In 2009, Fonterra announced a three stage plan to alter its capital structure. The first two stages were put to the vote in November 2009 and passed. As a consequence, members are now entitled, if they wish, to purchase an additional 20% of shares beyond what is required as service capital of one share per kg of annual milksolids. Members will be paid the ‘distributable profit’ (a new Fonterra term) on these ‘dry’ shares.
The constitution was also amended so that the ‘fair value share’ price at which farmers and Fonterra transect the buying and selling of shares would reflect that the shares cannot be traded in the market, leading to a lower value than would otherwise be the case.
Most farmers regarded these changes to the constitution as being non controversial, and the proposals easily met the required support level of 75%. However, there is a fair chance that many farmers did not fully understand the long term implications of the 20% rule. In the short term it should prevent capital from ‘sloshing in and out’ (to use Fonterra’s own term) as production varies according to the vagaries of climatic conditions. But in the long term, it may actually increase the redemption risk, as dry shares are easily redeemed in tough financial times.
The third part of the Fonterra proposal was, and is, that all shares, both ‘wet’ and ‘dry’, would be tradable amongst farmers. Despite some farmers being initially keen that this to should be put to the vote in November 2009, Fonterra wisely recognised that more work needed to be done on the proposal, and its implications, before putting it to the vote. But let there be no doubt, it is very much on the Fonterra agenda for 2010. It is a huge issue, beguiling in its apparent simplicity, but far reaching in its implications.
From Fonterra’s perspective, it has the potential to solve two major problems. First, it solves the redemption risk. (See my earlier post of 21 Feb 2010 here on the redemption issue as to why redemption is a risk to Fonterra: Fonterra redemption risk 21feb2010). Once shares are made tradable, then Fonterra will no longer have to redeem the shares of departing members. Fonterra’s quasi equity (i.e. redeemable equity) would now be genuine equity. Following on from this, Fonterra would also be in a stronger position with its banks, opening up some possibilities for further borrowing to fund growth.
However, in making shares tradable, the redemption risk has not actually gone away. Rather, it has been transferred to the individual farmer members.
To take an example, which might initially seem extreme, but which illustrates the point. Assume that Fonterra lost 17% of its production to competing milk companies such as Open Country, Synlait and NZ Dairies, or to additional start-up companies such as the proposed Oceania Dairies. These departing farmer members would want to sell their shares, but who would buy them? The only purchasers would be the remaining 83% of farmers. But they could only buy an additional 20% of shares. And 20% of 83% is only 16.6%. So in relation to the original Fonterra share capital, we have 17% of shares for sale but the remaining farmers are only entitled to purchase 16.6%. Inevitably the share price would have to crash, based on the fundamental law of supply and demand.
In practice, it would require a lot less than the 17% loss of milk supply to cause such a crash. This is because some of the remaining farmers would already be at their maximum share level of 120%, and many others would have no wish to buy additional shares.
How big would the crash be? Well, if all departing members were to sell their shares it would crash to zero. When I have said this to some farmers, then a typical response is that ‘someone would come in and buy them’. But the whole point is that there are insufficient people with an entitlement to buy them.
So the big message at this point is that, to the extent that redemption is a risk to Fonterra, then share tradability transfers that risk to individual farm businesses.
So what would happen at that point? The obvious solution would be to open up the share register and give farmers an additional entitlement to purchase dry shares, for example 100% rather than just 20%. But how many farmers would be in a position to buy these shares? Inevitably there would be a clamour to open up the shares to non farmers. And the way that would be done is through a public share listing.
There are lots of other scenarios that need to be considered. For example, if times were tough then banks might say to their farmer clients: you need to sell your dry shares and thereby reduce your bank debt. This would make lots of sellers but few buyers. Once again the price would crash.
At this stage there are lots of unknowns about the Fonterra share proposal. For example, if new farmers enter the industry will Fonterra issue them new shares and if so at what price. What happens if existing farmers increase their production? Will they purchase new shares from Fonterra or will they have to get them from farmers who are decreasing production. Some complex rules may need to be defined, and these rules will affect the share price. The price of shares could become very volatile.
Farmers also need to appreciate that the trading proposal is not the same as at LIC where there are two classes of share with only one class tradable. At Fonterra there is only the one class of share and all would be tradable. Of course Fonterra could change this to two classes of share, but if they do this then it seems unlikely they will solve their redemption risk. And that, of course, is the reason for making shares tradable in the first place.
Given all of the above, farmers need to think very carefully before agreeing to make shares tradable. They need to realise that it transfers risk from Fonterra to their own individual businesses. They also need to realise that apparently simple steps can lead to the slippery slide. The journey down that slide is the journey from a co-operative to a listed company. If farmers want to expose themselves to that journey, then well and good, but they need to do it with their eyes open.
A pdf of this post can be downloaded here:Making Fonterra Shares Tradable Needs Careful Scrutiny 21 Feb 2010