Is Fonterra shooting itself in the foot with proposal to axe shareholders' fund?

Fonterra shareholders mulling big capital structure change proposal. Photo / File

Part of Fonterra leaders' preferred proposal for a major capital restructure risks undermining the very thing they are seeking to achieve - securing an economic lifeblood milk supply.

That's the view of Jarden investment bank head of institutional research Arie Dekker, who believes the two prongs of thinking behind directors' favoured proposal "don't go naturally together".

Farmers must buy shares to supply milk to Fonterra, New Zealand's biggest business.

Faced with the threat of falling milk supply, the board is proposing making the capital requirements on farmers more flexible, by relaxing the share standard from one share for every kilogram of milk solids supplied, to one share for 4kg.

At the same time the sharemarket-listed Fonterra Shareholders' Fund would be axed or capped.

This fund is separate from Fonterra's farmer-only share trading market. Into it farmers can sell their "dry" shares, those excess to milk supply, and units in those shares can be bought by outsiders. The units offer access to Fonterra dividends but have no voting rights.

"Essentially by taking away a potential demand pool - the fund - you could undermine the flexibility you were looking to provide by taking away a source of demand for shares," said Dekker.

"It creates issues because the capital base of the cooperative remains the same. It's putting something forward which will allow farmers to reduce the number of shares they hold.

"It's removing a source of demand which I don't think will be popular with farmers."

Arie Dekker, managing director, head of institutional research at Jarden. Photo / Supplied

Fonterra's 10,000 farmer-owners will be mulling over the proposal with the company in coming weeks and are likely to be asked to vote in November.

Dekker said they will "need to consider carefully the ramifications of reducing the investor audience through a closing or capping of the unit fund".

The fund was introduced in 2012 when milk supply was rising under a capital restructure called Trading Among Farmers (Taf). By design, fund and farmer share prices are closely aligned.

Under the board's proposal, Fonterra would buy back all or part of the fund - the market capitalisation is around $490 million - and trading of Fonterra securities would be restricted to within the cooperative.

The board acknowledges a farmer-only trading market will likely depress the share price, with little liquidity in the market.

But chairman Peter McBride has said ultimately the share price would be determined by Fonterra's performance and a restricted market was a more sustainable proposition than the alternatives confronting the world's fifth biggest dairy company by revenue.

Top of mind as always for Fonterra's board is to protect farmer ownership and control.

McBride believes reducing the number of shares a farmer must hold and removing or capping the fund achieves this.

Fonterra has two concerns about the unit fund. Dekker believes one is overplayed, and the other addressed by the proposed move to greater share flexibility, which takes the pressure off incoming farmers.

Fonterra says shrinking milk supply, because of various pressures including rising compliance costs, changes in land use and competitors, which don't require farmers to buy shares to supply milk, means farmers' "dry" shares could swell the scheme beyond thresholds.

Or as Dekker explains, when Taf came in Fonterra farmers were producing 1.6 billion kg of milksolids, so there were 1.6b shares. With milk production falling, farmers have been holding on to shares they haven't needed for milk supply.

Relaxing the share standard could also cause the fund to swell, Fonterra predicts.

As Dekker notes, an improvement in Fonterra's performance and a rise in its share price to $6 could prompt farmers to release their dry shares into the fund. At the moment the price isn't sufficient for farmers to do that and consequently, to attract outside investors.

Fonterra says exceeding Taf thresholds could force the company to buy back shares or units, or to allow more external investment. Buybacks could cost its shareholders up to $1.2 billion in the next 10 dairy seasons, modelling had shown.

But Dekker emphasised the fund had no voting rights and no control. Fonterra didn't need to buy back shares to address this concern - it could extend the potential fund size and keep a watch on the actual size, he said.

"It comes down to a trade off. Farmers have to think about whether they would prefer to have the fund there as a demand pool for shares, and whether they are sufficiently concerned about how large the fund can get when it has no voting rights. Despite the potential size being high, the actual size is very small.

"The trade off [is] between concern about a loss of control versus the ramifications of removing it [the fund] at the time you're potentially increasing the supply of shares."

Dekker said Fonterra continuing to turn around its poor performance of the past 10 years was key to making the shares more attractive to farmers and investors alike.

It had rightly focused on its key issue, retaining critical mass in New Zealand milk supply.

But at the same time farmers were being asked to consider how large the fund could get.

"I think the two naturally don't go together."

Dekker said the proposed new share standard was "pretty low for a cooperative".

"There is another mechanism by which they could reduce the capital that farmers have invested, which would to be exit further non-core assets and return capital to farmers.

"That could reduce the need for the share standard to be lowered as much as is being proposed."