Jenny Ruth: Open Country knows when to say cheese

Taking on the Fonterra juggernaut isn't an easy task and involves lengthy adjudication from the corporate regulator, Open Country Cheese's experience shows.

Open Country was founded in November 2001, the same day legislation restructuring the dairy industry passed through Parliament.

The Dairy Industry Restructuring Act allowed for independent processors to export dairy products for the first time - previously, the former Dairy Board had exclusive exporting rights.

In June last year, the new company went public with a $15 million share issue to fund the building of its factory in Waharoa in the Waikato. That's the first time non-dairy farmers have been able to buy equity in the dairy industry, New Zealand's largest exporter.

Under the act, Fonterra is obliged to supply specified amounts of milk to competitors, 50 million litres a year in Open Country's case.

In its first production season, Open Country made 6000 tonnes of cheese, 1000 more than its 2004 prospectus envisaged. The planned 5000 tonnes represented about 1.7 per cent of New Zealand's exported cheese volumes.

But that gave rise to its first dispute with Fonterra. Open Country is expected to pay Fonterra for the transport costs of delivering milk. Rather than the actual cost, Fonterra insisted Open Country pay its national average cost of transport. The actual cost estimated earlier this year was 14.76c per kilogram of milk solids compared with the national average cost of 22c.

To Open Country's way of thinking, it, a tiny player, is being forced to pay the industry giant a subsidy. A draft decision from the Commerce Commission agreed with that viewpoint, although it is yet to make a final decision. Open Country's complaint about this was lodged in September last year.

To finalise its accounts for the year ended May, Open Country had to wait until Fonterra set the price of the milk it is required to supply to Open Country. Fonterra had sold its stakes in Australia-based National Foods and rural supplies company Wrightson during the year. Open Country was taken aback when Fonterra insisted the resulting capital profits should be included in the price Open Country paid.

Open Country reckons this means it was over-charged by $737,037. So it was back to the commission. Open Country is still waiting to hear whether its complaint will be accepted for adjudication.

It's hard to imagine it won't be. Otherwise, Fonterra could keep manipulating the price it charges its competitors by selling assets.

Instead of beating its prospectus forecast of a $2766 maiden net profit with a $66,367 net result, Open Country had to report a $447,232 net loss, all thanks to the over-charging.

The prospectus projected a $633,140 net loss for the current year and a net profit of nearly $4 million for the year ending May 2007.

Open Country's first season used only about a quarter of its plant's capacity as it chose to take a cautious approach to commissioning its new factory. It is aiming to beef production up to its full capacity of more than 20,000 tonnes of cheese over the next two years.

The prospectus did discuss the possibility of sourcing additional milk from Fonterra over and above the amount it is legally obliged to deliver. Chief executive Alan Walters says it's "fair comment" that, in light of this history, it's unlikely Open Country and Fonterra will be able to agree on a mutually acceptable price for additional milk.

That means Open Country will have to source milk directly from farmers. It has 26 farmers signed up for this season and expects to process well over 70 million litres of milk.

Sourcing directly from farmers obviously means that Open Country has to better the price it gets from Fonterra and it is also more difficult to manage than having Fonterra deliver a set amount of milk every day.

Walters agrees it will require more work. "We will be ready for it. We're getting the systems and people in place to cope with it. Even at capacity, we would only have about 150 suppliers," he says.

The prospectus also talks about providing incentives to farmers to smooth out supply.

As part of gearing up to full production, Open Country has installed a whey powder plant. Last season, it paid to truck whey to farms for disposal.

Walters said the difficulty and costs of disposal turned out to be significantly more than the firm had expected, making the decision to go ahead with the whey plant, particularly given the high prices whey is commanding, an easy one.

Historically, whey, used as an ingredient in products such as confectionery and ice cream, had only earned its cost of capital so had not been much of a money spinner.

Although the IPO had made provision for over-subscriptions of up to $5 million and the issue was heavily over-subscribed, Open Country's directors opted not to accept over-subscriptions.

So instead, the company had to make a $5.4 million rights issue to finance the whey plant.

"The rationale [for not accepting over-subscriptions] was that we just didn't want to give away the shares at too cheap a price," Walters says.

The IPO shares were priced at $1 each and the rights issue was priced at $1.60. The shares, which are traded on the Unlisted facility, last traded at $1.90, giving the company a market capitalisation of $71.6 million. They have ranged between $1.45 and $2.50 over the last year.

Open Country's strategy once it reaches full capacity is to move up the value chain by producing higher value cheeses. Most of last season's production was cheddar but it also produced fancier cheeses including Havarti, Gouda and Kahui - the latter is the first cheese style developed in New Zealand exclusively for the Japanese market.

It doesn't have a retail brand, but that's an option too.

And if Open Country wants to increase its capacity "there certainly wouldn't be any shortage of capital", Walters says.

Joining the New Zealand Exchange is also an option for the future - given its market capitalisation and the fact that it already has more than 500 shareholders, it is already qualified.

Who, what, where

Open Country Cheese HQ: Factory Rd, Waharoa.
Profile: The company is a commercial producer of cheeses, most of which are exported, either as ingredients used by other processors or packaged and sold under other brands.
Market capitalisation: $71.6 million.
Latest results: The company reported a $447,232 net loss for the year ended May 31.
Management: Chief executive Alan Walters, cheese operations manager Mike Lawson, sales and marketing manager Barry Allison, cheese strategy adviser Frank Dunlop and financial controller Graham Fry.
Major shareholders: Together the directors own 47.4 per cent, with Andrew Talley's Talleys Fisheries owning 30 per cent.