Capital ideas set to churn

By RICHARD INDER


The threat of competition is looming large in the minds of the Fonterra board.

But their fears are not over the rivalry for customers overseas, as during the past century the co-operative's management and their predecessors have more than proven they can hold their own.

Instead, it is the threat of competition for the hearts and minds of the dairy giant's more than 12,000 farmer shareholders.

Graeme Hart's New Zealand Dairy Foods and Open Country Cheese - the south Waikato cheese factory set up by former Deputy Prime Minister Wyatt Creech - loom largest on Fonterra's radar.

Their existence and the possibility of other independent firms entering the fray are key reasons why the co-operative has begun a debate over its capital structure - a discussion it is cautiously making more public.

At present, NZDF and Open Country get all their milk from Fonterra. Their supply is virtually assured at a price that can be tested at the Commerce Commission.

The potential for acrimony was in evidence last week when Creech asked the commission to investigate the price Fonterra charged to deliver its milk.

And, if the perennial fights over the price Telecom charges for access to its network are to teach us anything, it is that disputes will become more common in the future.

Even if the costs and distractions of scrapping with Fonterra are set aside, Hart and Creech are still likely to explore alternatives for supply if only to satisfy themselves that they cannot obtain milk more cheaply. Farmers are also likely to listen for similar reasons.

Unfortunately for Fonterra, the peculiarities of its capital structure make convincing farmers to stay put more difficult. Farmers must own one share for every kilo of milk solids they supply.

In addition to any share price appreciation, farmers get a "milk payout". This includes a sum for raw milk and a contribution from value-added activities.

However, many farmers argue the system does not give clear signals about how their off-farm investment in Fonterra's manufacturing and distribution performs relative to their investment in cows and machinery. This hinders them from allocating cash to the most productive assets.

At the same time, Fonterra's shares - according to credit rating agency Standard & Poor's - have risen in value from $4.38 last year to $4.69 this year. Fonterra admits the rise is deterring new farmers from coming into the industry.

Potential solutions to both problems are many and varied - ranging from tinkering with financial reporting systems to slicing the co-operative in two and listing part or all of the "value-add" operations on the sharemarket.

Fonterra chairman Henry van der Heyden has, for the moment, ruled out a split of the co-operative and a listing.

He says there are alternatives that can deliver on the board's objectives of keeping the co-operative, maintaining Fonterra's position as a leading low-cost producer and growing the contribution of value-add activities to Fonterra's bottom line.

Still, whatever route van der Heyden supports, Fonterra has more to lose than Hart or Creech.

If Fonterra fails, farmers may decide to cash up the average $400,000 they have invested off-farm to become suppliers to Hart and Creech. New farmers may make a similar decision simply because entry costs to the industry are much lower.

Both moves, should they become a deep trend - and we are a long way from that - would be catastrophic for Fonterra.

Its share price would fall and the group's most important source of funds to grow the business would dry up.

If Hart and Creech fail, they can always call on equity markets for cash and - for the foreseeable future - call on Fonterra for milk.

* Richard Inder is editor of the Business Herald