Fonterra's performance may get more scrutiny from its farmer-owners under a capital restructure proposing more flexibility to supply milk and a less liquid market for their shares, says investment bank Jarden.
In an analysis of the potential capital restructure and what it could mean for Fonterra's listed unit fund, head of research Arie Dekker said Jarden believed the fund could ultimately be removed given Fonterra's broad objectives for change.
A buyback of the fund, which offers non-voting, dividend-carrying units in farmer shares, or capping this fund, is one leg of a two-part capital restructure proposal being considered by Fonterra's 10,000 or so farmers.
Any such move would restrict the market for farmers and is the flip side of the Fonterra board's aim to ensure continued farmer ownership and control of New Zealand's biggest business. Farmers also have their own share trading market, not open to outsiders.
The other leg of the proposal is to ensure Fonterra has a future milk supply by making it less financially onerous to hold milk supply shares. To do this it proposes relaxing its share standard from one share for every kilogram of milk solids supplied, to one share for 4kg.
Though it collects around 80 per cent of New Zealand's raw milk supply, Fonterra loses milk to processing competitors which don't require shares to supply. Also, national milk production is flatlining and expected to decline.
Jarden believes Fonterra leaders could get the proposal over the line with farmers. However, farmers had a big economic interest in Fonterra.
"Farmers have invested significant capital ... over the past 15 years at prices in excess ($4.50 plus) of where (the farmer-only market) trades today (around $3.30) ... we expect scrutiny to be high on what any moves to change the capital structure mean for the medium to long term value.
"We expect this process is going to force outside investors to consider Fonterra's value and that it will put a lot of focus from farmers on understanding where Fonterra is heading and what this will mean for them over the medium to longer term."
For "confidence and accountability" Jarden said Fonterra needed to provide not just a "high level" view on strategic direction, but also milestones and numbers for the next three years.
"This gives Fonterra the opportunity to put some detail around its FY24 objective to return to 50cps earnings per share."
There are two listed securities and markets for Fonterra trading. One is a farmers-only share trading market, the other is the unit fund, the Fonterra Shareholders' Fund.
Both share prices have fallen since the proposal was announced, provoking concern among farmers.
"Despite an improvement in Fonterra's performance in FY20 and FY21, including discipline in the use of capital, we remain cautious. Transparency in the business is an issue, including on strategic direction, which impacts on accountability and confidence, while earnings volatility and the drivers of it are also an issue," Jarden said.
"The outcome from the capital structure review is genuinely uncertain with the prospect that restricted trading could become entrenched. Our view is that the removal of the FSF fund could ultimately be approved given Fonterra's key objectives."
A buyback or capping of the fund would require a fair price offer getting 75 per cent support from unit holders.
Jarden believed there were still important issues to address about Fonterra reducing the scope of its business activities, which could also ease some of its competitiveness issues.
Outside investors had been invited into Fonterra in 2012-2013 to remove share redemption risk.
"Farmer shareholders appear now to essentially be being asked to take that risk on among themselves. It is a large capital base. If Fonterra continues to progress an option to wind up the fund, then it will have lasting ramifications for Fonterra farmer-shareholders."
There was risk competitors would still cherry-pick milk supply with the proposed changes, which were somewhat of a compromise due to Fonterra's regulatory constraints which made it hard for it to move to the nominal share standard that would make it more competitive.
Fonterra was created from an industry mega-merger in 2001 under special enabling legislation, on the premise it would be a national export champion.
The potential for cherry-picking was why Jarden believed other moves to shrink the size of the cooperative capital base and improve performance also needed to be considered.
This would include exiting non-core businesses outside of New Zealand and increasing transparency.
"Uncertainty could prevail for some time in any transition away from the status quo, but we highlight that in what is being proposed, an equilibrium will be found that should ultimately reference the earnings performance of Fonterra and the investor pool that can participate."
The proposal continued to highlight the challenges associated with funding a $10 billion enterprise value entity almost entirely from farmer capital, Jarden said.