The purpose of this post is to explain Fonterra’s redemption problem. The question of solutions is left to another post.
Fonterra’s redemption problem arises from the alignment of several factors.
1) Fonterra is a co-operative and hence the shares are redeemable by the co-operative rather than traded between members.
2) Fonterra has high liabilities relative to total assets. That means there is limited capacity for further borrowings.
3) There are no non-distributed reserves; i.e. all equity is allocated individually to members, rather than, as happens in most traditional co-operatives, part of it being held in common.
4) Since formation, Fonterra has tried to maximise payout to milk suppliers and minimise retentions to fund growth.
The redemption risk arises because, if a significant number of members were to withdraw their capital, either by shifting to non dairy activities or supplying an alternative processor, then Fonterra would not have the ready cash to pay them out. One option if that situation were to arise would be for Fonterra to borrow the cash from banks, but this could be difficult given the current high level of gearing. In 2009, Fonterra’s banks and the credit rating agencies made it plain that that they were already cautious about the existing debt. The second option would be to issue tradable capital notes instead of cash. This would probably be the preferable option, but capital notes are still a form of debt and have to be serviced.
Since Fonterra’s formation, there have been three significant start-up dairy companies (Open Country, Synlait and NZ Dairies). Collectively, they now process about one billion litres of milk per annum. Given the overall growth in the dairy industry, there has been no net loss to Fonterra. But if either these or additional new companies were to take another billion litres away from Fonterra, and if this were to occur during a period of no overall growth in the industry, then Fonterra would feel the pressure. It is easy to draw scenarios where Fonterra would, at the very least, suffer a decline in credit rating, with consequent higher interest charges, and a lack of new funding to take on development of new markets.
A few numbers from the Fonterra’s 2009 Annual Report can quickly bring focus to the issues. As of 31 July 2009, Fonterra had consolidated assets of $14.1 billion and liabilities of $9.3 billion. The difference of $4.8 billion was equity of which $4.56 billion was members’ funds. So Fonterra had just on $2 of liabilities for every $1 of equity. But this equity is not only in scarce supply, it is also different to the equity in an investor oriented company. This is because it all has to be redeemed by Fonterra if members decide to leave Fonterra. So at best it is quasi equity.
The situation is actually worse than painted above. This is because the redemption liability relates to the fair value share, as promulgated by Fonterra itself, which is currently (Feb 2010) $4.52. Given that there are 1.227 billion shares, then the total redeemable share value is approximately $5.55 billion. But the quasi equity in the balance sheet to support this share value is only 4.56 billion of which $2.8 billion are intangibles. Mmmm!
When Fonterra reports its debt for popular consumption it calculates the figures somewhat differently to how I have done it. It talks of a ‘debt to debt plus equity ratio’ of only 52.7% as of 31 July 2009, which doesn’t sound too bad. But it gets to this figure by only including its net interest bearing debts of $5.17 billion, rather than total liabilities of $9.3 billion.
Fonterra’s response to criticism on this point is that they have always calculated the figures this way, which is true. But that does not alter the fact that Fonterra owed creditors a lot more than $5.17 billion at that time. If they had reported liabilities to total capital, the figure would have been about 68%. All of these other liabilities, such as trade payables and money owing to milk suppliers, are still debts, even if not interest bearing, and they all have to be paid!
Despite these problems, the situation that Fonterra faces in 2010 is far from an immediate crisis. In early 2009 it was starting to look that way, but good weather in the 2009 spring and early summer, plus a spectacular lift in dairy prices in the second half of 2009, has taken away the short term pressure. The 2010 balance sheet (as at 31 July end of year) should look better, even if it is still relying totally on quasi equity.
Nevertheless, to use an analogy from yachting, Fonterra is still set up for downwind sailing. It is poorly set up for tacking into the wind, and it still needs to do something to remedy a position that is less than comfortable. Of course Fonterra knows that it needs to do something. It says so quite openly itself, but can get defensive when others say it. The challenge is in finding the right solution, that is consistent with remaining a co-operative, and which members will accept. But that is an issue for another post.
For a pdf of this post download here: Fonterra redemption risk 21feb2010