Fran O'Sullivan: Another step, but road ahead looks rocky

Sir Henry van der Heyden makes the point that what matters to farmers is the payout, not wealth creation. Photo / APN

Fonterra's top brass emerged from their Monday board meeting claiming a clear mandate to proceed with the controversial trading among farmers (TAF) scheme.

It's going to take a lot of work to rebuild trust between the Fonterra board and management, and many of their farmer shareholders if TAF is to be bedded down without more public brawling.

A week before Fonterra's shareholders finished casting their votes on June 25, company chairman Sir Henry van der Heyden, director John Wilson and chief executive Theo Spierings thought they had about two-thirds support in the bag.

But they weren't leaving anything to chance as they continued to meet groups of farmers right up to the weekend to get them over the finish line.

The resolution for TAF ultimately received a 66.45 per cent vote - way down from the 89 per cent majority that was recorded after the scheme was unveiled.

But this doesn't mean two out of three dairy farmers voted for TAF.

The vote is based on milk solids production. So it is quite possible the voting margin on a per farmer basis would have been much smaller on the day if, as expected, the big corporate farmers swung their votes Fonterra's way.

Fonterra won't disclose just how many farmers did vote in favour of the resolution - Election NZ should easily be able to find this information but does not make it publicly available - and how many opposed it.

This is one of the defects of the current voting structure as it leaves considerable power in the hands of incumbent directors who are in a better position to control the information flow.

But the failure of Fonterra leadership to get at least 75 per cent approval, which was an earlier bottom line position, indicates that the "vocal minority" that had so upset van der Heyden and Spierings when they started to get antsy and oppose the detail of TAF earlier this year, is probably much bigger than one-third of the 10,500-farmer base.

The TAF scheme will be on the agenda at Federated Farmers' annual hui, which gets under way in Auckland today.

There is still plenty of scepticism over the scheme.

Under TAF, farmers can also sell rights to their dividends to outside investors, via a shareholders' fund, while retaining voting rights for themselves.

The outside investors have no say in the direction of the company. But it is inevitable that while they won't get to vote on the company's direction, they will make their influence known by simply exiting if the fund's performance is underwhelming.

If all goes to plan the Government will soon have the enabling legislation in place, Fonterra will produce its prospectus and, assuming it wins 75 per cent approval from shareholders at the November AGM on a resolution to amend the company's constitution, trading among farmers will become a reality.

Fonterra's leadership has presented trading among farmers as a simple device to remove redemption risk and stop vast sums of capital washing in and out of the company's balance sheet.

There has been an element of fear tactics from the leadership in recent weeks - with the chief executive even going so far as to claim Fonterra's very survival would be at risk if the farmers did not vote for this rather clumsy scheme.

Spierings made a big deal out of how Fonterra did not have a Plan B if the TAF vote failed.

But frankly, Fonterra doesn't even yet have a Plan A.

Trading among farmers is not the only mechanism that could have been used to remove redemption risk.

For instance, the board could have moved faster to retain more earnings rather than paying the bulk out to farmers.

This would have resulted in increased balance sheet strength.

TAF was essentially brought into play as Option B after dairy farmers made it clear they would not go along with the original capital restructuring proposal that would have resulted in Fonterra's business operations being spun out into a separate listed company with the co-operative holding the controlling interest.

Farmers feared they would lose control to outside investors.

But the IPO would have provided vital funds for growth.

Bizarrely enough, many farmers are anxious that the TAF scheme could also be used as a backdoor capital- raising mechanism.

The real issue - which Fonterra's brass will have to start publicly confronting soon - is that removing the redemption risk from the company's balance sheet back on to the farmer's own balance sheet (via the TAF scheme) still does not provide sufficient capital to underpin Spierings' expansion plans.

Sure, Fonterra will now be able to boast it has considerable "permanent capital" on its balance sheet which it will be able to leverage.

For instance, if the company wanted to fund the building of a new brand which is big enough to dominate the Asian infant powder market, that would soak up considerable capital.

So too, the farm expansion programme in China.

Fonterra's top brass have got support from the National Government for their international strategy.

It's no mistake that MFAT, for instance, is dubbed the "Ministry of Fonterra and Trade" - such is the prominence this sector receives in all New Zealand's trade negotiations.

But the Government has grown weary over the farmers' lack of ambition and rigid opposition to the notion that "foreigners", such as Shanghai Pengxin, will come into their domestic market while they remain oblivious to the fact that Fonterra is also a major player in many other competitors' markets.

In truth, the Government needs Fonterra to grow if its growth objectives for New Zealand are to be achieved.

As I reported before in 2007, 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 with the NZ Dairy Board (the industry's overseas marketing arm), and an alternative 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 in the dairy industry restructuring legislation.

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 home front.

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

What the TAF vote tells us is that there is still a two-tier ownership system within Fonterra.

A sizable and dominant group wants to invest in Fonterra, access outside capital, take some risks and build a much bigger and profitable global company.

And another sizable group is predominantly focused on the milk payout, doesn't want to share any growth dividends with outside investors, and is risk averse.

Fonterra's competitors are not standing still.

If this company can't finally get its act together and fulfil its potential, it would be better to break it up and let the ambitious farmers move ahead at the required speed.

Right now it's still underwhelming.