to work from Fonterra's current position. There are definitely some people talking about stranded assets. And if Fonterra were to lose say 20% of supply then that would very definitely be the case.
KeithW

Up
0

Would we be better to split the company into two more nimble and responsive competitors rather than the large, fat, bumbling monolith that we have now?

Up
0

Chris-M,
In pre-Fonterra days, NZDG and Kiwi were those two competing companies. But even then, farmers really had only one choice because they were operating in different locations and hence different supply catchments. I am not aware of any support for going back to those days. Most of the more recent two-company thinking has been based on the premise that one company would focus in turning raw milk into ingredients and the other would focus on taking ingredients through to consumer goods. Farmers would be mainly interested in the first of these companies and it would logically be a co-operative. The second company would logically be investor-financed. There are a number of existing small-scale companies in the second category but nothing of significant scale.
KeithW

Up
0

Lil. Come on Keith, the man said nimble and responsive.

Up
0

Nimble and responsive are both simple words.
But constructing companies that have those attributes is far from easy.
KeithW

Up
0

Keith - you expect change in the final outcome of the Fonterra review however looking at the experience of the current board there must have been some sounding out of support by the big shareholder/suppliers before going public. As a board you do not go public without a degree of confidence in the outcome.
A consequence not canvassed is how control of Fonterra may change - and not for the better. With smaller less well capitalised suppliers only needing 1 share per 4 kg ms, this group will include those under pressure by their banks to sell shares to reduce debt and those where the dividend does not cover holding costs. The better resourced corporate and multi farm owning entities who can afford to purchase their full shareholding will gain increased relative voting control that potentially will allow them in the future reconfigure both Fonterra's capital structure and dividend policy to their advantage.

Up
0

Wilco
Although Fonterra surveyed its farmers as to the priorities that farmers wanted them to focus on in any restructure, I don't believe there was any leaking about the specific proposals. And Fonterra has been explicit that the proposals are not locked in stone.
The proposed voting relates to kgMS backed by shares. Fonterra has used the example of a farmer who produces 80,000 kg MS. If that farmer has 20,000 shares then the farmer gets 20 votes. If the farmer has 80,000 share then the farmer gets 80 votes. If the farmer has >80,000 shares then the farmer still only gets 80 votes, with this figure being constrained by the amount of kgMS they are supplying.
A key issue would seem to be that the total dry shares is around 14 percent with about 6.5% thereof held as units but linked to dry shares. Then there is another tranche of dry shares still held by farmers as fcg shares rather than via investor units - it seems that these make up around 7.5% of the total shares hence the total dry share figure of around 14%. Apparently the total dry shares allowed in the constitution is 15%. So either the constitution has to be changed or else Fonterra has to start buying shares back. Most people (and until recently that included me) did not realise how close to the 15% maximum that Fonterra was sailing. I had never seen that current figure of around 14% stated until the consultation booklet came out on 6 May.
KeithW

Up
0

If Fonterra wants to attract suppliers to a strong stable intergenerational cooperative, they need to uphold and communicate fundamental cooperative principles, one of which is a policy of retained earnings which acts as service capital. A policy applicable to any successful business.

While I agree that the current proposal isn't perfect in the share standard disparity, it's a step in the right direction, and aligns with strategy of focusing on NZ milk. A factor no one mentions regarding future destabilising forces is representation as a proportion of share backed supply. That differentiates suppliers as much as a flexible share standard.

Up
0

Omnologo,
Part of the strategy reset back in 2019 has been an increased focus on retained earnings. That reflects a more conservative philosophy within the Board.
KeithW

Up
0