1st January 2008
Performance | Cow to Customer | Risk | Shareholder Council | Conclusion
Introduction
I support the Bayliss and Joyce criticisms of the Fonterra Board’s preferred capital structure option and Fonterra’s performance generally. Further I believe the Bayliss and Joyce venture capital proposal is worthy of serious consideration as an alternative. I am also concerned that approving the initial restructuring, which only requires a 75% majority of those that actually vote, will start an irreversible process before suppliers are fully informed. Accordingly I pose some questions for both the Shareholder Council (SC) and suppliers to think about before they do so.
The CEO has stated that a Total Shareholder Return (TSR) of 12.4% per annum has been achieved over the last three years while acknowledging improvement is required. The TSR essentially comprises the added-value portion of payout above a Commodity Milk Price plus the change in the share price from the previous year.
The share price has increased in part due to methodology changes and correction of modeling errors. While technically correct this can give a misleading picture of real valuation changes. In addition forex hedging gains (and losses) have been included in the added-value but are unlikely to be sustainable in the long term, as demonstrated by the Dairy Board experience.
The added-value quantum is a theoretical calculation which is absolutely dependent on the assumed milk price. The Board has already acknowledged that the current milk price methodology is flawed. It is very likely that the milk price has been understated thus exaggerating the added-vale returns. As a test of reasonableness the SC should compare Fonterra’s historical milk price with say those of Westland and Murray Goulburn over recent years.
The forecast value-added component of this year’s payout of only 20c is further evidence. While high commodity prices will be a significant impost on the added-value businesses, this is a challenge currently facing many food manufacturers and listed companies with continuous disclosure obligations are not indicating they will be as badly affected. Real input costs simply have to be passed on albeit with a lag. The forecasted drop is more likely to be a belated acknowledgement that last years 58c return was exaggerated in error.
The above discussion would suggest that the real TSR has been considerably less than the claimed 12.4%. It is imperative that the historical TSR be recalculated with the proposed milk price methodology.
The Board has claimed a key rationale for their preferred structure is the need to maintain an integrated operation. I note the article in the Jan 2008 Dairy Exporter by John Shaskey who has recently resigned as Managing Director of Fonterra Ingredients, after 30 years in the dairy industry, which seriously questions this. He highlights the conflict between milk price and the profitability of added-value businesses and the difficulties this poses for management in developing a clear focus. He notes that while there is value in common ownership there has not been in integrated management. Certainly Fonterra’s performance, to the extent that it is disclosed, does not demonstrate any tangible lift in financial performance through being an integrated operation.
On a first principles basis you would not expect a commodity ingredients manufacturer to also demonstrate FMCG excellence. Fonterra performance seems mediocre in this area.
Shaskey also points out that there is no compelling case outlined for the investment of the additional capital and that some options could be in conflict with NZ suppliers. What is so attractive that we should put our local processing assets on the line?
There has been very little discussion of risk other than the very appropriate overall debate over farmer control. While the capital restructure review is supposed to address farmer investment choice, risk has not been adequately considered. A question suppliers should consider is “Should I risk a partial sale of my NZ processing assets to invest behind borders in predominantly third world countries?” This needs to be considered in the context of NZ, with a good water supply, exporting grass-fed dairy products, probably never being in a fundamentally better economic position. Why would you give up highly likely good returns from exporting our own dairy commodities and ingredients to invest behind distant borders with a manager who has not demonstrated a successful track record of doing so? Note that investment behind borders is not required to market third party commodities or ingredients.
The setting up of venture capital vehicles as suggested by Bayliss and Joyce seems a sensible solution that provides supplier choice and additional capital, perhaps on a more modest scale, but at considerably less risk to NZ suppliers.
Fonterra PR generally and the capital structure presentation in particular, is light on fact. Commercial sensitivity may be an issue but surely the SC, with its privileged access to information, has a role to provide independent analysis and verify or otherwise claims made. It must professionally critique the options as opposed to simply collating necessarily uninformed farmer feedback. It is evident to me that suppliers have a sense of unease about this fundamental, irreversible proposed restructure but in the absence of hard data are concentrating on issues such as governance and control which they can understand.
The historical performance of Fonterra’s offshore investments does not justify the putting of NZ processing assets at risk to fund further such investments. Further the claimed necessity of maintaining an integrated operation has not been substantiated nor has any information been provided on a compelling investment case for which the additional capital is required.
Generally the debate so far has been characterised by a lack of information. The Shareholder Council should undertake a proper independent appraisal of the proposal and past performance, restated under the proposed milk price methodology, before shareholders are required to vote.
Graeme Edwards
Northland Supplier