Fonterra’s decision on 6 May to present an alternative capital structure has opened a can of worms. The shares have dropped around 15 percent and investor units are down 13 percent. There are no immediate cash implications, but Fonterra’s capital value has declined by more than $1 billion. This transfers through to farmer balance-sheets. Given that this is just a proposal, the market response is remarkable.
There is close to zero chance that the proposals will be implemented in their present form. But the worms cannot be simply put back in the can. Fonterra has made it explicit that its current structure is no longer fit for purpose. Those are not the exact words that Fonterra is using publicly, but they are the exact words coming in on the breeze.
Prior to the proposals being announced, there was no immediate need for action. Fonterra could have kicked the can down the road for several years and left it for another governance team, but they decided to front-foot it. To that extent, their actions are laudable. But shooting themselves in both feet was not needed.
There are two key parts to the proposal. First, the plan is to reduce farmer requirements to own shares. The idea is that farmers will only need to hold one share for every four kg of Milksolids supplied, compared to the current one share for every kg of supply. However, other farmers who have cash looking for a home can buy up to four shares as investments for each kg of supply.
The second part of the proposal is a plan to buy-out or at least cap the investor-unit fund.
If the proposals are accepted, then the only incoming equity capital will be retained earnings plus cash from asset sales. That is the same as the current situation. However, buying up the existing investor fund would soak up funds.
The driver behind the need for change is Fonterra’s concern that its milk supply is going to decline. The key reasons are environmental regulations and urban-spread plus horticultural conversions. Under the existing structure, this would lead to shares of departing farmers being transferred to investor-owned units. This in turn could led eventually to those investors demanding control, although there is no mechanism in law to assist them.
Although the proposals are only up for discussion, Fonterra has already cut the two-way pipeline connecting shares to units. This means that if farmers now leave Fonterra, their shares will have to be purchased by other farmers who buy them as voluntary investments. This creates a big risk that the share price will eventually crash owing to a lack of willing farmers with liquidity to buy investment shares.
There is a saying in business management theory that strategy comes before structure. Well, that is the way it is meant to be. But if strategy and structure are misaligned, then structure controls strategy like a bungee cord pulling strategy back to what is feasible.
In Fonterra’s case, the new strategy created in 2019 focuses on marketing New Zealand milk rather than also trying to dominate global trade using milk produced in other parts of the world. Fonterra still has sizable foreign operations both in Australia and South America. Fonterra supposedly no longer has any ‘sacred cows’ when it comes to this overseas-sourced milk.
It makes sense for these overseas processing assets to be sold. It is a case of finding the right time to sell them at an acceptable price. At that time, Fonterra’s consumer-branded business will become considerably smaller.
At that time, Fonterra will also be much closer to having a structure that aligns with what farmers want. Their priority is to have control over the processing of New Zealand milk until that milk is in a stable form. That primarily means powders of various forms and sophistication, plus cheese and butter.
In email correspondence, some people have been suggesting to me that it is time to look again at the two-company model. Going back more than ten years, I saw merit in that structure and advocated for it. But those were the times when Fonterra’s strategy was to take on the world.
As long as Fonterra had a big focus on consumer brands as well as business-to-business (B2B) brands, then there were strong arguments for a two-company model. Consumer-brand companies need a different internal culture, deeply embedded in the company operational DNA, as compared to companies that focus on ingredients.
It is very hard to make consumer-focused and B2B strategies work in the same company. There lie some of the answers as to why Fonterra’s overall performance since formation has been so disappointing.
However, with Fonterra already losing much of its overseas-sourced milk plus the likelihood of losing more, Fonterra does not have a big future in fast-moving consumer brands. It no longer needs that second company.
To clarify that point, there may well be scope for a big consumer-brand company using New Zealand milk, but it needs totally separate management and governance from Fonterra. Let Fonterra focus on the things that it does well such as collecting milk from farms and turning it into long-life commodities and sophisticated ingredients, including potentially the supply of ingredients to totally separate investor-owned consumer-product companies.
If Fonterra structures itself this way, with a dominant focus on converting its suppliers’ milk to long-life products, then new capital needs will be modest. Sales of existing overseas assets can be used to further pay own debt.
Given Fonterra’s concerns about losing supply, this low debt becomes a safety factor for Fonterra going forward.
Fonterra’s farmers are saying to Fonterra that they want it to remain a co-operative under farmer control. Fonterra needs to remind those farmers that a fundamental structural provision of dairy co-operatives that do not have outside-investor equity is that the farmer suppliers have to be responsible for ‘service capital’. The notion that a processing and marketing co-operative can prosper without adequate service capital from its suppliers is fanciful.
My key criticism of the existing so-called ‘trading among farmers’ (TAF) system has been that it was based on a falsehood that it somehow removed redemption risk. But that does not mean that TAF had no worthwhile features. Some alternatives are worse than the existing TAF.
Right now, there is no urgent need to buy out the existing investor fund. Having such a fund has meant that there is tension between milk price and dividend, but the proposed system simply shifts that tension elsewhere within the company. This is because the proposed system is that farmer shareholding relative to supply can vary by a factor of 16, with this being the range between the proposed minimum supply shareholding of 1:4 and the proposed maximum of 4:1.
The simplest path for Fonterra right now is to continue to sell assets related to overseas-produced milk as and when market conditions allow and to further reduce debt. In the meantime, it might also be best to consider a mea culpa and restore the pipeline between shares and investor units. As for the notion of reducing the service capital provided by Fonterra’s farmer members, that needs to go back to the drawing board. If the current proposal is implemented, the long-term future of Fonterra will really be at risk.