Comment: Fonterra could end up being owned offshore

Wellington-based economist Peter Fraser has studied Fonterra closely and has come up with some solutions to improve performance.

Established with the vision of being "New Zealand's Nokia", Fonterra is now making headlines for all the wrong reasons. In the wake of the failures of farmer-owned dairy cooperatives Westland Milk Products and Australia's Murray Goulburn, can Fonterra survive? More importantly, should we care, asks economist Peter Fraser

Disclaimer: Fraser is providing economic advice to an independent processor associated with the current Government review of DIRA, the legislation governing the dairy industry.

Fonterra's creation is part of Kiwi folklore: it started with the dream of a unified dairy industry with the size and scale to "take on the world and win".

These hopes were seemingly dashed when the reality of a "mega merger" was stoutly rejected by the Commerce Commission.

Undeterred, industry leaders persisted with the idea until it was adopted by the Clark Government, which neatly sidestepped the commission and passed special legislation – with bipartisan support – in 2001, thereby permitting the merger to proceed.

The resulting company, Fonterra Cooperative Group Limited, collected 96 per cent of New Zealand milk production. Only regional minnows Westland and Tatua choose to remain independent.

Big and confident, Fonterra was clearly destined for great things – as its size and structure was considered the step change necessary to enable the New Zealand dairy industry (which was, in effect, Fonterra) to shift away from a near-reliance on commodities and diversify into high-value goods and sophisticated branded products.

But almost two decades later, the dream has gone sour. Most of Fonterra's earnings still come from turning milk into powder, putting powder into 25kg bags, stacking 25kg bags on pallets and loading pallets into 40-foot containers.

A good business, yes – but transformational, no.

Fonterra has simply not turned out to be the national champion it was meant to be, and the divestment of businesses like Tip Top means it never will be.

So, what has happened?

To borrow a term from paediatrics, Fonterra has "failed to thrive". Share price is a useful measure as it allows different companies to be readily compared.

As a cooperative, only farmer-suppliers can own Fonterra shares. However, in late 2012, Fonterra introduced a complex arrangement called TAF for Trading Among Farmers, where farmers could sell the dividend component of their shares to outside investors (called units) yet keep the voting rights. Critically, the market price of the units directly links to the value of Fonterra shares – and hence value of the company.

Fonterra units were initially very popular. They quickly jumped to $6.67 (from an issue price of $5.50) and by May 2013, had broken the $8 barrier – giving Fonterra a then market value of more than $11.5 billion. However, after this initial flourish, the units and the index began to diverge. Unit values started their long and relentless drift downwards whereas the index trended up in a series of leaps and bounds.

Since 2012, the NZX50 index has increased by more than 250 per cent, whereas Fonterra's unit price has decreased by 40 per cent. Units are now trading at around the $4 mark, half their all-time high and valuing Fonterra at a modest $6.4b. Critically, if units had of continued to match the index (rather than diverging), they would be now worth $16.70, implying a market value for Fonterra of $26.7b.

It can be argued a comparison against similar companies is better than a comparison against an index – as one is comparing "peers". Fonterra's performance is therefore compared against group of listed "food" companies with the results summarised in the table below:

The simple reality is in a sector that is creating considerable shareholder value, Fonterra is a stand out as a serial value destroyer. So just how bad is Fonterra's performance?

This question can be answered by a further comparison: this time between a large-scale New Zealand-based "success story", Xero, and a company that has performed poorly, Fletcher Building.

The most telling finding is Fonterra's unit performance is even worse than that of Fletcher Building, a company that has been extensively criticised.

And the performances of Xero and Synlait Milk not only show what is possible, but hints at the type of performance that was expected from Fonterra and used to justify its creation.

So, no matter how one runs the numbers, the simple reality is Fonterra's long-run financial performance is not only poor, it is astonishingly poor.

The strategic review

The 2018/19 season was something of an annus horribilis for Fonterra, with a $196 million operating loss and three dividend downgrades (September 2018, January 2019 and May 2019).

