Fonterra’s capital structure is no longer fit for purpose

Fonterra’s delay in announcing its results, driven by Fonterra’s need for discussions with its auditors about appropriate asset values, provides an opportunity to reflect on Fonterra’s capital structure and whether it is still fit for purpose. The simple answer is that it is not.

The value destruction that has occurred and which is now coming to light means that inherent conflicts between the interests of farmer shareholders and investor unitholders have become too great to be papered over. Co-operatives do not survive long-term unless everyone’s interests align.

Two former directors of Fonterra, Colin Armer and Nicola Shadbolt, have both come out recently and said that reworking Fonterra’s capital structure is not the immediate priority. I agree with them. The immediate and urgent priority is to sell assets and create a new slimmed-down and financially-efficient organisational structure, with many fewer high-paid executives.

However, asset sales and creation of the new slimmed-down and non-bloated operating structure can only be the first stages of traumatic overall restructuring. Fundamental flaws in the current hybrid structure of farmer shareholders and non-farmer unit investors mean that a new capital structure will also be needed.

Fonterra’s current structure was created in 2012 following at least five years of angst searching for a new structural pathway. The leader of that journey was Chairman Henry van der Heyden, now Sir Henry.

The key argument was that Fonterra needed to have permanent capital, whereas in a traditional co-operative the farmer shareholdings are not guaranteed as permanent.

If a farmer leaves a traditional co-operative, the shares owned by that farmer have to be redeemed, although the redemption can be delayed. Hence, the argument was that there needed to be a mechanism to allow cash outflows from share redemptions to be balanced by new cash inflows from non-farmer investors.   

The challenge in finding such a mechanism was that farmers were not willing to let non-farmers have a vote in regard to company policy. The supposed solution was to create a structure where non-farmer investors could buy units in a new structure listed on the NZX and called the Fonterra Shareholders’ Fund. These units would have the same economic rights as shares but no voting rights. If farmers departed, then the number of units would be correspondingly increased, and hence the redemption risk would be solved.

The name ‘Fonterra Shareholders’ Fund’ is an inappropriate name. In fact, it is aimed at non-farmer investors.

The legal structure of the Fonterra Shareholder Fund (hereafter the ‘Fund’) is complex. I won’t go into the details here. The overarching principle is that the Fonterra-nominated Custodian can hold shares to Fonterra and sell units to their economic rights. The shares themselves stay with the Custodian but hold no voting rights for anyone.

The Fund is a key part of the overall capital structure called ‘Trading Among Farmers’ (TAF). This too is an inappropriate name as much of the trading actually occurs between farmers and non-farmer investors. 

It can be useful to think of the Fund as a balloon, with a two-way umbilical cord through to Fonterra itself that is managed by the Custodian.

 If farmers sell their shares, then new balancing investor units are created in the Fund. In this way, the number of units in the Fund get pumped up.  Also, a payment passes via the Custodian through the umbilical cord from the purchasers of the units to the departing Fonterra farmers.

Conversely, if farmers are buying shares from Fonterra, then the Custodian can sell shares to the farmers and buy units from the Fund at the same price.  These units are then cancelled. The money that the farmers have paid the Custodian is shovelled on to the departing unit-holders and the size of the Fund shrivels.

It sounds complex and it is complex. However, the system has now been working for close on seven years and it has indeed worked, at least until recently, largely as intended.

Over these years, farmers have been able to buy and sell shares, unitholders have bought and sold units, and the Custodian has managed the process such that the price of shares and units is always within a cent or two of each other.

Two other outcomes have been that Fonterra has received no new capital when farmers bought shares, and Fonterra has not had to pay out money when farmers departed.

A key insight relevant to how the Fund works in practice is that the size of the Fund is largely determined by farmer decisions to buy and sell shares. These decisions are largely driven by their need to hold one share for each unit of production, measured as one kilogram per annum of ‘milksolids’ (fat plus protein).

Another key insight is that although the number of units in the fund is largely determined by farmer decisions, the price of units and hence also the price of Fonterra shares, is determined by willingness of non-farmer investors to buy and sell units.

