Might of Fonterra may monopolise market

20:36, Jun 26 2012

Last November, the High Court in London ruled on an extraordinary case involving a wealthy Russian businessman, a Russian state-owned bank, a dairy company and various tax haven entities.

In 92 pages of detail, Justice Arnold described allegations that Chalkie wouldn't mind pinching for a pulp fiction plotline.

In essence, Russia's second largest bank, VTB, claimed that in late 2007 it loaned US$225 million (NZ$286m) to finance the purchase of Russian dairying assets from a company called Nutritek, believing it was a genuine arm's-length transaction.

Nutritek was controlled by the businessman Konstantin Malofeev, who, the bank alleges, controlled both buyer and seller and there was a conspiracy to jack up the deal value and defraud the bank.

The buyer, a special purpose company formed to buy the assets from Nutritek, defaulted on the loan a year later and VTB contends the assets backing the loan were really worth just US$35m-$40m.

Then there was VTB's admission of a side deal giving it an extra US$3.5m in fees, "the true purpose of which was to avoid tax", said the judge.

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Malofeev contests the overall allegations, which, Chalkie understands, are yet to be fully tested in court (the November case was a preliminary skirmish).

Still, they provide intriguing background to the fate of South Canterbury dairy processor New Zealand Dairies which is owned by Nutritek.

The association began in earnest in mid-2007, when Nutritek advanced $56.5m to complete construction of NZ Dairies' new factory at Studholme, between Timaru and Oamaru.

The Russian company was seen as a white knight because NZ Dairies, founded by a local farming group in 2006, was struggling to find Kiwi investors to finance the project.

But it wasn't long before Nutritek was in trouble – in late 2008 it defaulted on a euro bond issue and also on a rouble bond a year later. Nutritek's parent company was declared bankrupt in March this year and a major creditor, VTB, appointed receivers to NZ Dairies last month.

Among NZ Dairies' big creditors were 37 local farmers, who were owed about $25m for milk. It is significant these farmers were supplying one of the few companies to try competing against the might of Fonterra, only to suffer the sharp end of what corporate types call counter party risk – the chance the person you're dealing with can't hold up their side of the bargain.

Last week, Fonterra turned fairy godmother with a deal to buy NZ Dairies, to pay suppliers everything they are owed and to run the Studholme plant.

Market talk says the total bill for Fonterra will be about $55m, well north of what anyone else was prepared to offer – sources say the underbids were in the $35-$40m range.

This is good news for the farmers, but there is a quid pro quo: Fonterra wants seven years of loyalty. The farmers must become fully shared-up members of the co-op within six years of the 2012/13 season.

This is double the three-year share standard under Fonterra's new capital structure, so it represents a significant easing of the financial burden for joining.

Farmers whom Chalkie has talked to reckon the arrangement is fair. The amount of money is significant, though.

Local farmers supplied NZ Dairies with 161.2 million litres of milk last season and were expected to supply 121.1 million litres this season.

At those production levels and at the current Fonterra share price, they would have to invest $45m-$60m to become co-op members.

If the deal goes through, it appears Fonterra will have effectively financed its purchase of Studholme with the equity from former NZ Dairies suppliers.

Although Fonterra must generate a return on that capital to benefit from the deal, as any purchaser would, there are mutterings over how the dairy giant could afford to pay so much more for NZ Dairies than anybody else. Buying Studholme, they say, looks more like a move to stifle nascent competition than a genuine investment.

In terms of processing capacity, there doesn't seem much in it for Fonterra: the co-op's Clandeboye plant processes more than 12 million litres a day, and its Darfield plant, due to open next month, will process more than 6 million litres a day.

Fonterra, meanwhile, says Studholme will complement Darfield and support its strategic goals of growing milk volume and production capacity.

The competition issue will be addressed by the Commerce Commission, whose approval is required, and there is a common belief it will be a "rubberstamp affair" because Fonterra is buying Studholme out of receivership.

Chalkie reckons this is not the case. The commission's guidelines on the acquisition of a failing firm say the deal must be compared against the alternative, which in this case would be the purchase of the assets by a competitor, not the demise of the operation.

The commission's record suggests it doesn't see a problem with Fonterra's dominance in milk purchasing.

In 2006, Fonterra bought cheese maker Kapiti Fine Foods from supermarket group Foodstuffs for $169m, in a deal that eliminated a competitor for milk supply in the Manawatu.

The commission's view was that although the market was highly concentrated, Kapiti was so small "its removal is unlikely to result in a significant enhancement of Fonterra's market power".

The same reasoning would presumably apply to NZ Dairies, although Chalkie can't help thinking it amounts to a monopolist's charter if small competitors can be taken out because they are small.

More than that, some argue Fonterra's milk pricing policy will forever keep competitors small or non-existent, and the failure of NZ Dairies is another example of how hard it is to combat the co-op's market power.

Clearly, anyone needing milk supplies to run their own processing business must offer farmers at least as much as Fonterra does.

As a co-op, Fonterra can return cash to its members in two ways – the price it pays for milk and the dividend it pays on shares.

If returns are uneconomically skewed to the milk price, competitors may struggle to compete for milk supply.

Fonterra consistently argues to do so would be counter-productive and many thousands of words have been written by economists arguing this point.

Chalkie must necessarily be more brief, but it is worth observing first that there are valid reasons for concern about Fonterra's milk pricing; and second that current legislation going through Parliament may entrench those problems.

The valid reasons are in essence that Fonterra bases its cost model on how much an imaginary, highly efficient competitor could afford to pay for milk. The basic idea is sensible because it drives Fonterra to be more efficient.

But the cost model imagines a competitor who doesn't produce cheese, for example, which has historically been a product with lower returns than milk powders, so it is argued Fonterra's imaginary competitor is unrealistically efficient.

Hence rival processors must not only be more efficient than Fonterra itself, but at least as efficient as its hyper-efficient ghost.

Economic consultancy Castalia is among those saying the result is a system that blocks new entrants to the market for milk processing, although its report last July said it could not quantify the scale of the problem.

Former Agriculture Ministry economist and dairy policy adviser Peter Fraser is less equivocal, saying the proposed scheme will be a "blatantly anti-competitive regime".

While Fonterra can take competitors out of the market, he suggests it "also slowly strangles competitors by forcing them to pay too much for milk".

The Dairy Industry Restructuring Amendment Bill currently before Parliament acknowledges the need for competition – a select committee report this month said the farmgate milk price "should be set at a level that provides an incentive to Fonterra to operate efficiently while also providing for contestability in the farmgate milk market" – but it essentially supports the Fonterra cost model process.

Chalkie, it has to be said, is a fan of Fonterra. There are great benefits in having such a big co-op operating in the world market and the business has been a strong performer.

However, those benefits will not endure if competition is stifled. Fonterra may have a virtual monopoly on milk but it does not have a monopoly on ideas – less competition means less innovation and a business monoculture that risks being left behind as the world market moves on.

It is already apparent that new milk processors struggle to attract investment as New Zealand financiers fight shy of taking on Fonterra.

South Island processor Synlait, believed to be an underbidder for NZ Dairies, needed Chinese money to reinforce its ambitions, while an operation proposed by Oceania at Glenavy, not far from Studholme, remains in hibernation with local investors conspicuous by their absence.

Open Country, New Zealand's second biggest milk processor, continues to lose money.

With that sort of experience among Fonterra's competitors, Chalkie reckons the playing field is tilted in the co-op's favour and legislators should heed advice to inject more balance.

Driving new processors into the arms of Russian investors hasn't been a great success.

- Chalkie is written by Fairfax Business Bureau's Tim Hunter.

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