| Updates | Posted | Have your say or ask Harry and Michael about specific issues |
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11th Nov 2008 |
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| Main Discussion Paper | On this page | |
Further Comments - Dairy Exporter Articles |
1st Jan 2008 | |
| Support Document from Northland Supplier Graeme Edwards | 1st Jan 2008 | |
| Comments on the Irish Situation4th December 2007 | ||
Fonterra Board Preferred Option | Fonterra Board Rationale | Redemption Risk | Farmer Choice |
Lack of Capital to Deliver Fonterra’s Strategy
Preferred Option vs Redemption Risk|Preferred Option vs Farmer Choice|Preferred Option v’s Providing Capital
The Fundamental Conflict between Farmers Suppliers and Shareholders of ‘Fonterra
Introduction
The Fonterra Board has been through a review of the current Capital Structure and on 15th November 2007 presented their preferred option to shareholders at a Special Meeting broadcast to seven different venues around the country. Shareholders had no prior notice of any information relating to the preferred option and a written form of the presentation was not available until several days after the meeting.
Fonterra Board Preferred Option – ( a summary )
Fonterra shareholders will vote in May of 2008 to approve the establishment of a new company, ‘Fonterra’ ( a Corporate not a cooperative). The shareholder vote will also mandate the transfer of all the assets and liabilities currently held by Fonterra Cooperative Group to ‘Fonterra’.
In May 2010 a second vote of shareholders will mandate the ‘Fonterra’ Board to list ‘Fonterra’ on the Stock Exchange with an initial 20% of shares in Fonterra floated publicly on the market, with a further 15% of shares allocated to existing Supplying Shareholders. The remaining 65% of shares would be held by Fonterra Cooperative.
Supplying Shareholders will elect 8 Directors to the Fonterra Cooperative Group and a further 2 Director would be appointed as independent Directors. This Board would then appoint 6 Farmer Directors to the ‘Fonterra’ Board with a further 4 independent Directors being appointed.
The rationale given by the Fonterra Board in the presentation, for the Capital Structure review and the Preferred Option, was that the current Capital Structure:-
Exposes the Company to unsustainable redemption risk.
Does not allow farmer choice.
Will not allow the delivery of the Fonterra Strategy due to insufficient capital.
So let’s have a look at each of these issues individually.
The fear is that if a significant number of farmers either decide to change their land use ( eg retire from dairying & put on beef stock) or take the decision to supply their milk to a competing Dairy Company, then the cost of share redemption would significantly challenge the Balance Sheet strength of Fonterra.
While it is inevitable that a small number of farmers will make a lifestyle choice to cease dairying, it is unlikely that the numbers will be sufficient to cause a significant threat. Indeed much of this land may either support surrounding dairy farms to increase production by supplying feed or conversely may in a relatively short time return to dairying with a new generation of dairy farmer.
Farmers who take the decision to supply a competing company are potentially a greater issue. They are not only taking their capital out of Fonterra but also ensuring that a greater volume of NZ dairy product is available to our customers, driving a reduction in potential returns for all products.
But the fundamental issue here is not that they have left, but that Fonterra’s performance has been insufficient to ensure that they are worse off economically by leaving.
It can be argued that the potential redemption risk is a very positive discipline driving company performance. The better the performance, the lower the redemption risk and visa versa.
It is argued that there can be a big variation in the attitude of individual farmers. For example, their view on the balance between Milk Price Payout, Investment Return and Business Value Growth or alternatively their view on the balance of risk and return. For this reason it is argued that the single Fair Value Share system, directly linked to production levels, is too inflexible.
However the amendments to Fonterra’s Constitution two years ago allowing supply based on contract or the deferral of the need to be fully shared against production means there is significant flexibility available to farmers.
In addition, some people would argue that too much choice is not in anyone’s interest because of the resultant complexity and cost of systems, and the confusion around defined direction. By and large, if farmers know the rules, they can be quite innovative in their ability to maximise their own situation within those rules.
Lack of Capital to Deliver Fonterra’s Strategy.
The argument here is that part of Fonterra’s Strategy is to invest significantly offshore to develop business opportunities in a number of key markets. Specifically it entailed the targeted investment in White Milk sourcing, processing and marketing within the borders of countries such as China to take advantage of the rapid development of such markets. This strategy could potentially require significant capital requirement.
