By Guy Trafford
First New Zealand Capital (FNZC) analyst Arie Dekker recently published a report on the Fonterra Shareholders' Fund (FSF).
His bottom line is that FSF is severely underperforming and that unless there is a change of strategy of how or where it gets future capital from it is at risk of “being picked off by independents in a low growth milk environment”.
These independents will not be as constrained by capital for growth. FNZC believe that the poor performance of FSF (as an investment) is whittling away at the confidence of its farmer shareholders, who, over time are starting to see more attractive options in aligning with other ‘independent’ processors who are matching FSF in milk price while not requiring them to invest their capital.
Given New Zealand is close to or at ‘peak milk’ and with significant processing capacity in New Zealand, FNZC questions the wisdom of FSF looking overseas to invest capital “in offshore milk pools” especially when the funding of these investments comes from New Zealand. With the benefit of hindsight the investments in Beingmate and China Farms have been particularly disappointing and underline the above view.
A response to the threat of independents has been to lift the farm gate milk price at the expense of earnings, however, this approach is not seen as sustainable and is only available as a short term strategy and will eventually result in a (further) loss of shareholder confidence as the share price reduces in the attempt to bolster the farm gate price. The lack of a transparent strategy for FSF’s way forward has FNZC questioning the wisdom of the FSF as an investment for both outside and farmer investors. They believe:
- FSF needs to perform better if farmer or external capital is going to be part of the solution. And;
- Farmers need more flexibility in sharing up given the competition from independent processors.
A converse response to a higher farm gate price is to reduce the milk price and effectively lift the earnings of the added value share holdings. Given that Fonterra is often criticised for lifting the farm gate price above its ‘natural’ level to apply competitive pressure on the independents, there's likely to be room to do this and still appease the Milk Price Panel.
FNZC state that FSF has already done this before when it withheld funds and invested into Beingmate. However, given the result of the last foray this option is unlikely to be pursued in the current environment. Also, the threat of such actions is one of the reasons that there is some farmer control on who sits on the Milk Price Panel to protect their direct interests.
Another way favoured by FNZC to free up capital for further offshore investments is for FSF to separate the off-shore assets from its New Zealand centric processing. This would allow shareholders to match their shareholding with where they are comfortable. Unconstrained by the cooperative rules the off-shore vehicle would then have the freedom to source capital from a wider market, although hopefully still with a cornerstone farmer shareholding of choice.
This would allow FSF to then sell off minority shareholdings of some of the off shore assets to attract additional capital to expand into other areas off-shore and not necessarily put the New Zealand centric business under threat. Businesses FNZC suggests Fonterra could reduce shareholdings in are the consumer and food service businesses. The Oceania and Asia C&FS are strongly inversely related to the New Zealand milk price and countries with C&FS businesses worthy of exiting could be Australia ingredients, Latin America (Latam), China farms and unsurprisingly Beingmate.
This would provide the capital to “right size” the balance by providing, according to FNZC, $2.4 billion of new capital on a 10x earnings before interest and tax (EBIT) multiple. FNZC accepts some ‘assets’ would provide no EBIT, surprise, surprise these are Beingmate and China farms. This approach to gaining more capital will help address the issue farmers and outside investors have with being the cash cows for FSF with little obvious benefits or meaningful value creation.
FNZC accept that a paper exercise is an easy way to suggest options, but they believe that the status quo is no longer an option and the DIRA (Dairy Industry Restructuring Act) is unlikely to provide any real relief. They also believe one of the major obstacles FSF has for potential investors in its current form is a distinctive lack of transparency and this needs to change in any future strategy.
However, in the short term who knows what may be revealed if rocks are overturned and a light shone upon them. It may potentially have a reverse effect on share values, at least for a while.