Economic cornerstone Fonterra needs a formal profits distribution policy so farmers being asked to invest cash in the dairy giant know what payoff they are likely to reap, says the Fonterra Shareholders' Council.

The call to Fonterra directors comes in the watchdog's annual report, and can be interpreted as a condition of the council's continuing agreement to a rejig of the capital-starved co-operative's financial structure.

The first stage of the Fonterra board's three-step capital restructure proposal is to offer farmer-shareholders the opportunity to buy 20 per cent more shares.

These shares will not, as is the norm, be linked to how much milk a farmer supplies New Zealand's biggest company. The proposal, if voted in by farmers at this month's annual meeting, has the potential to inject up to $900 million new capital.

The watchdog's annual report said development of a formal retention policy, accompanied by clear economic signals to farmers, would bring major benefits to the business and the sector.

The council had asked the board to consider the development of a retention policy in its capital planning, it said.

The report also pressed directors to set financial performance target-measuring more than one year out.

Council chairman Blue Read told the Business Herald that retaining money from profits was "a normal way of doing business".

"It would be very, very conducive to farmer investment capability if they knew in broad terms what [dividend] is possible or likely."

A formal profit distribution policy was "essential" with Fonterra moving to a structure where farmers made an investment outside their milk production, he said.

"They need to know what that is going to return, and a dividend policy, retention policy, call it what you like, is essential at that point. You must know what board policy is around distribution of profits. We call it a retention policy, but maybe it should be called a distribution of profits policy."

Fonterra's co-operative constitution demands it pay out as much of its operating profits as possible to shareholders each year. In its eight years in business the heavyweight co-operative, which had revenue last financial year of $16 billion, has retained a total of $694 million.

Read said the council was not asking for guarantees of a minimum or maximum payout. It sought an indication each year of at what earnings point retentions might kick in, and in a highly profitable year, the point where a farmer could expect a "certain level" to be paid out.

He said the council wanted some progress on policy by the end of December, when farmer-owners would have to decide whether to buy the "dry" shares. Stage two of the capital restructure proposal is to revalue existing Fonterra shares to recognise they are not freely tradeable (currently they are market valued). Step three is to introduce share trading between farmers.

Read said it was "reasonable" that Fonterra directors had to date paid out most earnings to farmers.

"It's been the old story, if they can't find an investment that's more profitable than on-farm investment, then they should distribute those funds.

"And the fact is farms have been increasing at such a rate of capital appreciation there's no way Fonterra could invest the money and do better ... but we are in a whole new world."

Read said if Fonterra could make sales worth another $1 billion from an extra $200 million of investment from retained earnings the whole economy, rural and city, benefited.

Another message for directors was that their "statement of intentions" needed to move beyond the "very short term" of one year, Read said. "We want short-, medium- and long-term objectives so you can create an atmosphere where people are being measured and remunerated on a long-term basis as well."

The report praised Fonterra's achievement of a $5.21/kg milksolids payout and financial strategy through "extremely difficult" trading conditions during the year.

But it noted that by the time the third successive payout forecast chop had been made in January, many farm costs had been committed, causing cash-flow problems for farmers.

WISH LIST

* The council representing Fonterra's 10,500 farmers wants the co-operative to retain more profits.
* The council also wants longer term financial performance targets.