Fonterra heads towards a new capital structure with scope for unintended consequences

Fonterra’s latest proposals to change its capital structure will be far reaching. If implemented, they will essentially undo the misleadingly named ‘Trading Among Farmers’ (TAF) system set up in 2012. I say ‘misleading’ because in reality that was a scheme of trading between farmers and non-farmer unit investors. But the proposed changes do not stop there.

The second part of Fonterra’s proposal is to allow Fonterra’s shareholder farmers to hold as little as one share for every four kg of Milksolids (the ‘capital M’ as sometimes used by the industry reflects that it is actually fat plus protein and ignores other solids) that are supplied, or as much as four shares for every kg of these supplied Milksolids.  The full implications of that will be profound, although not all are identified within Fonterra’s proposal booklet.

Taken together, these will be the biggest changes to Fonterra’s structure since it was formed back in 2001. But first I will deal with each of the two elements separately.

The Reversal of TAF
The TAF system was brought in to reduce the perceived redemption risk. This was the risk that if Fonterra lost a significant number of suppliers, then under the old co-operative structure they would not be able to pay out the departing members for their shares. It was also stated, including by directors although generally when speaking off-the record, that it was about shifting the balance-sheet risk away from the co-operative and passing it to the farmers themselves.

The way that the system was engineered to achieve this has been that the shares of departing farmers would be shuffled across to the newly formed Fonterra Shareholders Fund which in reality was mainly for non-farmer investors who would purchase non-voting equities called investment ‘units’. The size of that fund would fluctuate, not only with fluctuations in the price of the units, but by two-way movement between units and farmer-held shares.

This two-way flow of units and shares meant that the price of shares and units would always be very similar, within a cent or two. This thereby created a value for Fonterra’s shares determined by the market rather than administratively by Fonterra itself.

TAF was a very clever system with considerable complexity. One of the consequences of this was that it became challenging to communicate the limitations of the systems in simple terms. Those of us who tried to point out those limitations were essentially smothered by the Fonterra public relations machine, combined with dominant leadership within Fonterra itself both at Board and CEO level.

To clarify that last point a little further, although Theo Spierings was the CEO when TAF was finally implemented, the scheme was largely developed by the time he arrived. In any case, TAF was very much a policy decision and hence it was the Board and not the management that had to take overall responsibility.

Nine years later, with a totally different Board, there is a recognition that TAF does not actually remove the redemption risk.

Here, I now return to that fundamental flaw in the thinking behind TAF. The flaw was that the only way TAF could remove the redemption risk should Fonterra lose a major number of suppliers was by taking on a new risk of losing control of the company to non-farmer investors.

That risk was always obvious. So why did Fonterra take nine years to come to that conclusion?

One key reason for the change in thinking is that farmers have now told Fonterra very clearly that it is imperative for the sake of their own farming businesses that farmers remain in control of Fonterra. The logic of that is very clear. Farmers are correct in their thinking.

Ironically, this was also how farmers felt at the time that TAF was implemented. The difference then was that the proponents of TAF kept beating away over a three-year period and eventually overwhelmed the opposition to TAF and its predecessor proposals.

At the time TAF was implemented, Fonterra saw the main risk as coming from new entrants to the industry. These were companies such as Synlait and Miraka, plus Open Country which was in expansion mode.  That source of risk is much less right now.

The new source of risk that Fonterra perceives is that regulatory and perhaps market factors might lead to an overall decline in the size of the dairy industry.  Fonterra states this with carefully chosen words, but their thinking is clear. Fonterra wants to front-foot the risk and get its house in order for supply decreasing by perhaps 10% or 20%.  The specific figures are mine not theirs. Ten percent would be manageable under the current structure but 20% would not be manageable. They want to be proactive rather than reactive.

If Fonterra’s thinking about redemption risk is correct, then TAF has to go.  That means that the ‘Fund’ as Fonterra now refers to it must either be dismantled or capped at its present size. The preference is that it be dismantled but that can only happen if 75% of the unitholders agree.

This will mean offering investors a price well above the current price of those units. Therefore, there has to also be an alternative should unitholders not agree and hence the possibility of a fund that is capped to its present size in terms of the number of units.

Before moving on to the second part of Fonterra’s proposal, I need to make one point very clearly. TAF was never about providing significant new capital. It was always about removing or at least reducing redemption risk. Fonterra made that clear many times, but this is something that commentators often failed to recognise.

Changing the Share Standard
If the unitholder fund is to be dismantled, then the key question that has to be addressed is how can Fonterra then deal with leakage of funds from the balance sheet should milk supply decline?

Fonterra recognises that it does not itself want to purchase these shares from departing farmers. The solution is to invite other Fonterra farmers to buy the shares as investment shares at up to four times the standard; that is, up to four shares for each kg of Milksolids that they produce.

Fonterra also feels pressure from its members to allow lower shareholdings than the current one share per kg Milksolids. So, the idea here is that the minimum shareholding in future should be only one share per four kg Milksolids.

Comparing the proposed new maximum and minimum farmer shareholdings relative to their milk supply gives a ratio of 16:1.   That creates a massive mis-alignment of interest between some shareholders and others. Some shareholders will want to have the dividend maximised and others will want the milk pay-out maximised. This is something that Fonterra has not made explicit. Yet this tension between dividend and milk pay-out is the fundamental reason why farmers do not want to lose control to non-farmer investors.

The effects on share and unit values
Should the Fonterra proposals be implemented, then even if the Fund remains in a capped form there will no longer be alignment in price between the shares and the units. Indeed, that alignment will disappear as soon as the market re-opens on 7 May, given the pipeline between the two funds will be non-operative from that day.

I am writing this while the overall market for Fonterra shares and units remains closed. But my expectation is that there could be an immediate increase in the price of units.  Investors will recognise that Fonterra will have to offer a premium to buy them out.

In the longer term, there is a considerable risk that the shares held by farmers may decline in price. This is because there could be a loss of market liquidity. More farmers will want to release some capital by selling than there will be farmers wanting to buy.  Fonterra recognises that this is a possibility.

What Fonterra has not acknowledged is that banks will now place a higher risk weighting on Fonterra’s shares in farmer balance sheets.

An alternative pathway
All that I have written above are my initial thoughts. What I have not addressed is an alternative pathway for Fonterra, given the acknowledgement from Fonterra that the current system does not manage redemption risk.

I am intrigued as to what the best pathway forward might now be. The challenge is that it is not easy to unscramble an egg that was cooked nine years go. What a great pity that Fonterra was so arrogant back in those times.

***

Update May 7 at 1.30pm
The market has reacted very negatively to these proposals with the units declining by 8.7% as at 1.30pm since the market opened this morning, and the shares declining by 13.3 %, albeit on low turnover of the shares, with this the first of the unintended consequences given that at this stage it is only a proposal.
KeithW

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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