Fonterra’s new capital structure brings its own risks, designed for choppy seas but not for a storm
The Government has been wrestling for many months as to how to respond to Fonterra’s proposed new capital structure, which its farmer-members voted for overwhelmingly. The Ministry of Primary Industries, on behalf of Agriculture Minister Damien O’Connor, has now released a discussion paper indicating the Government proposed response. Essentially the Government is conceding to Fonterra’s wishes, but with some shackles proposed to constrain Fonterra‘s subsequent behaviours.
To understand what is happening, it is necessary to go back to the formation of Fonterra in 2001. The Fonterra that was formed at that time, with 96% of the national milk production under its control for processing and marketing, would not have been allowed if assessed under the Commerce Act. It would have run foul of restrictions on monopolies.
Accordingly, special legislation was put in place via the Dairy Industry Restructuring Act (DIRA) by the Labour Government of the day. Regulations were set in place allowing Fonterra to act as an effective monopoly in relation to marketing New Zealand milk overseas, but constrained in exerting monopoly power in the local New Zealand market.
The imposed constraints related to relationships with both farmers and retailers, plus any new processors brave enough to compete for supply of raw milk. The justification for the legislation was that Fonterra would become a ‘national champion’ of which we could all be proud as it drove New Zealand’s economy forward.
Fonterra, in its first life starting in 2001, was structured as a traditional co-operative where every farmer was required to provide ‘service capital’ in proportion to the supply of milk they were providing. The share price was set by the Board.
Most farmers were joining Fonterra via legacy co-operatives to which they had already supplied capital, so no further cash was required unless they were increasing production.
One key advantage of traditional co-operatives funded this way is that there is no need for arguments as to the split between milk price and share dividend. Regardless of the split, the overall income received by each farmer is not changed by the specifics of the split.
Generally, there are two main criticisms of this traditional co-operative capital-structure. The first is there is no genuine price-discovery mechanism as to what capital is actually earning. At least in theory, this can lead to inefficient use of capital.
The second key limitation is that if a farmer leaves the co-operative, then the co-operative has to pay back the farmer’s capital. This can be a disaster if the co-op loses a significant number of members.
It was only a few years before deep discussions were being held within Fonterra as to the need for a more ‘modern’ capital structure. I won’t here go into all of the twists and turns that occurred, but will jump to the new capital structure approved by farmers in 2012.
This new 2012 structure created an open market for shares where farmers, but only farmers, could buy and sell shares between each other rather than buying and selling shares from Fonterra itself.
Fundamental to this new structure was a separate ‘shareholders fund’ which actually was not a ‘shareholders’ fund at all. Rather, it was a fund in which non-farmers could buy financial units which would receive dividends but would have no voting power in the co-operative. Also, and this was very important, there was a pipeline set up between the co-operative and the fund which allowed units and shares to be shuffled back and forwards between the fund and the co-operative via a so-called ‘market-maker’ who would do the buying, selling and conversion of shares into units and vice versa, thereby managing the pipeline. This set-up ensured that the price of units and shares were within a cent or two of each other.
Much of this new structure is still in place right now but big cracks have appeared. The Board has temporarily cut the pipeline between the co-operative and the fund to stop the fund growing, and hence the market-maker is no longer active. Also, right now, farmers are not required to purchase shares in alignment with any production increase. Further, Fonterra, has had mechanisms in place for quite some years whereby new farmers did not necessarily have to purchase shares to supply milk.
In the last 12 months since the cracks opened up, the price of both shares and units has tanked, with the shares even more so now that there is no market-maker. Unit holders are not happy, but farmers seem to have largely shrugged their shoulders in an environment where the milk-price they are receiving is very high.
The key factor driving Fonterra towards a new structure is the fear that the current structure places Fonterra in a poor position to compete with new entrants to the dairy processing and marketing sectors. Fonterra fears that new farmers will be attracted to processers who do not require farmers to provide capital. That would increase the flow of shares to non-farmer units.
Fundamental to this new perspective, is that Fonterra is now a very different creature than it was ten years ago. Back then, Fonterra was trying to take on the world and to be a global player with power brands. In contrast, in the last three years, Fonterra has been in divestment mode, having now sold its China, Europe and Brazil assets, currently trying to sell its Chilean companies, and also looking at selling its Australian operations.
The current directors of Fonterra have very different perspectives to the directors of 2012 when the current capital structure was set up. Fonterra is now a commodities and specialised ingredients company, including a focus on food service, but with low involvement in consumer brands, and focusing only on NZ-sourced milk. Fonterra’s share of national milk supply has dropped to 79% from the original 96%. The philosophical change is profound.
So, now I come to the new structure which Fonterra proposes, driven primarily by a perceived need to minimise loss of supply in an environment where total New Zealand dairy production is at best static and with a risk of significant decline. This is so different to the scene back in 2012.
Fonterra’s proposal is that although Fonterra’s total company shares will still align with total Fonterra production, individual farmers will only need to hold one third of a share for every kg of milksolids (fat plus protein), but can hold as many as four shares per kg. This will supposedly reduce the risk of farmers leaving and joining processing competitors.
This new structure has overwhelming support from farmers who trust their current directors to come up with the best solution. However, those of us with a strong background in co-operative structures are nervous.
The reason for this nervousness is simple. A fundamental principle of co-operatives is that members supply capital in proportion to the business they do with the co-operative. Breaking this principle is a recipe for conflict, with some members wanting a high milk price and others preferring high dividends. I know of no co-operative that has survived long-term with such a structure.
In this situation, the Minister and the Government are caught between a rock and a hard place. On the one hand, they don’t want a fight with Fonterra that leaves electoral blood on the floor. However, the Minister is clearly concerned.
The Government proposal therefore is to require the Fonterra milk-price committee, which will have five to seven members in total, to include two ministerial nominees plus a chairman who is also independent of any financial interests in the dairy industry. It is highly likely that Fonterra will accept this as a necessary compromise to get the overarching proposals accepted.
The reason they must get Government acceptance is that the new structure requires legislative changes to the DIRA.
The second key requirement from Government is that there must be a market-maker, essentially there to reduce share-liquidity issues. My own judgment is that this will prove highly problematic. Better to let Fonterra deal with that by itself.
My current expectation is that the essential elements of the new capital structure proposed by Fonterra will now be implemented over the coming year. But whether or not it will thereafter be set in stone is another matter. It might last five years but I doubt if it will last ten years.
The proposed new structure will only last as long as Fonterra can provide good dividends that make the holding of voluntary shares attractive. As such, it is designed for choppy waters but not for a storm.
[This post is also available here at interest.co.nz, including some discussion within the comments]