While the wisdom of this strategy could be debated, it is not the key to this part of the discussion. The key point is whether Fonterra’s growth is indeed constrained by a lack of capital. And if so is the Preferred Option the best way of addressing the issue. While Capital can be a constraint on business growth, it is normally not the greatest constraint. The ability of management to handle growth is normally of far greater importance.
It is unfortunately a fact that Fonterra’s business performance has not been where it needs to be. The significant businesses we currently own have overall, not delivered a return above the cost of capital, even in a relatively low commodity price environment. In the current high commodity price environment, the challenge is significantly higher. If our current business was performing as it should be, we would have sufficient profit being generated year on year to allow material reinvestment in growth if and when the opportunities arise. Normal business practice would suggest that 40% of net profits should be retained to fund growth
Unfortunately access to further capital could well make the current underperformance an even greater problem.
So we can see that the issues claimed to necessitate a Capital Structure Review, have not been justified.
Even if we are prepared to accept for the benefit of discussion, that these three points are indeed issues, we need to test whether the Preferred Option resolves them.
Preferred Option v’s Redemption Risk.
Under the Preferred Option the value of the Cooperative shares will be set by reference to the traded value of the ‘Fonterra’ shares. Therefore when shareholders wish to leave the cooperative, their shares will be redeemed at this value and the cash paid by the Cooperative will need to be funded out of the Cooperative Balance Sheet.
While initially the Cooperative will be able to consolidate the Balance Sheet of ‘Fonterra’ into its own, the fact that the only asset it will own, will be the shares in ‘Fonterra’, will limit its ability to finance any share redemption. This will inevitably lead to a further sell down in shares in ‘Fonterra’.
This is exactly what happened in Australia. Bonlac farmers initially set up Bonlac Supply Cooperative ( identical structure as that suggested for Fonterra Cooperative) and sold 25% of Bonlac Foods to NZDB. Despite Bonlac Supply Company having far greater constitutional protection against cash redemption, it still came under increasing pressure and did not have the Balance Sheet strength to maintain the support of its bankers. As a result they were forced to continue to sell down, and have ended up owning nothing other than a supply right to Bonlac Foods, ironically now called Fonterra Australia.
While it will be argued that there will be protections in place to stop sell down past certain points, in exactly the same way that pressure increased for Bonlac Supply Company to sell more of Bonlac Foods, so it will be with Fonterra. Even the 35% minimum shareholding to be set in legislation will not last 5 minutes when the balance sheet pressures are great enough.
So the upshot of all this is that rather than reducing the redemption risk of the Company, it will simply be transferred away from ‘Fonterra’ to Fonterra Cooperative and because of the less liquid Balance Sheet, the issue will be magnified significantly for Fonterra Cooperative.
Preferred Option v’s Farmer Choice
At the outset it needs to be emphasised that farmers will only own shares in Fonterra Cooperative as part of their supply. While existing shareholders will be allocated shares in ‘Fonterra’ at the time of establishment, this will not be the case on an ongoing basis. It will only be farmers who decide to buy ‘Fonterra’ shares on the sharemarket, just like you can buy shares in Telecom, who will directly own shares in the downstream business of ‘Fonterra’.
It should also be remembered that Fonterra Cooperative will simply be a shell company. None of the manufacturing plant will be owned directly by Fonterra Cooperative, and the tanker dockets, and even your monthly payment statements will all be printed by a company farmers do not directly own. This is again exactly the same as the situation with Bonlac Supply Cooperative.
So while it will be argued that the Preferred Option will give farmers greater choice, it could also be argued that we have ample choice available now and this option actually reduces choice significantly.
Preferred Option v’s Providing Capital
The Preferred Option looks at floating 20% of ‘Fonterra’. There have been various figures put forward suggesting that the capital raised would be in the vicinity of NZ$2.5-2.8Billion. It should be noted that because of the change in the structure there will be a need to regear ‘Fonterra’s Balance Sheet to maintain our existing Credit Rating. This is likely to require NZ$1.8 Billion to be retained for this purpose. As a result of this there would only be NZ$0.7-1.0 Billion actually available for the capital program that is deemed to be necessary. Quite clearly this would not be sufficient to fund the sort of projects that are possibly being mooted. In which case a further float would be necessary to fund further growth.
So there is no doubt that it is quite misleading to suggest that floating 20% of ‘Fonterra’ will lead to a stable viable solution. As further shares were floated Fonterra Cooperative’s share of the company would reduce, leading to even greater pressure on its Balance Sheet. This would unfortunately be as inevitable as it would be irreversible.
