Stephen Ward: Supportive supplier base crucial for bottom line

Taking a look at rural sector co-operatives and their investment capital issues can be a little like opening an export container load of worms.

It again raises the delicate question of whether co-ops could issue non-voting shares to non-suppliers, thereby raising extra capital without diluting farmer or grower control.

The subject of potential co-op capital constraint has gained prominence in the wake of the recent Food and Beverage Taskforce report, which suggested co-ops may focus too hard on maximising short-term supplier payout at the expense of investing in longer-term growth options.

With co-ops such as Fonterra so dominant in the food and beverage sector, this poses a potential risk for the wider economy's growth.

The report's comments draw on a paper by Fonterra's strategy and growth director, Graham Stuart, who sat on the taskforce.

It is relevant to the whole discussion to ask why we have co-ops at all.

A recent Ministry of Agriculture and Forestry paper quotes a 1936 commentator: "Rightly or wrongly, the farmer has thought that middlemen are making excessive profits and that some form of co-operative organisation will increase the returns to the producer by reducing marketing costs or transferring the profits of marketing from the middlemen to him." Put simply, co-ops can provide strength in numbers to small producers and protect them from market power abuse by "downstream parties".

The Fonterra shareholders council's latest annual report notes the co-op exists for the benefit of its suppliers and must "act in the collective good of all supplying shareholders".

However, MAF's paper says restricting share ownership to a limited pool of suppliers can affect capital raising, posing challenges for co-ops seeking to compete globally "given the investments this increasingly requires" in value-added processing and other improvements.

"These challenges require adaptations to the traditional co-operative model - such as linking ownership contributions to patronage levels or using non-voting equity instruments to access external capital." But the paper adds that co-ops have advantages, such as stable ownership and supply base credibility, when competing globally.

Stuart's paper, meanwhile, says it can be argued that the maximising of producer payout means co-ops are more likely to miss opportunities to lift sector performance.

While kiwifruit exporter Zespri insists it isn't affected by short-termism and meat company PPCS doesn't believe it faces business disadvantages from being a co-op, Stuart has indicated in an interview that similiar-sized multinational dairy companies have "greater access to capital than we do".

Milk production growth in the past five years means dairy farmers have put hundreds of million dollars of new equity into the co-op but Stuart suggests a private company's general practice would be to also try to retain more of earnings for investment purposes.

Continuing to get increases in the price of dairy farmers' shares, driven by the co-op's value-added performance, is important in encouraging farmers to leave capital in Fonterra or inject new money.

That makes the shareholders council criticisms of last season's value-added showing very pertinent.

Encouraging milk production growth is another route to increasing farmer capital contributions and Stuart says the co-op is working hard to remove any impediments it can to such growth.

The embryonic area of Dairy Equity swaps and ANZ-National's possible similiar product, as well as opening up share ownership to sharemilkers, will also help inject extra capital into Fonterra.

In the meat sector, PPCS's consideration of a new class of "supplier shares" is another interesting idea for boosting farmer capital input.

Also, looking at the wider food and beverage sector, Stuart's paper makes several suggestions aimed at helping more small businesses grow into mid-sized firms. They include investing a portion of the Cullen Fund strategically in New Zealand "where analysis tells us there are better-than-average prospects, instead of investing it offshore".

Meanwhile, Murray Boardman, a technical team leader at charity World Vision, who has done post-graduate research on co-ops internationally, believes they have been unnecessarily "marginalised" by the suggestion they have more limited ability to raise capital. "While there is some truth to this, it is often distorted and made bigger than needed - especially as good management and governance is shown to adequately manage this issue."

He suggests "ideologically-based" knockers of co-ops can have a bias against them, seeing them as "old school" or "socialist", while his research indicates they are just as efficient as other structures.

Boardman says a key to retaining or attracting more capital from co-op members is providing them with high-quality information about the business.

This type of transparency and good quality communication from co-ops - and other businesses for that matter - is about much more than just good PR. As the Fonterra shareholders council's comments last week imply, having a well-informed and supportive supplier base is crucial to the bottom line of co-operatives.


Alternatives to dairying

The criticism of Fonterra's value-added performance prompted the director of a Waikato-based rural lender - with a book of more than $100 million - to report signs of dairy farmers being increasingly concerned at a sector income squeeze.

Don Fraser, of Fraser Farm Finance, said costs had risen from about $2/kg of milk solids three years ago to $2.60/kg to $2.90/kg before interest costs, compared with a payout last season of $4.10/kg.

Fraser says more farmers have approached him recently to explore alternatives to dairying as they aren't getting much margin out of their businesses and are looking at alternate land uses.

If more land is taken out of dairying that could cause problems for growing Fonterra's milk supply and its shareholder capital base.