[This post was first published in the Fairfax NZ Sunday Star Times on 9 March 2014]
This is an outstanding year for dairy farmers with record farm-gate milk prices. Barring another major drought, national milk production records will also be set. But for Fonterra it is not a good year.
The problem is that Fonterra itself lacks fundamental profitability. Indeed if Fonterra were this year to pay its farmers the price which Fonterra’s Milk Price Manual calculations say it should be paying, then Fonterra would make a big loss.
Fonterra’s solution for 2014 is to build capital by retaining some 70c per kg milksolids (i.e. per kg of fat plus protein) from the theoretical milk price. This will see about $1 billion retained in Fonterra’s bank account, which in turn will avoid major new borrowings.
To date I have seen no criticism from farmers. Most of them have been too busy over the summer with on-farm issues to focus their minds on what the retention means. Indeed for most of the farm owners it will not be a big issue. Perhaps they would prefer to have the additional cash, but they also realise that the retained funds will be supporting the share price. For them, the loss of cash will be balanced by gain on a book asset. And they understand that a strong Fonterra is necessary.
However, there is another big group of farmers who will indeed miss out relative to what the Milk Manual calculations say they are entitled to. These are the sharemilkers, and there are several thousand of them. Their contracts entitle them to a share of the milk price. For those sharefarmers who own the cows the share is typically 50%.
These sharemilkers do not own Fonterra shares. So they are losing on the cash payout but getting nothing back as an asset in return. In aggregate, their loss from this year’s retention will be about $100 million. Consider a young sharemilker who owns 400 cows, farming them on a 50/50 milk price agreement. The sharemilker will have dairy assets (mainly cows) of about $1 million and debt of well over half a million. This sharemilker will be forgoing about $45,000 in cash.
The second group of losers will be farm owners who have sold down their shareholding as allowed by Fonterra’s new capital scheme with its misleading title ‘Trading Amongst Farmers’, or ‘TAF’. They will be losing about $75 million in cash with no compensating gain in share asset.
So who is getting the benefit of what these groups are giving up? There are two groups. First there are the non-farmer investors. Second, there are the dairy farm owners who contract with the sharemilkers.
Non-farmer investors will be gaining about $75 million that they would not otherwise be entitled to. About $10 million of this will be in cash dividends and the rest will be retained by Fonterra to underpin the share price.
The second group is the farm owners who contract with sharemilkers. They will receive the full benefit of the retained milk price component as an asset whereas they would only be entitled to a proportion of this sum if it were paid out. The rest would have belonged to the sharemilkers. This gain will be about $100 million.
Given that Fonterra says it is in no financial position to pay out a milk price as per the Milk Price Manual, then two alternative conclusions are possible. The first is that the rules set out in the Milk Price Manual are poorly designed. However, Fonterra Chairman John Wilson confirmed last week that the calculations themselves are sound. So that leaves only one other conclusion. It is that playing by the rules as set out in the Milk Price Manual, Fonterra is unprofitable.
The key message from Fonterra’s retention decision is that there are no longer rules in place by which Fonterra determines its milk price. Rather, that price is set by the Board according to what it thinks is fair and reasonable. Farmer owners are well represented on that Board. Non-farmer investors are also very capable of making their voices heard by indirect means. The key group without representation is sharemilkers.
Fonterra has got itself into this situation because of the new TAF capital structure. What we have seen so far is just the tip of the iceberg. Behind the scenes they will now be working to create new rules. However, papered-over cracks always reappear. The Government bureaucrats responsible for giving a tick to TAF must also be squirming in their seats, given that Government’s position has always been that there must be clear rules for setting the milk price.
So how does Fonterra get out of the TAF straitjacket? Where can it get the funds if it is to take New Zealand’s economy to new places? That is the issue for next week.