The Fundamental Conflict between Farmers Suppliers and Shareholders of ‘Fonterra.’
The Dairy Industry has been through at least four different Capital Structure Reviews in the last 15 years. In each of these reviews the current Preferred Option was looked at but was discounted very early in the process because of the fundamental conflict between the farmer suppliers and the shareholders in ‘Fonterra’. In the model we cannot assume that farmers will be shareholders of ‘Fonterra’ on an ongoing basis. We can see that farmers will be wanting as high a milk price as possible to maximise their farm profit, whereas the shareholders of ‘Fonterra’ will want the lowest milk price to maximise the profit of ‘Fonterra’. This is a fundamental conflict that will not be resolved.
Our current model handles this conflict by ensuring that supply and ownership in the company are directly linked. It means that the Board and Management can be confident that the interests of farmers, as milk suppliers and as shareholders, are aligned. They are therefore in a position to give the company direction without constantly grappling with this conflict.
The Board of ‘Fonterra’ in the Preferred Option will be significantly conflicted. In the Bonlac Foods situation, when it came to setting the milk price, it was a farcical situation. Because the farmer elected Directors were conflicted, and the Fonterra appointed Directors were conflicted, the decision to set a milk price was made by the two independent Directors. All other Directors literally left the Board Room to allow discussion and a decision to be made by the two independent Directors.
So where do we go from here.
Rather than simply say that there are no compelling reasons to change from where we are, and that the Preferred Option is unacceptable, therefore we should stay as we are, perhaps we need to ask if there are other ways of addressing perceived concerns. For debate then, the following is put forward as one example of an alternative.
If we assume that in the future there will be investments that may be at the margin, either in terms of risk profile or sheer volume of capital required, let us look at another way of providing the necessary capital without disrupting the linked ownership and control we currently have in Fonterra.
In this model Fonterra sets up Venture Capital Companies, as and when necessary, specifically targeting certain investment profiles.
Venture Capital Company No. 1
This company may, for example, have a stated business intent of investing in a high return, low value growth strategy. This would be the cash cow type business where the initial business investment would be relatively high, with minimal value growth but the business would produce regular, dependable returns.
Venture Capital Company No. 2
This company could, for example, have a stated business intent of investing in a high risk, high potential value strategy. This would look at start up, leading edge technology ventures with a relatively low initial business value and little or no dividend stream, with even the likelihood of further capital injection necessary but with the possibility huge value growth.
Now these are probably examples at the extreme and there are likely to be a number of potential examples in between.
This model would have Fonterra owning a controlling shareholding in each of these venture capital companies but the rest of the company could be listed. Each company would be likely to attract a different profile of investors depending on their own individual respective risk preference.
These companies would have the ability to invest along side Fonterra, in investments Fonterra believed fitted its overall Strategy. So for example the investment in setting up a Dairy Farm in China, may suit the profile of one of these companies so Fonterra would invest 50.1% in its own right and the other 49.9% could come from the Venture Capital Company. As a result it would reduce the absolute exposure of Fonterra, and hence Fonterra Shareholders, while allowing outside investors, including farmers, whose risk preferences fitted the investment, to be involved.
The model would allow the risk of each investment to lie to a far greater extent where it should. In the Preferred Option it is claimed that a float would be very successful. A major contributing factor in this is that the 20% floated portion of the shareholding would, to a large degree, be underwritten by the individual Balance Sheets of the Milk Suppliers.
'Conclusion
This Discussion Paper concludes that, while there are no compelling reasons to change from the Capital Structure we currently have, the Preferred Option not only fails to address perceived weaknesses, it will inevitably lead to the loss of farmer control and a huge destruction in Farmer business value.
The real concerning issue in this Capital Structure Review, is that the ‘Board has lived and breathed this for a year.’ The issue that has so urgently needs the whole team focus, specifically the need to lift performance significantly in a rapidly changing marketing environment, has not had the priority that it requires.
It is hoped that farmers understand the key points put forward in this paper. It is essential that there is widespread and considered debate amongst Fonterra Shareholders. We hope that you will take the opportunity to take part in the debate and ensure that your feedback is forwarded to your Shareholder’s Councillor or on Fencepost if the opportunity is available.
Harry Bayliss
Michael Joyce