Fonterra needs a milk rethink

Last week I wrote how Fonterra needed more capital. The balance sheet as at June 2013 shows total capital of $NZ14.4 billion, liabilities of $7.6b and equity of $6.7b.

This is much better than in 2009 when liabilities were $9.3b and equity was only $4.8b, but it still leaves only modest capacity for funding further investments from borrowings. So if Fonterra is going to grow with any rapidity, it is going to need more shareholder funds.

Fonterra's solution for 2013-14 is to siphon funds from the theoretical milk price, as calculated using the rules in Fonterra's Milk Price Manual.

In doing so, as I said last week, this actually takes money away from some groups, including sharemilkers who rely totally on the milk price.

In contrast, some other groups benefit from the transfer, including the non-farmer unit holders who are not normally entitled to those milk price funds. Their returns are supposed to come from profits.

Fonterra will probably be able to get away with all of this in 2014, but only because groups such as the sharemilkers are already getting high prices this year, and anyway are too busy milking their cows to organise protests. In future, Fonterra will want to develop new rules to ensure that the Milk Price Manual does give them reliable profits.

Determining the milk price under Trading Among Farmers (TAF) was always going to be a challenge. Given the absence of a competitive market, it was always going to be the outcome of complicated back-room calculations. Realistically, these new rules are still unlikely to give retained profits of more than $500 million after paying out dividends of about another $500m.

So how far will that $500m go?

We can get some idea of this from one of Fonterra's key new investments this year, for a UHT (ultra-heat-treated) milk plant costing $120m, which will produce 100m litres per year of consumer-branded UHT milk that will be sold to consumers and food service buyers in China and other Asian countries.

This will also require investment in logistics and brand development. I would expect this additional investment to take the total investment up to at least $200m. In other words, at least $2 of capital is required for every litre of annual capacity.

Fonterra will this year process more than 17 billion litres of milk from New Zealand, plus additional milk from Australia. The trend is upwards each year. Currently most of this NZ milk is sold as commodities, so let's assume that Fonterra's long-term aim is to turn 10 billion litres of this commodity milk into consumer products. That would require $20 billion of investment! About half would need to come from equity, which would then give access to a similar amount of borrowings.

There is no way that Fonterra can access these levels of equity funds, given its current capital structure.

Apart from profits, the main source of new funds will be from farmers who increase their production and need to buy new shares.

Most of this money will be used for infrastructure to process the additional milk into basic commodities.

The other option would be to increase the proportion of shares held by non-farmer investors as investment units, but Fonterra does not have its farmers "on side" for that to occur. A Fonterra mega-shift to consumer products is not going to happen.

Many and perhaps most dairy farmers will not be upset by this situation. Commodity prices are excellent, and likely to stay that way for some time. Farmers would generally prefer to invest money in land and cows, rather than Fonterra shares.

At a country level the hopes may be somewhat different. The Government has great plans as to how food and beverage exports are going to increase as a result of further processing and value-add, but much of it is just hot air.

For that to occur, it is not just Fonterra that is not making the necessary investments. No other NZ company has the necessary size to even make a modest dent in the necessary numbers.

That leaves only overseas capital. So for we have been seeing New Zealand investments by three of China's big dairy companies. These are Yili in South Canterbury, Mengnui-Yashili in the Waikato, and Bright in Mid Canterbury. European companies are also becoming active investors. So the choice may come down to New Zealand-owned commodity companies or overseas-owned value-add companies.

Either way the land will still be here. And the second option will provide more jobs, more competition, and possibly more taxes. It needs some thought.

* Keith Woodford is Professor of Farm Management and Agribusiness at Lincoln University.

Sunday Star Times