Capital Markets report: Fonterra's co-operative conundrum

Fonterra chairman Peter McBride.

Fonterra's farmer-owners want to have their cake and eat it too, says chairman Peter McBride, as New Zealand's biggest business continues a gritty shareholder consultation on a proposed capital restructure.

Nearly 50 meetings into the first stage of the consultation, McBride notes a "misalignment" between the corporatisation leanings of some farmers and a will to retain the Holy Grail of an inter-generational farmer-owned and controlled co-operative.

"On one hand there's the (desire for an) intergenerational business or cooperative with new farmers coming in and on the other hand the desire of some farmers to maximise the share price. As I've previously said, those two objectives or outcomes are incongruous.

"As a co-op we have to decide which one of those two outcomes is most important to us — at the moment we want to have our cake and eat it too. We have to make a choice."
McBride's not surprised by the mixed sentiment.

But given the diversity and range of ages and stages, objectives, goals and aspirations among shareholders and suppliers, a one-size-fits-all compulsory capital structure doesn't work, he says. "We have a shared problem. When you go to cater for all that it becomes problematic again. We've got to work out what is the most overwhelming objective."

So far around 4000 farmers have turned out to meetings with Fonterra leaders to discuss the board's preferred option for a capital restructure of the $20 billion revenue dairy exporter.

The overarching aim is to ensure Fonterra has a sustainable critical mass milk supply to support a new business strategy which prioritises the value of New Zealand milk.

At first blush the proposal has had a negative response among Fonterra's 10,000 farmers.
The share price of the farmers-only Fonterra Co-operative Group share trading market has dived 23 per cent on one month ago, and in the aligned Fonterra Shareholders' Fund, which offers dividend-carrying, non-voting units in farmer-owned shares, the price is down 15 per cent.

To understand why, it's necessary to digest the board's proposal — something McBride says some farmers hadn't done before they turned out to meetings. Perspectives have changed with deeper understanding, he says.

Essentially the proposal is to relax Fonterra's share standard so that supplying farmers only have to buy one share for every four kilograms of milk solids supplied instead of the current one share for one kg, and either axe the Fonterra Shareholders' Fund or cap it.

Reducing the share standard, the board says, would offer farmers the flexibility they've been calling for over their capital exposure to Fonterra — $8b in the past decade for disappointing returns.

The level of capital investment now required makes it challenging for new farmers to join and can be a major factor for existing farmers in deciding to leave so they can pay down debt or invest in other things. The latter scenario can be a real challenge for succession, forcing difficult decisions when a farm business transitions from one generation to the next.

At a share price of say $5/kg, a farmer supplying 150,000kg milk solids has $750,000 invested in Fonterra. A stronger financial performance only increases the required investment and further tempts farmers away to dairy processors which don't require shares.

But providing more investment flexibility raises a constitutional issue which the board seeks to address with the second leg of their proposal — to axe or cap the shareholders fund.

Their concern is that if capital investment demand is reduced, the co-operative's constitutional thresholds, designed to balance the interests of farmer-owners and outside investors in the fund, could be exceeded within the next five or so years, putting farmer ownership and control at risk.

Without making any other changes to capital structure, the thresholds could be quickly exceeded, because farmers would be able to hold fewer shares, and non-farmers invest more through the fund.

The fund size, currently capped at $500m, could grow if milk supply falls. Nationally, milk production is flatlining and expected to decrease under pressure from regulatory changes, climate change impacts and alternative land use.

Now when milk supply falls, the number of Fonterra "wet" shares on issue — those backing milk supply — decreases, and the number of "dry" shares — surplus to milk supply — increase by the same amount. These dry shares can be exchanged into units at any time, increasing the potential size of the fund.

To stay within thresholds, Fonterra would need to buy back shares or units, creating an uncertain demand on its capital and potentially affecting strategy and growth. The board says buybacks could cost shareholders up to $1.2 billion over the next 10 years. As it is, the proposal will require a buyback.

The size of the fund has been capped while consultation continues, by suspending shares in the farmer-only trading market from being exchanged into units in the fund. Outsiders can continue to buy units. The proposal to remove a source of investment demand has prompted calls for caution from market observers.

Jarden investment bank head of institutional research Arie Dekker predicted early that it would not be popular with all farmers, and could undermine what the board was trying to achieve in capturing a critical mass milk supply for the future.

"It creates issues because the capital base of the co-operative remains the same, at the same time they're putting something forward which will allow farmers to reduce the number of shares they hold," he said.

McBride acknowledges the share price has fallen in response to the prospect of a restricted market, but says the market is thin and uncertain. He believes it's a short-term reaction.

The fund recommendation is not one the board has made lightly, he says, but "kicking the can down the road" for future governors and owners to deal with isn't an option.

There will be another round of meetings with farmers next month with feedback consolidated in July, to form the base for more consultations in August and September.

Meanwhile, McBride says there seems to be a general consensus that the capital structure needs to be addressed to financially sustain future generations. Farmers have come up with "some really good and interesting" ideas which will be formally considered.

Whatever the restructure model, everything hinges on Fonterra's financial performance, he says. The board wants to put the final proposal to a farmer vote in November.

It would require 75 per cent support, plus a tick from the administrative board of the fund. But the timeline isn't set in concrete. McBride is anxious the consultation process is thoroughly inclusive and worthy of the name.

Everyone seems anxious to avoid a repeat of the divisive and years-long process that led to the 2012 introduction of the present capital structure, Trading Among Farmers (Taf).

What some saw as a thinly disguised effort by the then-board to list Fonterra, and aggressively promoted as a counter to share "redemption risk" during a time of soaring milk production and emerging processing competition, resulted in the compromise hybrid we see today.

McBride says the second stage of consultation later in the year doesn't mean that's the end of the process.

"We have to work out how we cater for this broad and diverse shareholder group. It's a really, really important decision."