Agribusiness: Focus on the fundamentals

Karen Silk, GM Commercial, Corporate and Institutional, Westpac NZ.

Farming profitability at home becomes even more important as competition hots up in the Chinese market, writes Karen Silk.

To combat weaker global commodity prices, New Zealand farmers must continue to improve their focus and execution on the delivery of high quality product with impregnable integrity and efficiency.

We would argue this can only be achieved with a sustained focus on the fundamentals of cost control, effective capital management and an increasing level of understanding of the factors driving revenue volatility.

Competition in our fastest growing export market (China) is increasing at the same time as European producers are being forced to divert product away from Russia.

At the same time, within China excess supplies accumulated in 2013 are still being worked through and the Chinese consumer demand may carry further risk (at least in the short term) as that market faces its own stiff head winds.

"Deliquification" is clearly hitting Chinese equities, and speculation is increasing that this weakness may migrate to the credit-fuelled Chinese property market. Should this occur we can expect a more muted level of consumer confidence and demand.

Farming for profit means ensuring that all costs are closely monitored and all proposed capital projects are submitted to a detailed cost benefit analysis that considers their impact through cycles and not just a point in time.

Money invested to drive production gain through higher cost structures (for example, supplement feeding to support higher stocking rates) will make sense when commodity prices are high or increasing.

However, the same investment can become difficult to unwind in periods of lower return, in particular when underlying capital structures have been premised on the maintenance of high levels of production.

As volatility increases, long term capital structures need to adjust to incorporate sufficient flexibility to carry the business through periods of lower return as providers of capital (shareholders and banks) will require compensation through all parts of the cycle.

New Zealand dairy farms have traditionally been valued on a sustainable (profitable) productive capacity basis.

New Zealand producers will increasingly need to take a holistic view of what's driving the global market, and ensure that their farm management systems and capital structures support a flexible and efficient approach to production.

Recent behaviours within the New Zealand market would suggest that a combination of offshore equity seeking participation in the longer term protein growth story and existing domestic participants seeking scale and capacity have driven both consolidation and conversion activity.

The time has come for these investments to realise the operational efficiency and return benefits envisaged when these projects were initiated -- with failure to do so posing risk of not only a cash but potential capital loss.

As outlined in the adjacent chart, sale prices for dairy farms are highly sensitive to movements in commodity prices, at least that's been true up until recently.

The current divergence between land values and dairy export prices is the widest we've seen in a long time, and based on history provides a chilling signal for what may come if export prices don't improve (or the NZ dollar significantly weakens) over the course of this season.

It could be argued that the current level of divergence may be exaggerated in part due to the lower number of properties sold over recent months at the "high market prices".

However, it may only take a small number of distressed sales in the same environment to establish a new, lower benchmark for farm prices across the country, and there is no evidence that the historic approach to valuing farmland should change.

If commodity prices do start returning to more normal levels this year, what qualifies as 'normal' these days?

We are still firmly on board with the story of China's long-term development, which will drive demand for proteins for decades to come. But we need to recognise that the rest of the world is now on board with this story too - including China itself.

When China emerged as a major buyer of dairy products last decade, New Zealand found itself uniquely well positioned to meet that demand. But years of high dairy prices have persuaded other countries to expand their own milk production and invest in extra capacity.

China's own dairy herd has grown significantly in the space of a few years. And the removal of Europe's milk quota system this year (which operated as a fine for excess production, rather than a hard limit on volumes) means that European dairy farmers will be able to respond more flexibly to changes in demand in the future.

The bottom line is that a growing number of players will be chasing the world's consumers of milk. At the very least, that suggests that the cycles in world dairy prices could become even shorter and choppier, as producers jump on to any rise in prices.

It means New Zealand producers will increasingly need to take a holistic view of what's driving the global market, and ensure that their farm management systems and capital structures support a flexible and efficient approach to production in order to preserve profitability and in turn maintain enterprise value.

Karen Silk is General Manager Commercial, Corporate and Institutional with Westpac New Zealand.