Mark Lister: Dairy giant may soon offer taste of NZ Inc

The dairy industry has a lot to smile about given New Zealand's advantages. Photo / Paul Estcourt

Opinion

At our annual investor conference last week, one of the presentations was from Fonterra. Feedback from the 600 private client attendees was that this was one of the most interesting talks of the day.

This was no small feat given the calibre of other speakers, who included Don Braid from Mainfreight, Jonathan Ling from Fletcher Building, Finance Minister Bill English and Grant Spencer from the Reserve Bank.

The first point made by Jonathan Mason, Fonterra's chief financial officer, was that New Zealand is a great place for dairy farming, if not the best in the world. The key reason is simple. We have an abundance of water, which makes us great at growing grass and gives us a distinct cost advantage over many countries.

According to Water NZ, New Zealand receives the same amount of rainfall that lands on the entire Australian continent each year, despite Australia being 28 times our size. This ample rainfall underpins New Zealand's position as a low-cost producer of protein.

Our rainfall averages 2m a year, more than double the 0.8m world average. Food production is very water-intensive, with one litre of water required to produce a calorie of food, and 2000 to 3000 litres needed to satisfy one person's daily dietary needs.

This level of rainfall has a huge bearing on our ability to provide pasture for grazing dairy cows and gives us a strong competitive advantage over other parts of the world that have to supplement their stock with various types of feed, which are usually grain-based. While few local dairy farmers use grain-based supplements, as much as 90 per cent of the rest of the world's dairy cows rely on this, and face its consequently higher cost structure.

Grain prices have increased about 70 per cent in the past 12 months and this has added significantly to the cost structure of many global competitors. So while domestic dairy farmers have undoubtedly seen increased costs, for the likes of fertiliser, they still maintain an overall advantage.

Australia and some parts of South America and South Africa operate in a similar way to us, and certain areas in the United States have begun to adopt our model. However, New Zealand still offers a superior environment. We have a stable political landscape and a reputation for safe, high-quality food products in our favour, too.

This advantage is one reason why, against a backdrop of increasing costs and a persistently high currency, Fonterra last month announced an increase in its forecast profitability for 2011. The updated payout range before retentions is now expected to be between $8 and $8.10, which would be a record for the co-operative.

A co-operative owned by 10,500 farmer shareholders, Fonterra is the world's largest exporter of milk powder, has revenue of $17 billion and operating earnings of $1 billion. It has 432 tankers across 17 depots, operates 86 plants in New Zealand and has the largest milk dryers in the world. It uses 11 New Zealand ports to send 140,000 containers each year to its millions of customers in 140 different countries.

While New Zealand only accounts for about 2 per cent of world dairy production, we export 95 per cent of this. This is in contrast with most other dairy producing nations around the world, where the vast majority is consumed domestically.

Unsurprisingly, China is a key export market, taking nearly a third of Fonterra's milk products last year. With total GDP of US$5 trillion ($6.2 trillion), China has overtaken Japan as the world's second-largest economy behind the United States - which has GDP of US$14 trillion. China's growing demand for high-value agricultural products bodes well for New Zealand. The local agricultural sector, blessed as it is with high rainfall, is well placed to benefit from a China that is expected to become a major importer of food.

Urbanisation in China is expected to see 350 million people migrate from rural areas to the cities over the next 15 years. This is three times the 103 million rural Chinese who have migrated to urban areas since 1990.

This leads to a growing middle class, which will see a rise in incomes, and an increase in demand for higher-value food products, such as protein foods like dairy produce and meat. GDP per capita in China is US$4000, although there are now 120 million people who have incomes of US$7000 a year.

In addition to the growing demand, water shortages could see China become a major food importer in future. China has only one-third of the freshwater per capita of the global average and, unfortunately, the worst water shortages often coincide with the populous northern region. This region has only 19 per cent of China's naturally available water resources, but 46 per cent of the population. This same region also accounts for 65 per cent of the arable land, meaning any water shortage has major implications for food production. As urbanisation continues, a higher proportion of fresh water will be required for residential consumption, further limiting what is available for use in agriculture.

As compelling as all that sounds and aside from the indirect benefits to the broader economy, it is a difficult investment theme for many New Zealanders to gain an exposure to. Short of buying a dairy farm (the average price is $3.5 million, according to the Real Estate Institute), most investors have limited options.

But that may change soon. Capital structure changes approved by Fonterra shareholders last June have paved the way for a Fonterra Shareholders' Fund to be established, which would be listed on the stock exchange. Owning a unit in this fund would not allow any voting rights - farmers would retain those - but it would give investors the right to distributions and changes in the market value of the units.

This would allow outside investors to gain a non-voting economic exposure to Fonterra.

The timing of these changes is uncertain although Fonterra has the ability to put the regime in place before the end of 2013. It could be sooner, as early as next year, or it may not occur at all should the board decide not to proceed.

As well as keeping all voting rights in the hands of farmers, there would also be limits on how many shares will end up in the fund. Fonterra has said it will set the limit at 25 per cent, but it will aim for a level closer to 20 per cent.

This means that at any one time about 80 per cent of Fonterra shares would still be held by their traditional owners. Such limits and protections were no doubt part of the reason that such a large proportion of farmer shareholders (who are traditionally quite conscious of retaining control of the company) voted in favour of the changes. Almost 80 per cent of Fonterra's shareholders turned out to vote and almost 90 per cent were in support.

From an investor's perspective, Fonterra warrants close attention. For starters, it's seriously big. It is one of the top six dairy companies in the world, accounts for close to a quarter of our total export earnings and represents 7 per cent of our total gross domestic product.

Agriculture is the backbone of our economy. Having Fonterra as an investment option will provide many New Zealanders with the ability to invest in what really is "NZ Inc".

It should also be a good long-term investment. Any land-based venture is not without risk and cyclical ups and downs are to be expected. It should also be noted it does not provide specific exposure to dairy farms or the commodity milk price - rather, it is a manufacturer and marketing company of dairy products. However, the long-term growth potential for Fonterra is enormous.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as personalised investment advice. Craigs Investment Partners and Deutsche Bank New Zealand are capital markets advisers to Fonterra.