Fonterra faces big milk problem

If Heath Robinson designed a contraption to pluck the feathers from a mallard with barbecue tongs, it would be the epitome of elegance compared with Fonterra.

Our giant dairy co-operative, bless it, is like an elephant balancing on a stool built by engineering students out of toothpicks - a gravity-defying feat of complexity that threatens to go crashingly wrong at any moment.

The elephant hit the deck big time last week when Fonterra had to press the manual over-ride on its intricate milk pricing machinery and Chalkie reckons the damage will be more than a few splinters in the bum.

The co-op's many stakeholders, who now include financial investors in its NZX-listed Shareholders Fund, have been shaken to the core.

Indeed, the announcement on December 11 was a tacit admission that Fonterra's operating system is under huge stress and something must be done to fix it.

At the system's foundation is the milk price manual, which calculates how much to pay farmers through a formula based on the price of a basket of dairy products sold through an auction called Global Dairy Trade.

Although it is an improvement on the old process, which involved consultants sucking their pencils and staring at the ceiling, Fonterra's new milk price manual was highly controversial when it was introduced in 2009.

Critics said it would distort the milk market to the detriment of competition and its supposedly objective mechanism was open to artificial adjustment by Fonterra's board.

Those critics can now nod sagely and say: "I told you so".

According to Fonterra's announcement, the milk price manual said it should be paying farmers $9 per kilogram of milk solids this year but it would instead hold its payout at $8.30.

Financially, it is a big change.

Assuming New Zealand milk production of 1.52 million kg this year, which is last year's plus 4 per cent, the 70c difference is equivalent to a non-payment to farmers of $1 billion.

Granted $8.30 is still a record high payout and farmers will do very well, but the Fonterra board has intervened in its carefully constructed price mechanism because it would lose a great deal of money if it did not.

Forsyth Barr analyst Andy Bowley has put the potential loss at $300-$400 million, citing guidance from Fonterra, which has also said that holding the price at $8.30 should allow it to deliver earnings before interest and tax of $500-$600m in the year to July 2014.

To put that in context, in the 2013 year Fonterra reported ebit of $937m, which was in the same ball park as 2012's ebit of $987m. So Fonterra is withholding $1b from farmers in order to report a profit, albeit a lower one than before.

The tricky bit here is that the co-op now has investors in its Shareholders Fund to consider. These people have put money into the fund, which supports Fonterra's balance sheet, in the expectation of dividends - and dividends are paid out of profits.

As recently as September, Fonterra was saying the 2014 dividend would be held at 32c a share, the same as the previous two years. In money terms that is about $500m.

Last week's announcement cut that forecast to 10c a share, which amounts to about $160m.

Most of that will go to farmers but it is fair to say many of them would be fine with having no dividend at all because the milk payout is so high.

The fund investors, meanwhile, are seeing their dividend drop from about $35m to about $11m.

Not nice, but better than nothing.

The situation has led to mutterings that Fonterra's board is trying to keep its new city friends sweet by maintaining a dividend, however small, when it would be prudent to cut it completely.

Chalkie reckons there is probably some truth in that, although the actual amount being transferred to non-farmer investors is a relative drop in the bucket.

However, if anyone thinks farmers are missing out on $1b because Fonterra is prioritising dividends, they should be smacked upon the mazard with a wet mullet. The real problem here is the huge gap between the milk price manual and reality.

It is a gap of Fonterra's own making and the board is beginning to appreciate how awkward it can be.

Briefly, the manual assumes all of Fonterra's milk is used to make products sold and priced through the Global Dairy Trade auction - basically milk powders and butter. These are known as reference products.

After production and capital costs are deducted, the remainder is the milk price.

The other, non-reference products include cheese and casein, which have historically fetched lower prices.

But Fonterra production is not all reference products - in fact, they are about 70-75 per cent of its production because of the set-up at Fonterra's dairy plants, which vary in age and efficiency.

The reason for pretending all Fonterra's production is milk powder is that almost all new investment in dairy factories is to make milk powder, so the powder price was seen as the most representative of the market. As the co-operative describes it: "Because returns from the sale of milk powders and their by-products represent the ‘marginal' returns that would drive the price of milk in a competitive market in New Zealand, the farmgate milk price is based on these products."

In practical terms, the effect of the assumption is to skew the milk price higher than if it were based on the co-op's actual commodity sales.

Competitors have long argued against this system because it makes milk supplies more expensive and harder to get, but the economic logic of marginal returns has held sway - so far.

Chalkie reckons the flaws in that logic are now being exposed.

High demand for milk powder, particularly from Asia which accounts for about 50 per cent of Global Dairy Trade sales, is pushing up the milk price and encouraging New Zealand farmers to supply increasing amounts.

Indeed, so much milk poured into Fonterra in the peak season between September and November that the co-op could not process it all and has dumped large quantities in smelly buttermilk lakes or at sea.

Fonterra is refusing to say exactly how much milk has been dumped but Chalkie reckons you could not get a clearer sign of market failure.

The co-op has blamed its financial difficulties on an unprecedented and temporary gap between the prices of powders and non-reference products - if you can sell cheese for X, say, and have to pay X+Y for the milk to make it, the numbers look ugly pretty fast.

Fonterra has put a figure of $800m on the problem.

A co-op in that position might even find it less costly to throw milk away than process it into a loss-making product. How crazy is that?

Chalkie reckons Fonterra did the right thing in throwing away the milk price manual and holding prices at $8.30 - to do otherwise would only have damaged the balance sheet to the long-term detriment of all shareholders.

But it leaves an obvious question: what is the point of having a supposedly objective price mechanism if the board ignores it when prices become inconvenient?

The Commerce Commission's latest milk price manual review released on Monday did not address this issue but it surely must next year.

The elephant is not just in the room, it is on its back with its legs in the air.

This is Chalkie's last column for 2013. Your correspondent looks forward to your company in 2014 and in the meantime wishes you a merry Christmas.