Brian Gaynor: The right choice for farmers is obvious

Yesterday's announcement regarding Fonterra's capital structure is realistic even though it could have been more innovative and NZX chief executive Mark Weldon will be bitterly disappointed with the outcome.

The decision is realistic because Fonterra's shareholder communications have been poor and the co-operative hasn't done sufficient preparatory work with farmer shareholders that would encourage them to embrace a more radical approach to capital management.

There is also a strong belief among some farmers that the sharemarket is a zero-sum game, there has to be a loser for every winner. Because of this they believe that a sharemarket listing would be negative for them as they would lose if outside investors profited.

In light of this, Fonterra's directors had little option but to take the softly, softly approach because capital structure changes require a 75 per cent approval at a shareholders' meeting.

Fonterra's capital structure has a number of deficiencies including the difficulty of raising new equity, the ability of farmers to redeem their existing shares, the absence of any retained earnings and the non-payment of dividends. The absence of dividends means that there is less reason for farmers to hold on to their shares.

The accompanying table shows the liabilities side of Fonterra's balance sheet from its first balance date on May 31, 2002, through to January 31, 2009. The co-operative's 2009 year result will be released next week.

There are a number of important features regarding the balance sheet table, including:

The total value of shares has remained static at approximately $4.4 billion over the 80-month period. Peak notes were effectively converted into co-operative shares when Fonterra last changed its capital structure on June 1, 2006.

Total equity has fallen from $4.485 billion to $3.79 billion, mainly because of a large negative movement in the cash flow hedge reserve in the six months ended January 2009. Some, or all, of these may be reversed in the second half of the year.

Fonterra's borrowings have surged from $4.755 billion to $8.134 billion since formation.

Other liabilities, mainly derivative financial instruments and trade and supplier payables, have also become extremely important funding sources.

As a result the co-operative's equity ratio (total equity to total liabilities) has fallen from 38 per cent in May 2002 to just 21.1 per cent. This is far too low for a commodity-based company and means that suppliers must suffer a big reduction in their payout when commodity prices fall.

By comparison the world's largest dairy co-operative in revenue terms, the Dutch based FrieslandCampina N.V, had an equity ratio of 30 per cent at the end of 2008.

Fonterra's high leverage is partly due to farmers' fear that they will lose control if the co-operative issues equity to outside sources. This perception is not necessarily correct.

The order of priority in most commercial organisations, including Fonterra, is that lenders rank first, suppliers second and equity holders are at the end of the chain.

Those of us who were around in the 1980s are brutally aware that majority shareholders lose control when companies are highly leveraged and get themselves into trouble. In that situation the lenders take full control and shareholders have limited rights.

This is occurring with a number of companies at present, including PGG Wrightson.

Farmer resistance to outside capital could ultimately weaken their control because it forces Fonterra to borrow more and more and these lenders rank ahead of farmers, both in terms of their supplier and shareholder roles.

There is a strong argument that farmers would have more control of Fonterra if the co-operative issued new capital to outside shareholders, farmers continued to hold a clear majority of the shares and the new capital was used to repay debt.

If outside capital is used to repay debt then farmers are in a better position, particularly as far as their supplier role is concerned.

The recent receivership of Dairy Farmers of Britain clearly indicates that dairy co-operatives are not immune from the realities of the commercial world. Dairy Farmers' receiver, PricewaterhouseCoopers, believes that the banks won't get all their money back and farmers will lose all their equity invested in the co-op.

Dairy Farmers of Britain is farmer-owned yet it is now controlled by the banks.

There is no suggestion that Fonterra faces this outcome but a high dependence on borrowings puts a co-operative, and its equity, at risk.

A number of farmers also believe that Fonterra's only role is to look after them, to pay them the maximum amount for their milk.

This concept is highly questionable as directors of commercial organisations, including co-operatives, have a fiduciary duty to look after the interests of the organisation, not the shareholders. This is a basic principle of company law.

Fonterra's position is unique because it was set up by special legislation that allows it to bypass the full scrutiny of the Commerce Commission, including the commission's monopoly provisions.

Fonterra was established under special legislation because it was seen to be in the national interest, the co-operative is expected to play a major role in the growth of the New Zealand economy.

In light of this is it appropriate for farmers to believe that they have the right to extract every last cent from Fonterra in the form of supplier payments and should they reject all forms of outside capital when it means that the co-operative has to take on more and more debt?

This column is not suggesting that farmers necessarily want to extract every last cent in the form of supplier payments, and are happy with a highly leveraged co-op, but these are the consequences of a 100 per cent supplier payout and the reluctance to accept outside capital.

Yesterday's announcement will allow the co-operative to address most of the issues raised above although it will be a slow process.

Under Step 1 it is proposed that farmers will be able to acquire up to a maximum of 120 per cent of their existing share allocation, which is based on milk production. This would allow Fonterra to raise up to $800 million of new equity and these additional shares, which we can call dry shares, cannot be redeemed until May 31, 2011.

Fonterra proposes to pay a dividend on all shares, both wet and dry, although no specific details on this, and the impact it will have on the milk payout, have been revealed.

Step 2 involves a change to the Fonterra Fair Value Share valuation methodology and Step 3, which is the most important one, will allow farmers to trade shares among each other and will remove Fonterra's obligation to redeem wet and dry shares. This is an extremely important step because the requirement to redeem shares is a major disadvantage to the co-operative.

Fonterra shareholders need to look at yesterday's announcement as the first step in a long process that will take a number of years to complete.

These shareholders can look at the proposals from two perspectives:

* Do they want to fully own, but not necessarily control, a highly indebted co-operative with a weak capital structure and poor growth prospects?

* Do they want to have majority ownership, but full control, of an organisation with a strong balance sheet, secure capital base and robust growth prospects?

The second option is clearly far better than the first.

Disclosure of interests; Brian Gaynor is an executive director of Milford Asset Management.