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Fonterra’s big capital structure reform plan: What does it really mean?

5 min read

Proposed reform of Fonterra’s capital structure is a big deal its farmer-owners will be chewing over for weeks, but what does it mean for prices at the dairy chiller and the company’s long-ago promise to be New Zealand’s national export champion?

New chairman Peter McBride, who’s driving the proposal for major structural change at New Zealand’s biggest business, offers no comfort on the supermarket effect. That’s influenced by global commodity prices – strong right now – and largely out of Fonterra’s control, he said.

But he’s unequivocal on why reform is essential – and not just to fulfil the export performance pledge which propped up the dairy industry’s controversial case for creating Fonterra in 2001 under special enabling legislation from a sector mega-merger.

Some observers say 20 years on that promise has yet to be fulfilled, despite the world’s fifth-largest dairy company by revenue still controlling just under 80 per cent of the New Zealand milk market.

Nor has it performed in recent years to the liking of its 10,000 farmer-shareholders.

They must buy shares to supply milk and in the past 10 years have invested a whopping $8 billion for lacklustre returns on their capital. Not long ago there were a couple of large splashes of red on the balance sheet.

At the same time Fonterra’s facing an existential crisis about its co-operative future as national milk volumes fall, environmental compliance costs rise, banks shy from dairying exposure and land use swerves to horticulture.

“Our concern is over time we lose our scale and efficiency, which will impact on the milk price which will have a profound impact on wealth in New Zealand and the economy,” McBride told the Herald.

Capital from shareholders could get scarce. But those same farmers remain fervent about retaining ownership and control of Fonterra. To do that they have to keep supplying milk to it and buying shares for the privilege of belonging to the industry’s export big cheese and receiving the best possible market price for their milk. (New Zealand’s tiny consumer market means it has to export 95 per cent of milk production.) Emerging export competitors don’t require shares to supply but don’t have Fonterra’s market clout or co-operative spirit either.

All this is where the proposal for a big change in capital structure – and export performance – comes in.

Recognising today “cash is king” and the present capital structure, a clunky 2012-introduced hybrid of sharemarket listed, publicly available units in farmer-owned shares and a farmer-only trading market, McBride and his board propose relaxing Fonterra’s share standard and axing, or at least capping, the listed Fonterra Shareholders’ Fund.

The board favours the chop for the fund. But the overall result of the proposed change would bring all securities trading back within Fonterra and result in a farmers-only market.

This restricted trading would potentially result in a drop in the value of Fonterra shares, at least initially.

McBride told the Herald that is the biggest issue farmers will have to get their heads around in coming weeks as directors hit the road to discuss the reform proposal. Farmers contacted by the Herald identified the issue as an initial concern.

But McBride said the effect would be short-term and what is at stake is the long-term future health of the co-operative and the economic return of farmer investment.

“Currently the model is publicly listed and because of the fungibility between the farmer (share) market and the fund, essentially public investors set our share price for us,” said McBride.

“This comes back to perspective and timelines – if you look at it from the perspective of an inter-generational, sustainable co-op, the model is incongruous. They’re not aligned at all.

“If you take a long-term view, primarily 90 per cent of our assets are our land and livestock. The concern is about sustainable milk supply over time when we potentially lose our economies of scale … we are really focused on that 90 per cent.

“How farmers behave in how they invest and think about shares – their weighted cost of capital is significantly higher (than an outside investor) and that’s at the heart of all this.”

The proposal calls for Fonterra to buy back the fund, which has its own board and administration. As at May 4 it had about 107.2 million units on issue and a market capitalisation of around $493 million.

While farmers chew over the reform proposal, Fonterra has temporarily capped the fund size, by suspending shares in the separate Fonterra Shareholders’ Market from being exchanged into units in the fund. Any wholesale exchange by farmers of shares into units could have seen the fund blow out in value, making it unaffordable for Fonterra to buy back.

To attract more share-buying farmers and sustain milk supply, the board proposes a new supply price of one share for every four kilograms of milk solids supplied, instead of the current one share for 1kg requirement.With the average herd producing 169,595 kg milksolids these days, and the share price in $4-$5 territory, the current regime is onerous for farmers also financing land and livestock costs.

The proposed new share standard would also make it easier for currently locked-in older farmers to sell their shares and exit with cash in hand.

Currently a first farm owner is required to buy a minimum of 80,000 shares and a maximum 160,000 shares – the proposal would require a minimum of 20,000 shares and a maximum of 320,000.A retiring farmer looking to immediately release capital is currently required to retain a minimum of 120,000 shares. The proposal would only require 30,000.

“The compulsory nature of capital can be a strength in a co-op – but it can be a weakness as well. Compulsion is a real issue here,” said McBride.

“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 (constitutional) thresholds.

“We will be asking this generation to consider the next generation but also themselves, because at some point they will want to retire and exit so a farming family can buy their farm.”

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