It is not surprising that Fonterra's new chairman John Monaghan, and equally new chief executive Miles Hurrell, announced a "strategic review" in January of this year.

It is not difficult to understand why: chief financial officer Marc Rivers explained that Fonterra had total interest-bearing debt of $7.3b as at January 31 2019, which is concerning for a company with a then market value of only $7.4b.

It is also not surprising that $800m of asset sales were announced, with funds earmarked to reduce Fonterra's very high gearing.

Fonterra CEO Miles Hurrell faces the media after announcing a net loss of $196 million.

The market reaction has been brutal: a billion dollars has been knocked off Fonterra's value in the four months since the review was announced – with $350m of that being lost in the week following Fonterra's May 23 market update (and yet more bad news).

While units have plummeted in value since January, the wider point is they were already on the slide: units that started the season at $5.20 had fallen to $4.80 by January and then collapsed to a meagre $4.00 in by the end of May. This knocked over $1.8b in total in value off the company in only a year.

So, in June 2018, Fonterra was a $8.2b company with $7.3b of debt, but by January 2019 was a $7.4b company with $7.3b of debt but a $6.5 billion debt target. However, by May 2019 it is a $6.4b company with a $6.5b debt target. The simple, but frightening, reality is over the last quarter Fonterra has been shedding value faster than management is able to sell assets.

The result looks increasingly like a race to the bottom - and that is unlikely to end well.

It is therefore no wonder – especially in light of the failure of Westland Milk Products and Australian dairy cooperative Murray Goulburn – the question about national champions has long since been forgotten and a more chilling one arises of whether Fonterra can even survive?

In the short term, the answer is yes. In addition to the business units already earmarked for sale, Fonterra has non-core assets in Chile (Saprole) and Sri Lanka that must be high on the divestment list – especially as Fonterra appears to be retreating towards a "back to basics" strategy. (Fast-moving consumer goods companies often require considerable capital investment – and Fonterra is out of money.)

However, asset sales are only a temporary reprieve unless the business is fundamentally turned around, because once the assets run out then so do the options.

Fonterra milk tankers at their specialty powder and casein manufacturing plant at Longburn, near Palmerston North. Photo / Mark Mitchell

How did Fonterra get itself into such a mess?

While Fonterra has made major strategic mistakes and a slew of poor investments, the problems it faces are deeply ingrained and systemic in nature. Many have been almost 20 years in the making and turning them around is easier said than done.

A good starting point is debt: Fonterra has long relied on payout subordination (this is where banks have first call on the Fonterra payout, thereby offering a high level of comfort to lenders) – without this Fonterra's debt would be well over a billion dollars lower. In addition to choosing high levels of debt (over a long period of time), Fonterra has also made low to non-existent retentions (also over a long period of time).

A telling, but insightful, fact is that over the first eight years of its existence, Fonterra's farmers spent more on plastic ear tags for their cows than Fonterra retained as earnings to grow the business – hence the failure to thrive.

Given its current plight, Fonterra really needs a significant equity injection – and as a cooperative, the only way Fonterra can raise new equity in an environment of little or no milk supply growth is via retentions – but retentions are incredibly difficult for Fonterra.

So why no retentions?

The answer is simple: Fonterra pays its farmer-owners "too much" for their milk, meaning there is little left to keep after the farmers are paid out.

The reasoning is a bit topsy-turvy, but it goes like this.

Under DIRA (the Dairy Industry Restructuring Act), Fonterra is permitted to set its own milk price – despite being a near monopsony (a single buyer) in the market for raw milk. Because of its size (Fonterra still collects about 80 per cent of New Zealand domiciled milk), when it sets its own milk price it also sets the industry price. The issue here is how Fonterra does that. Rather than set a milk price based on its actual performance and actual product mix, Fonterra's milk price is based on the imaginary performance of an imaginary processor with an imaginary product mix. This is called the "Hypothetically Efficient Competitor" (or HEC) and can be thought of as "Fonterra's imaginary friend".

