[This post was first published in the Sunday Star Times on 19 January 2014]
The Achilles heel of Fonterra’s new capital structure, first implemented in late 2012, was always going to be the tension between farmer members and outside investors. That tension is now going to increase greatly as a direct consequence of Fonterra’s directors, at their December 2013 meeting, casting aside the projected pricing recommendation from their Milk Price Committee.
The rejected price was calculated as per the rules set out in the Milk Price Manual. These rules underpin the integrity of decisions as to what farmers should get as a milk price and what investors should get as dividends.
Fonterra’s directors have now found that the expected company income this year is going to be insufficient to pay out the calculated milk price, which is currently estimated at $9 per kg milksolids. Instead they expect to pay only $8.30. They are also planning to pay a dividend of 10c per share, whereas if they followed the Milk Price Manual there would be no money available for a dividend.
The overall effect of these decisions is a transfer of approximately $75 million of assets from farmers to non-farmer investors.
It is hard to argue against the decision to retain 70c from the calculated milk price. This is because the Directors have been boxed into a corner by a poorly designed system. It is the system that is at fault. However, the decision to pay a dividend of 10c is very much a political decision aimed at appeasing investors. Financial logic says there should be no dividend.
Fonterra has no-one but itself to blame for the current situation. They made the rules but failed to adequately test these rules under different market conditions. The problem lies in the fundamentals of the capital structure that Fonterra has set up.
The prices that farmers are supposed to receive, as per the milk price manual, are based on the commodity prices for whole milk powder, skim milk powder and anhydrous milk fat. The cost of manufacturing these products from raw milk is deducted from the auction prices to give the raw milk price.
It all sounds very simple but in practice there are lots of complex details. The ‘cost of make’ is based on theoretical calculations which assume efficient production and a specific cost of capital. The details of the calculations run for many pages.
A key issue is that not all of Fonterra’s products are these base commodity products. Other important products include casein and cheese. In some years products like cheese and casein produce better returns than the milk powders, and in other seasons the reverse applies. Each type of product requires different processing plant, and so it is not possible to quickly shift from one type to another. This is particularly the situation in the peak of the production season during spring and early summer, when all plants are working at capacity.
In this current production year, it is the basic commodity milk powders that have been giving the high returns. This favours a high milk price but a low return to investors. It is not the first time this pricing relativity has happened and it will not be the last time. It is simply the reality of the ebb and flow of global markets.
Having cast aside the rules as laid out in the manual, the door is now open for ongoing arguments and lobbying by the various parties. If the rules can be ignored once, then they can be ignored again. In effect, there are now no rules. Pricing allocations between milk suppliers and outside investors are now simply a case of whatever the directors think is ‘fair and reasonable’. The outside investors will do their lobbying and the farmers will do their counter lobbying.
One of the fundamental concepts in a co-operative is to ensure alignment of interests. Under the old Fonterra system where farmers supplied capital in proportion to their milk production, this fundamental alignment did exist. Farmers were more interested in the overall payment to milk plus capital rather than the components, and the split between the two components had no effect on the overall payment they received. However, that all changed with the new capital structure.
The new capital structure introduced in 2012 is highly complex. It is also highly innovative in that no co-operative anywhere in the world has previously set up such a structure. Of course Fonterra is not the first co-operative to introduce a hybrid structure that includes both outside investors and members who supply product, but the Fonterra structure does include key elements that have never been tried before. Also, Fonterra’s overall dominance in the market creates unique conditions where there is no natural market price.
Given the innovativeness of the system, it was imperative for Fonterra to simulate prior to implementation how the new system would react to various events. Fonterra claimed to have road tested the system in this way with the help of highly paid consultants. Yet now it is clear that the system has failed at the first hurdle. The designers must be feeling more than a little embarrassed, because the current problem is just the start.
At Lincoln University there are three academics who take a close interest in co-operatives, and we all predicted that there would be tensions between farmer suppliers and outside investors. However, none of us thought these tensions would surface quite this quickly.
It is likely that milk powders will remain high priced relative to cheese for at least the next 18 months. This is because of the huge current shortage of milk in China, and this shortage is going to continue for some time. If the game were to be played as per the rules then this should be a great time for Fonterra farmers but a poor time for Fonterra investors.
The potential situation for investors is made even worse by the threatened legal action against Fonterra by Danone. If things go badly this could cost Fonterra $500 million, which in theory should come from investor assets rather than from the milk price. It will indeed be interesting to see how Fonterra manages this problem.
The season is still far from over, and all of the numbers at this stage are projections. Given that there are now no rules, there will be lots more lobbying in an effort to influence the final outcome as to who carries the burden. However, the even bigger issue relates to the long term capital structure. The road ahead now looks very rocky.