Fonterra unveils new capital structure options, shareholders' fund could go

Fonterra has announced a raft of changes to its capital structure. Photo / NZ Herald

Fonterra directors are proposing an easier entry for farmers to the big dairy cooperative and either axing or capping through a buy-back the listed Fonterra Shareholders' Fund to protect farmer ownership and control.

This is the preference of the board of New Zealand's biggest company after a major review of its capital structure.

And in what directors agree could come as a surprise, the size of the Fonterra Shareholders' Fund will be temporarily capped, by suspending shares in the separate Fonterra Shareholders' Market from being exchanged into units in the fund.

This is to prevent shares owned by Fonterra's 10,000 shareholder-owners from being exchanged into units in the fund while consultation about the proposal is underway.

Without a suspension, there was the risk shares could be exchanged for units in the fund during the consultation process this year. This could have resulted in the size of the fund doubling or more, and making the option of buying the fund back unaffordable for
Fonterra's balance sheet, chairman Peter McBride said.

Trading in NZX and ASX-listed units in the fund were halted on Wednesday pending the capital structure review announcement. Trading will resume on Friday morning. The temporary cap on shares in the farmer market being exchanged into units will take effect then. Holders of listed dividend-carrying, non-voting units in the fund can continue buying and selling from Friday morning.

The market capitalisation of the fund is $493.2 million. It is capped at $500m. Jarden senior analyst Arie Dekker suggests the fund is mostly owned by farmers anyway.

While the board considered several options, including sticking with the current capital structure, its preferred option is to reduce Fonterra's share standard and either have no fund or a capped fund, McBride said.

Fonterra has just under 80 per cent of the raw milk supply market in New Zealand and is the world's biggest dairy exporter and fifth largest dairy company by revenue.

To be a member of the cooperative and have their milk collected, farmers currently have to buy one share for every kilogram of milk solids supplied. The proposal is to change that to one share for every 4kg.

With average milksolids production per herd at 169,595kg according DairyNZ, and shares at $4-plus the present share standard is a very expensive proposition for a new entrant also funding land and cow costs.

McBride said the share standard change would make it easier for new farmers to join the cooperative and give more flexibility to existing farmers who want to free up capital or who are working through a succession plan.

"A key outcome of this change is that shares would be bought and sold between farmers in a farmer-only market.

"I want to be clear that these changes could impact the price at which shares in our coop are traded, and there may not be as much liquidity in the market. Ultimately the price for farmers' shares would be determined by the performance of the coop and trading between farmers.

"We believe this is a more sustainable proposition over the longer term than the alternatives we re confronted with," McBride said.

Fonterra chairman Peter McBride. Photo / George Novak

Other options the board considered in its capital structure review over the past 18 months or so were: dual share structures, which would move from the current single coop share to a compulsory supply share and a separate, non-compulsory investment share; milk supply without the share-buy requirement; a traditional nominal share structure; a split cooperative model.

Fonterra's current capital structure, introduced in 2012 and considered by industry observers and market commentators to be a clunky hybrid oddball, has come under pressure for reform from several influences.

New Zealand's milk production is flatlining and even declining as environmental and compliance costs bite and more land is converted to horticulture, Fonterra's share of the raw milk market is being eroded by competitors which don't require share purchase to supply and capital is becoming scarce.

Farmers have invested $8 billion in the company over the past decade for disappointing returns.

It must find a way to achieve capital sustainability while remaining in farmer ownership and control.

McBride said Fonterra's current structure was put in place when milk supply was growing rapidly in New Zealand.

"It now needs to be prepared for flat or potentially declining milk supply as a result of factors such as climate change impacts, regulatory changes, and alternative land uses.

"Our coops's financial performance will always be the main determinant of our share of New Zealand milk. But we also know that a more flexible capital structure, that caters for the diversity and different aspirations within our Co-op, would support a sustainable future milk supply.

"This is critical for us to deliver our strategy, which prioritises New Zealand milk."
Declining milk volumes or providing more flexibility for farmers' shareholding requirements could cause the fund size to grow significantly, McBride said.

"That would mean the thresholds that were put in place to help protect farmer ownership and control could be exceeded within the next few seasons.

"To stay within the fund size thresholds, our coop would need to take action – such as buying back shares or units or increasing the thresholds to allow a greater degree of external investment. We don't think either of these are ideal outcomes.

"Buy-backs create an uncertain demand on our capital, potentially impacting our ability to invest in strategy and growth. Under the scenarios that we've modelled, buy-backs could cost shareholders up to $1.2 billion over the next 10 seasons."

Following consultation with shareholders, if the board decides to reform the capital structure, it will likely aim for a farmer vote around the time of the company's November annual meeting.

Change will require a 75 per cent vote of support.

If the decision is to buy back the fund, 75 per cent approval will also be required from unit holders entitled to vote.

Any vote is likely to be conditional on changes to legislation governing Fonterra and the $15 billion dairy industry. The Dairy Industry Restructuring Act (Dira) in 2001 enabled Fonterra to be created from an industry mega-merger, to provide scale to be a "national export champion".