Fonterra can proceed with its capital restructure, but it's been a long road. Photo / NZME
After three years of jumping through hoops to get the all-clear for a capital restructure and 21 years as New Zealand’s biggest business, dairy goliath Fonterra couldn’t be blamed for asking if it’s time it was allowed to cast off its regulatory chains.
As the big export co-operative gears up to next year implement a major capital rejig that required the Government’s final okay, it’s a question chair Peter McBride doesn’t have to think hard about.
He’d prefer Fonterra wasn’t regulated at all.
But he’s a realist.
“That probably would not be allowed until our market share reached a certain point, and there are conflicting views on where that point is.”
So what is that point?
“I think we are real close now.”
McBride, involved in the restructure plan from the get-go, and appointed chair during its convoluted 42-month journey to last month’s Government green light for the required changes to dairy industry legislation, says that’s because Fonterra now has sufficient processor competition at home.
Those competitors, eyeing Fonterra’s 78 per cent market share of New Zealand’s raw milk supply even 21 years after that legislation enabled its creation, may disagree.
So does Agriculture Minister Damien O’Connor.
“Deregulation of the industry and removal of DIRA (the Dairy Industry Restructuring Act 2001) is not on our radar and indeed I don’t think it would be smart to do that,” says O’Connor, also New Zealand’s trade minister.
“The success of the industry has been built on the disciplines of legislation and regulation since the 1950s.
“There are real risks that in a completely deregulated environment there would be serious consequences for the dairy farmers of New Zealand. Farmers only need to look across the Tasman to see what deregulation has delivered for their industry.
“Dairy farmers have an asset for 48 hours, then it becomes a huge liability. That exposure is often exploited by process companies and other participants in the industry.”
What O’Connor is also getting at is that the regulation which gave Fonterra its privileged headstart back in 2001 (it had 96 per cent of the raw milk market then), on the flipside compels it to take milk from any farmer offering it. (The obligation has been expensive on stainless steel and after prolonged Fonterra grumbling, has been relaxed so that from next year it doesn’t have to accept “new” milk from an existing supplier.) So while Fonterra might be fighting for future milk supply in a region crowded with processors such as Waikato, regulation ensures that in areas where competition is absent, a dairy farmer can rely on their milk being picked up.
Dairying is a cornerstone of the New Zealand economy. It is forecast to contribute $23.3 billion of record expected food and fibre returns of $55b in the year to June next year. Fonterra is the dairy sector’s big cheese, posting $23.4b revenue in the 2022 financial year.
Created under DIRA in 2001 from an industry mega-merger, it was promoted as being “a national champion”. The legislation allowed it to circumvent Commerce Commission objections.
Fonterra needed DIRA to be amended to replace a capital structure implemented in 2012. It pitched that its business strategy (reset after disastrous 2018 and 2019 financial results, largely due to overseas investments) now prioritised New Zealand milk. To do this efficiently it needed to ensure it had sufficient milk supply. With national milk supply flattening and forecast to shrink, the farmer-owned company said the level of compulsory investment it required to supply was a barrier to retaining and attracting milk. The proposed new capital structure would make it easier, cheaper and more financially attractive for farmers to join and stay with the co-op.
Fonterra’s 8000 farmer-owners voted in support of the restructure plan a year ago. Since then they’ve been waiting for policymakers to give it the final okay, which came with provisos intended to keep checks on Fonterra’s market power at home.
The journey hasn’t been smooth.
Processing competitors screamed blue murder about what they saw as further relaxing of the reins on Fonterra. (The co-operative sets the national base price of raw milk by dint of its size. Competitors alleged it “games” this position and called for much greater independence in milk price setting.)
Share values took a bath.
The restructure plan called for delinking of the misnamed Fonterra Shareholders Fund (FSF), a listed vehicle for units in Fonterra shares. Shares can only be held by farmer-suppliers but FSF, established in 2012, provided a way for outside investors to buy a non-voting, dividend-carrying interest in the company. Before Fonterra announced the restructure proposal in May last year, the price of farmer shares and units tended to be close. After the announcement, and news that the unit fund would be capped to ensure only farmers continued to own and control the company, both share values dived.
