Fran O'Sullivan: What's good for Fonterra is good for NZ

Fonterra chairman Henry van der Heyden needs to remove the spectre of redemption risk from the balance sheet. Photo / Mark Mitchell

Fonterra's top brass have already got backdoor support from the National Government for its three-stage capital restructuring plan.

A fortnight ago, Fonterra chairmen Henry van der Heyden, chief executive Andrew Ferrier and other senior executives briefed Prime Minister John Key at a meeting in the Beehive in Wellington on the broad ambit of their proposals.

Neither Key nor van der Heyden are speaking publicly (yet) about the finer detail of their discussions which are continuing at officials' level.

But van der Heyden told the Prime Minister that the controversial proposal for an IPO (initial public offering) was "off the table" and Fonterra would be looking to its own farmer shareholder base to finance its development in the immediate-medium term.

New Zealand's largest company was also seeking Government backing to ensure that it would not find itself high and dry when it comes to making legislative changes to underpin the measures that are contained in the capital restructuring process which van der Heyden will outline to farmer shareholders next Friday.

Impeccable sources indicate that while Key made it plain to Fonterra that the Government will support its capital restructuring plan, it does want to see the dairy co-operative lift the level of its ambition.

In phraseology somewhat reminiscent of the "what's good for GM is good for America" (though hopefully in Fonterra's case without the fallout that General Motors subsequently wreaked on the United States economy) Key makes the point that the future of New Zealand and the future of Fonterra are "inextricably linked".

The Government needs Fonterra to grow if its growth objectives for New Zealand are to be achieved.

As Key told an influential business briefing at Simpson Grierson, "Fonterra is 8 per cent of GPD in New Zealand ... there's no way out of it. That's it. You have to look at what's holding them back."

While van der Heyden must put his farmer shareholders first he is aware of the Government's viewpoint and Fonterra's wider responsibility to help New Zealand grow what Key calls its "top line" but the board's options are constrained by the co-op's constitution and farmers' appetite for risk.

Within the bureaucracy where Fonterra's senior management and officials are working through changes that will need to be made to the Dairy Industry Restructuring Act (2001) - along with the co-op's request for some "minor taxation" amendments - the view is not so sanguine.

The clear and irrefutable problem is that Fonterra has not realised the pre-merger expectations contained in the report by McKinsey & Co, which was brought in to advise the New Zealand dairy industry in the late 1990s on a new structure to set it up for a prosperous future.

McKinsey isolated two options: A mega-co-op bringing together the two major dairy co-ops together with the NZ Dairy Board (the industry's offshore marketing arm) and, an alternate proposal for two co-ops competing on both the milk processing and commodity exporting fronts (one of the pair also having a value-add agenda).

But ultimately the Labour Government opted for a watered-down variant of the mega-co-op merger in the dairy industry restructuring legislation.

At Cabinet and officials levels there is clear understanding that Fonterra cannot sport serious growth unless it stops paying out virtually every dollar it earns in returns to its farmer shareholding base as the company is required to do under a clause in its constitution to maximise the payout.

If Fonterra retains more of its earnings, the impact on some farmers' pockets might be painful in the short-term. But the company will be in a stronger position to grow.

Van der Heyden makes the point that what matters to farmers is the payout, not wealth creation. While operating profits have been paid out the company has retained capital profits realised on the sale of assets.

But the Government also wants assurances that Fonterra will increase its growth dividend for New Zealand, particularly given the growing chorus in political circles who believe the dairy giant's shareholders would step up to the plate faster if the "quasi-monopoly" faced more competition on the homefront.

Van der Heyden indicates the decision to abandon a public listing basically gelled during the last two months but was not confirmed by the board until its last meeting. He wants to keep his powder dry until September 18.

But clearly the board intends to promote measures which protect farmers' present investment (commonly called "wet shares" linked to the volume of milk farmers' supply to the co-op) as it evolves in parallel with what are loosely called "dry shares" to help underpin growth.

Before it can move down that track, Fonterra needs to remove the spectre of redemption risk from its balance sheet caused by the requirement to buy back shares from farmers that exit the business either because of retirement or because they intend to take their milk to a competitor.

As things stand Fonterra's redemption risk provisions are subject to gaming. A case in point is the $740 million excess shares Fonterra had to fund after a drought at the end of the 2007/2008 season impacted on milk production. The upshot was farmers surrendered shares bought at the previous season's higher price then bought them back at the lower price.

The $740 million impact was reduced to $600 million as dairy conversions that year were larger than defection or retirements.

But the net effect was a $600 million equity loss that had to be funded by raising debt or selling assets, and the net debt to equity ratio shot up. Van der Heyden agrees this puts Fonterra at a disadvantage and works against interests of all other farmers in the co-operative.

In 2007, Fonterra looked at six options for capital restructure but only two were seriously considered: The proposal for a partial listing that got up farmer shareholders' noses, and, a partial divestment of downstream business with the co-operative having controlling interest.

The rejected options included non-voting B shares - which van der Heyden confirms was rejected by the board this year - and hybrid debt, letter stocks and a co-operative call option over processing assets.

Within the industry there have been calls for farmers to invest alongside Fonterra in joint-venture growth companies overseas, but with many farmers stressed by high debt and lower returns the investment appetite is mixed.

Options for introducing outside capital will not be on the table in the short-term.

If Fonterra gets through its first three stages - stage four will come on to the agenda. In essence there are other options that will evolve and be discussed - assuming our farmers can accept the first three stages - that don't include a public listing.

"If there ever comes a time when the majority of farmers want to have the discussion then of course we will have the discussion but for Fonterra in the medium term, as long as we can deal with the big issues around redemption so we don't have all this money washing in and out of the co-operative, we can fund the balance sheet we need to write out the cheques," says van der Hayden.