Fonterra’s journey

[This is the second of five articles on Fonterra that I have been writing for the Fairfax NZ Sunday Star Times. This one was published on 8 February 2015. The previous article was titled ‘The evolution of Fonterra’ ]

Last week I wrote about the battles that led to the formation of Fonterra in 2001. However, Fonterra’s structure and associated institutional culture have moved a long way since then.

Sufficient time has elapsed since Fonterra’s formation battles that they can now be seen in reasonable perspective. But subsequent events are still raw. In line with corporate policy, the participants have largely kept their opinions private, and the official line is a product of the public relations team. However, in a co-operative structure, it is inevitable that information does leak. One thing for sure, is that some of the internal debates have been vigorous.

When Fonterra was formed its co-operative philosophy was straight forward. Every farmer supplier was required to own shares in proportion to their production. Apart from those who had special winter milk contracts, milk payments were the same for each month of the year. There were no external investors. As a consequence, there was close alignment of members interests; what was good for one was good for all.

Now in 2015 there is no longer close alignment of members interests. Some farmer members have more than one share per kilogram of milksolids produced. Other farmers have less than one share per kilogram of milksolids. As from this year, some new farmers in particular parts of New Zealand will not have to own any shares at all for at least five years.

When Fonterra started there was no such thing as dividend payments on shares. The Board reported both a commodity price and a value-add component, but these were lumped together as one milk price. Given that everyone’s shares were aligned with production, the system worked well. The final payments that farmers received were the same regardless of the split between the commodity and value add products. In the new Fonterra, the value-add returns are now paid out as a dividend to capital contribution rather than a component of the milk price. For investors, the milk price is now a cost.

The split between commodity milk price and value-add dividend may sound straight forward. But in practice it depends on assumptions, formulae, and back-office calculations. Last year Fonterra simply ignored the formulae when they did not provide the split that Fonterra wanted.

Non-farmer investors still cannot own shares in the co-operative, but they can own dividend-earning ‘units’. These units fluctuate in value just like the shares, and the only real difference is that they have no voting rights.

Currently, the investor units only make up about 7.7 percent of Fonterra’s equity capital, and less than 4 percent of total capital (debt plus equity). But it is the market price of these investor units that determines the share price at which farmers must buy and sell their co-operative shares. Accordingly, although the unit holders have no voting power and no representatives on the Board, in reality the fund management companies (mainly from Australia) that dominate the unit register have considerable impact on co-operative policy.
With every decision that Fonterra now makes, a key issue is how will these fund management companies react in terms of their unit ‘buy and sell’ policies, which then drive the share price for the whole co-operative.

The policy issue that has been most vigorously debated by farmers over the last ten years has undoubtedly been capital structure. However, there have been at least four other big policy issues that have been fundamental to the journey which Fonterra is travelling, but which have received less public scrutiny. These ‘big four’ have been cash retentions from the milk price, off-shore sourcing of milk, value-add policy, and China.

There have also been three events, rather than issues, which have had fundamental impact. These have been the 2008 melamine disaster, the 2008/09 global financial crisis and Fonterra’s 2013 botulism scare.

In the early years, Fonterra held back minimal cash from the farm gate milk price to finance development. The policy was called ‘pass through’. Farmers wanted it that way, but the directors were lax in not forcefully communicating to farmers the need for Fonterra to retain more earnings if Fonterra were to grow.

The weakness became very apparent as the 2008/9 financial crisis unfolded. Indeed Fonterra was in considerable difficulty in December 2008, and there was much concern within Fonterra as to whether the necessary cash could be found to make the December payment to farmers. Quite simply, milk powder was not selling, and the kiwifruit packing houses suddenly became milk powder storage facilities. Fonterra had to find new lines of credit, at very high interest rates, and they were nervous times. There was huge relief with the successful market issue for $300 million of bonds in February/March 2009.

The story of Fonterra’s financial crisis over the 2008/9 summer has never been told in public. When it does eventually get told, it will be a good story. Although the extent of the crisis was kept well hidden from the public, it did impact on Fonterra’s thinking about capital structure. Something had to be done to strengthen the balance sheet.That then became the driver for capital restructuring.

Next week I will take up the issues of Fonterra’s global off-shore sourcing of milk and the internal debates within Fonterra about value-add strategy.