In my last article I wrote about Fonterra’s capital structure, how it operates, and how it is no longer fit for purpose. This article here explores aspects of how Fonterra got into its structural dilemma.
The starting point is to acknowledge that Fonterra made a fundamental flaw in thinking it could solve its redemption risks by setting up the Fonterra Shareholders Fund, hereafter called the ‘Fund’. Despite the name, this was actually a fund for non-farmer investors to buy units in Fonterra that have economic rights the same as shares, but no voting rights.
The Fund was and is a key part of an overarching scheme called Trading Among Farmers (TAF). This too was a crazy name because the fundamental mechanism was aimed at trading between farmers and non-farmer investors.
The rationale behind TAF was to shift redemption risk away from Fonterra itself and onto the balance sheets of farmers shareholders together with the capital accounts of non-farmer investors.
TAF has indeed achieved this risk transference to the misfortune of both the farmers and non-farmer investors. Both groups are now much poorer as a consequence.
However, what Fonterra has not done is remove its own long-term risks from share redemptions. And there lies the nub in the current environment.
This is because TAF can only work if non-farmer investors are prepared to purchase units. A constellation of events stemming both from Fonterra mismanagement and a forthcoming farm-compliance storm now make unit purchases unattractive.
So how did Fonterra’s experts and their high-priced consultants not foresee this scenario as at least a possibility?
The long journey to TAF from what was previously a more traditional co-operative structure was indeed contentious. It took a good five years of endeavour. However, Fonterra‘s leaders were determined this was a path they were heading down.
Initially, the idea of listing Fonterra on the stock exchange was seen as a way for Fonterra to acquire more capital as an alternative to capital being retained from the milk cheques. That option was rejected by farmers in a 2007 vote because farmers did not wish to lose control.
Over time, the focus then moved away from trying primarily to find new capital to a new focus on the removal of redemption risk.
The 2007/08 Waikato drought gave a big fright to Fonterra’s directors. Drought-stricken farmers no longer needed as many shares and withdrew a net $600 million of share capital. This gave the impetus to once again search for a way to list Fonterra on the stock exchange.
Around this time, I was Lincoln’s Professor of Farm Management and Agribusiness. I was brought in to be part of a project, called the ‘Waikato Project’, driven by Fonterra, but in partnership with Government.
This project was based on the assumption that if we kept looking, we would eventually find somewhere in China where we could recreate the Waikato dairy systems. I was brought in part way through to see if there were flaws in the thinking.
Finding flaws in the glossy consultancy documents was easy, and so the project died. However, what the project did illustrate was how grandiose Fonterra’s plans were, even back then. They wanted to take on China and the World.
This was just before the San Lu debacle. Fonterra was already committed to American-style barn-farming in association with San Lu, but the ‘Waikato Project’ was projected to be something on a much grander scale.
A few months later, the Global Financial Crisis (GFC) had struck and I suspected that Fonterra might be facing a liquidity crisis. I decided to do some analysis on Fonterra’s finances, using public documents.
My calculations quickly showed that Fonterra was highly indebted, with inventories apparently overvalued, and almost certainly running up against its bank covenants.
Rather than putting the analyses into the public arena, on 23 December 2008 I sent my document to Fonterra’s Chair Henry van der Heyden, to Fonterra’s CEO Andrew Ferrier, and to Blue Read as Chair of the Shareholder Council. I asked them if they agreed with what I was seeing.
Within 24 hours, Henry van der Heyden came back to me and said that I must come up to Auckland to talk to their financial team. That meeting happened in the first few days of 2009.
I spent a day with CFO Guy Cowan, who called in various other people to assist with information. Andrew Ferrier rang in several times during the day to see how we were going.
Guy Cowan was very frank. Yes, Fonterra was in a cash crisis. Later I learned that they had been at risk of not being able to pay farmers the previous month. The details are a story for another time.
Yes, all assets, including Tip Top and everything else not needed for basic processing of commodities and ingredients were up for sale. And yes, Guy Cowan found no fundamental errors in my analysis.
Guy Cowan’s most worrying point was that if I published my document then their big forthcoming bond issue would fail and they would be insolvent.
In the circumstances I decided to withhold publication. A few weeks later the bond issue did float, albeit at a high-risk premium.
A few months later, the global financial crisis was coming under control, dairy prices were now high, and the crisis was averted. But somehow, the message that Fonterra’s sails were set for smooth-water sailing either never got learned or was quickly forgotten. And so, the focus went back to debt-fuelled expansion and the associated problem of risk redemption in the absence of permanent capital.
It took another three years for the current system to be negotiated and accepted by farmers, but there was never any doubt as to where the leadership wanted to go.
Given the abundance of in-house expertise, plus the highly-priced and credentialed consultants, did anyone ever ask whether the chosen path was highly risky? The risks were not hard to see.
In regard to the consultants, the first rule for many consultancy firms is to work out what the client wants to hear. That is the best way to ensure an ongoing flow of consultancy work.
Within Fonterra itself, ever since around 2008, the culture has also been negative towards those who have a questioning attitude. It’s generally better for one’s career to be a ‘yes person’ and sing from the company song-sheet. Those who tried to question typically either moved on or got moved on.
When things go wrong there always has to be a scapegoat. The latest scapegoats are Theo Spierings and late Chairman John Wilson. They cannot escape responsibility. But Fonterra’s internal culture was flawed long before their reign at the top.
At least from 2008, the Fonterra culture was dominated by too many people who had become arrogant about their own abilities. They were not good listeners to alternative perspectives.
I am particularly critical of the external directors who came from the corporate finance world. They did not do their job. They must have known the yacht was set for down-wind smooth-water sailing.
As I write this article, Fonterra is just three days from announcing its 2019 annual results. The details of those results will be crucial in defining which pathways remain open for Fonterra. Rebuilding a strong Fonterra is crucial to the dairy industry, given the broader challenges the dairy industry faces.