With Fonterra's disappointing return on $8 billion of farmer investment over a decade and future capital looking scarce, it's time its leaders spelled out why it's worth keeping some overseas and mature businesses, says investment bank Jarden.
Analyst Arie Dekker said having stabilised trust and confidence since 2019 with "a high level view of a new strategic direction", Fonterra now needs to follow through on detail, providing stakeholders with clear justification for the portfolio of countries and products to be retained, and a clear view of the right debt level and capital base.
If the company intends to retain Australia and Chile and more mature consumer and food services positions in its portfolio, it needs to be clear on strategy and the financial outcomes expected from them, he said.
With capital scarce, it would be helpful for the company to say why it was retaining capital in areas where it did not have competitive advantage, or where categories were mature, against investment in priority areas which should provide better returns.
Dekker said it could be expected that farmer-shareholders were looking for confidence in Fonterra's optimisation of the value of their $8b investment and its management.
Improved financial disclosure in last week's 2021 half-year reporting provided a framework on which to fill out the detail on strategy.
Dekker's call echoes that of some shareholders, and is particularly relevant as New Zealand's biggest company picks up the pace of a capital structure review.
Farmers have to buy a share for every kilogram of milksolids supplied to Fonterra. The company is grappling with a shrinking milk supply, and pressure from ageing farmers who want to liberate some of their capital and from young farmers who can't afford the shares on top of land and cow purchases.
Dekker said strategy and capital structure were linked and Fonterra needed to supply more clarity in order to progress capital structure reform with its farmers.
It needed to demonstrate in businesses like food services and some core ingredients positions how they were expected to grow, where the capital was to come from, and expectations around performance.
"I think it would be useful to understand what the expectations are from those businesses, where they are expected to be in say three years, so farmers can say 'okay, you're holding on to my capital and I'm not getting a dividend, but this is what I should expect out the back end'. And if it's not achieved it doesn't get hidden in the inherent volatility of earnings from year to year, which tends to dominate the results anyway."
Dekker said it wasn't correct farmers only cared about the milk price they received.
"Certainly the milk price is 90 per cent of their income, but they have significant investment ($8b) tied up in the co-operative.
"It's been a disappointing investment over a long period of time - it continues to have a value that is broadly in line with 10 years ago and it hasn't paid out a particularly strong or consistent dividend."
Dekker said the capital structure review threw up important questions for the company.
"One is are we retaining capital in the co-operative, including a decent portion of earnings, to maintain investments we have and to grow others?
"The alternatives to that are returning a greater portion of profits to farmers and returning capital to farmers so they don't have so much tied up."
Fonterra would be getting messages about capital requirements from older and young corners of the shareholder base.
"They (Fonterra) may be more competitive and their farmers might be happier with a smaller capital base, which is why the onus should really be on to demonstrate why they are regions like Australia and Chile for example.
"That's a really fundamental issue.
"It's hard for farmers to have a strong opinion on that stuff without a really good understanding of the strategy and some confidence in the alternative, including why they are continuing to hold these investments."
Dekker said returning capital to farmers wouldn't be straightforward.
If Fonterra decided for example it had $2 billion of assets that were non-core in regions like Australia and Chile and weren't going to add significant value over time or had mature businesses (like Tip Top) where much more value couldn't be extracted, a portion of the sale proceeds would have to go to pay down the company's high debt.
But the reduced scope of activities could provide choices as to how much capital had to be invested by farmers, he said.
Mechanisms already existed for farmers to enter the co-operative and get time to pay off the shares, and for exiting farmers more flexibility could be offered on the share standard.
"But fundamentally there's no easy way to reduce the capital invested in the co-operative if farmers want to retain control.
"So (the choice is) to shrink the co-operative or reduce the amount of capital invested.
"It's difficult to see how they can hold onto everything and make it easier for incoming and outgoing farmers to hold less capital in the co-operative."
There was an opportunity cost to deciding what to keep within the business.
On speculation the capital structure review might see the end of the Fonterra Shareholders' Fund, introduced in 2012 under the Trading Among Farmers (Taf) scheme, Dekker didn't see it being a high priority for the reviewers.
Only supplying farmers can own shares in Fonterra but the sharemarket-listed fund allows the public to buy non-voting, dividend-carrying units in farmer shares, and farmers to trade "dry" shares.
"One of the reasons for removing it would be adding some simplicity to the capital structure," Dekker said.
"That being said, it actually operates pretty well and will cause other issues (if dismantled), a key one being how the price is going to be set for Fonterra shares.
"Some of the benefit is that it's a pool of capital with no ability to influence direction but a pool ... that helps with setting the share price and might provide some outside scrutiny of the co-operative, albeit that is significantly limited by the (level of) interest and the amount of information generally available."
Dekker said given the fund is capped at about $500m another question was where would the money come from to disestablish it. He believed farmers owned a big proportion of the fund anyway.