Once the Fund had been bedded down at the end of the July 2013 financial year, the Fund had 108 million shares, valued at $7.30 and the total Fund value was $788 million.

Fast forward to 1 January 2018, the fund had ballooned to 139.7 million shares valued at $6.38 with a total value of $891.6 million. This reflects that farmers were predominantly selling shares, unit-holders were predominantly buying units, and prices were holding up reasonably.

Fast forward again to 1 September 2019, the Fund had shrivelled to 102.1 million shares, each valued at $3.18 and the Fund value was $325 million. This reflected that farmers had predominantly been buying shares, allowing unit holders to exit and hence the fund to shrivel, but still the price of units had tanked.

 It may seem surprising that farmers have continued to buy shares despite Fonterra’s total production no longer increasing. The reason is that many farmers were using a Fonterra scheme called MyMilk that allowed them to delay the purchase of shares for five years. There are still some farmers who need to buy shares because of this scheme.

The longer-term problem going forward is that Fonterra is now likely to lose production, in part because of competition for milk from other processors who can afford to outbid Fonterra, and in part because of farmers exiting the industry linked to compliance problems.  The key question is who will buy the units that will then flow across the umbilical cord from the Fonterra Custodian to the Fund?

Over the past 18 months, the dominant perspective of non-farmer investors has been a wish to exit the fund, not enter it. Most of the major institutional investors have now achieved this.

Most of the unit-holders are now retail investors who, operating generally with weaker information, did not see the bad-news tsunami coming along.  Now, with Fonterra’s aura so badly damaged, they too will be looking to exit.

What this means is that the redemption backstop is no longer reliable. Hence, Fonterra’s problems have now got a whole lot bigger.

So how is it that Fonterra’s leaders and its high-priced consultants did not see this scenario back at the start when the new structure was introduced in 2012? That is Part 2 of this story.

About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
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2 Responses to Fonterra’s capital structure is no longer fit for purpose

  1. David Porter says:

    Thanks Keith. You summed it up when you said “The legal structure of the Fonterra Shareholder Fund…is complex”! It sounds like it was devised by high priced tax avoidance consultants to solve a problem but has created a myriad of others. It didn’t even really solve the problem that it set out to solve, only temporarily brushed it under the carpet. I don’t entirely blame Fonterra for this as co-operative law was designed when farmers used co-ops to simply club together to buy or sell using economies of scale rather than using it to try to build a modern corporate structure as coops are having to do now.
    Without the government changing the law to somehow facilitate this, and by the way I’m not suggesting I know how to, the problem of capital structure will continue for coops. I am a fervent supporter of the coop model as producers of very similar primary products, e.g. milk, meat, wheat, will always be taken to the cleaners if a few large non farmer owned buyers are allowed to predominate. Even if small coops predominate, the taking to the cleaners bit just moves up the chain to where the retailer takes the coops to the cleaners and the coop passes it back to the farmer; the outcome is the same either way. For this reason, if farmers are to gain anything other than an existence, a strong coop with sufficient marketing power to stand up to the next link in the chain (retailers these days) is essential.

  2. David Janett says:

    Good summary – I totally agree with the sentiments – as a silly retail investor who has Fonterra shares, plus knowing a lot of others who do as well, we have watched as low/zero interest loans were handed out to farmer suppliers in hard times and the milk price really kept to high and as such the value added end (dividend) was transferred to milk price. Going into China not once but twice plus farms there – sigh. The model dosn’t work as its really based around farmers farm income and not the business income/value as shareholders. Farmers really just want the best milk price and arent worried about long term brand/product development which is costly and long term to achieve – to achieve this you need a milk payout of $4 and a dividend of $2.50 – I have yet to see dairy farmers wanting this but if it happened they would have capital lining up to invest in Fonterra and the shares would be worth probably $40 to $50 (image the talk with the bank then!!). The real problem I see is where are they going to get capital from going forward? Institutional investors and silly retail ones (like me) wont be caught again, Fonterra’s debt is at its limit as is most farmers. Banks aren’t lining up to lend more to dairy – in fact the opposite as new RBNZ/RBA rules and risk weightings are introduced. Will be an interesting ride

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