The independently-run FSF called on Fonterra to show good faith by buying out unit holders. Fonterra said no.
McBride is unrepentant. But he concedes the May announcement caused “a lot of discomfort”. (More later on this).
“We were never compelled to buy them out. The decision was based on farmer feedback. We (the board) were agnostic on whether we bought out the fund or not. I’ve heard about the unitholders, but Fonterra shareholders were affected in the same way, if not more. We were all affected together.” (The chair of Fonterra must be a farmer-shareholder.)
McBride notes the result of the delinking proposal has played out as expected – the two markets have found their own levels. (At time of writing Fonterra farmer shares were trading at $2.60 each and units at $3.24, down 13 per cent on a year ago, but up on $3.04 a month ago. The market capitalisation of the FSF is $348m.)
McBride said he and FSF chair John Shewan had to “agree to disagree”.
On the crash in Fonterra farmer share value - a report by Castalia put the loss at an eyewatering $4.1b across all shareholders – McBride has this to say: “Ultimately shareholders and unitholders and farmers will determine the value and that will be based on our performance. That is the key issue here.”
McBride says the post-May value slump had been publicly forecast by the board and was a result of the markets “being in a state of flux” leading to the Government’s green light.
That was “the short-term view”.
“I take the long-term view. It (the capital structure) wasn’t a sustainable model. We had to either deal with it or keep sliding.
“Pretty much our capital structure was being used as a procurement tool by our competitors.”
(Some of those competitors would however argue that the nature of the capital restructure will simply tighten Fonterra’s noose on farmers and milk supply, in turn discouraging industry innovation and progress.)
In what way wasn’t the model sustainable?
“The bottom line is it wasn’t. This where John (Shewan) and I don’t agree. For farmers as investors, their opportunity cost of capital is different to that of a listed market,” says McBride.
“.... Shares were over-valued because of the fungibility between the fund and the farmer market. When you create that mismatch you create a bubble. That’s where it wasn’t sustainable.
“In a listed market your fund managers and mum and dad investors have cash in hand. In a farmers’ market they tend to be borrowing to support their shares. It’s marginal capital for them. They don’t need them to run their farms and supply their dairy factory, so it’s marginal. That’s the key difference and where clearly there were differences of opinion.”
Fonterra was pitched to be “a national champion”, so what’s in the capital restructure for New Zealanders?
“We believe it’s critical the New Zealand dairy industry has a farmer-owned co-operative at its heart,” says McBride.
“We’ve seen what happened in the UK and Australia. You don’t value things until they’re gone. Co-operatives were set up years and years ago and we see real value in that for small rural towns and communities. Farmers spend in their communities, we believe that is critical.”
Fonterra delivered $13.7b to the economy in FY2022 through milk payments to farmers.
McBride notes the DIRA framework is based on the global price of milk because not every dairy company in New Zealand supplies the local market. This gives rise to a lot of misunderstanding about the regulations and how Fonterra operates under them, he says.
“But the economic benefits for New Zealand are paramount. A number of dairy companies are not New Zealand-owned businesses.
“In countries that have lost their co-operative, farmers have become price takers, with the price driven to a large extent by retail, not processors.”
McBride says the most challenging part of the three-year capital restructure process was not being able to pre-communicate with shareholders about the proposal to cap or delink the unit fund.
“Because of [stock exchange] disclosure requirements and the legal side, we couldn’t go out and talk about it. That was a real challenge, having a co-operative mindset but being listed.
“At that point we had strong opposition, strong support and a whole bunch of people in the middle.
“We created a lot of discomfort early on.”
The board couldn’t go to shareholders with multi-choices for change, he says.
“We would have just gone around in a circle. So the board had to balance leadership with consultation. We looked at four or five options then said ‘this is the preferred option’.”
McBride says a high level of engagement and consultation with shareholders was important in such a process.
“It’s best to go out with an idea and plan to listen and be prepared to change or adapt based on the feedback. We got some really good ideas from the farmer base.”
While Fonterra strongly submitted against some of the provisos in the Government’s DIRA amendment bill which accommodated the company’s restructure, McBride says “we can live with them”.
“They could have taken the view that it wasn’t going to happen but they chose to support us.
“Now we get on with it.”
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