The problem for Fonterra (and by extension, the rest of the industry) is Fonterra's imaginary friend is not actually that "friendly" as the HEC can, and does, pay a higher milk price than justified by Fonterra own performance.

And we are not talking pocket change either: Fonterra admits to just under 50 cents per kilogram of milk solids, which at a company level translates to a margin squeeze of $800 million per annum. To put this into perspective, this is sufficient funds to buy back Tip Top twice, every year, and have change left over.

Fonterra was forced to sell Tip Top, a popular ice cream brand.

The margin squeeze is paid out to farmers as payments for milk rather than returns to capital. This means Fonterra is vertically foreclosed by its own pricing model, with Fonterra having to make up the shortfall by crimping its payments to capital (and by extension, its ability to retain earnings and fund a credible dividends).

So, while there is nothing wrong with using a HEC as the basis of a benchmark industry price (for example, to keep "players honest" by setting an aspirational or "stretch" target), it is fundamentally the wrong price for Fonterra and as a result it is progressively sending the company broke.

Solutions

So, what does a short and long-run solution look like?

In the short-run Fonterra needs to get out of the "race to the bottom" it currently finds itself in. It therefore needs retain at least 50 cents of the 2019/20 milk price and apply that to debt repayment.

However, strengthening its balance sheet will be for naught unless the collapse in share value is halted and turned around. To do this, Fonterra needs to announce a dividend payment of no less than 30 cents for the 2019/20 season.

If Fonterra undertook these two steps it would change from being a $6.4b company with a $6.5b debt target to a circa $9.6b company with $5.7b of debt.

That's better.

However, such a reset will also be largely pointless if Fonterra is still shackled with a milk price regime that is nothing short of madness and tantamount to commercial vandalism – as Fonterra argues it is caught in a legislative trap (albeit of its own design) that it cannot exit from. The solution (and arguably the only realistic option available) is the Government amends the DIRA and relieves Fonterra of the duty of setting the base milk price. The base or "industry benchmark milk price" needs to be set independently of Fonterra – albeit with the current mechanisms regarding a published milk price manual and Commerce Commission oversight.

This would leave Fonterra free to set whatever milk price it wanted – rather than forcing it to adopt a completely inappropriate one.

Critically, for fully shared Fonterra suppliers it would mean no difference in total payout. However, there will be a negative impact on sharemilkers, who typically only receive a milk price. That could well be painful.

Fonterra chairman John Monaghan, left, and chief executive Miles Hurrell at the Fonterra offices on Fanshawe St, Auckland.

A more realistic milk price would also remove a pricing distortion across the entire industry, as the result is a sub-optimal level of innovation at the factory gate (critically important for NZ given a "back to basics" future for Fonterra – value will need to be created elsewhere) and an excessive milk supply at the farm gate (often associated with the expansion of intensive farming into environmentally fragile areas). Repricing will begin to address both problems.

In the absence of a lower (and more realistic) milk price it is difficult not to see Fonterra eventually going the same way as Westland and Murray Goulburn: all cash-strapped cooperatives with too much debt that paid their suppliers too much and kept insufficient retentions.

The reality is short of a nationalisation, there is no New Zealand entity big enough to buy Fonterra. Like Westland, Tip Top and Silver Fern Farms it would therefore end up being owned offshore. More importantly, a demutualised investor-led Fonterra will quickly to abandon the HEC, and thereby realise the billions of dollars of "value" locked in Fonterra – as an under-cooked dividend implies an undervalued share and a windfall capital gain once that under valuation is removed.

This is an issue that farmers should care about. However, there is a broader public policy issue that the Government needs to show leadership on – as this is a problem only the Government can fix.

The Government has the opportunity to resolve the entire issue as part of its current DIRA review. There will not be another chance. Best not to waste it.

Peter Fraser is a Wellington-based economist specialising in agricultural issues who operates as Ropere Consulting. Disclaimer: Fraser is providing economic advice to an independent processor associated with the current Government review of DIRA, the legislation governing the dairy industry. The Government has announced changes to the Act which will now go to a select committee.