Brian Gaynor: Numbers reveal the scale of Fonterra's failure

Dairy farming in Ireland, where the milk price is much the same as NZ, but Kerry Group has a vastly higher value than Fonterra. Photo / 123RF

COMMENT:

Columns on Fonterra usually receive heated and emotional responses and the reaction to last week's article was no exception.

These comments can be divided into two general groups.

The first group is made up of readers who totally concur with the view that Fonterra's performance has been extremely disappointing.

The other group, consisting mainly of co-op shareholders, argue that they are fed up with the negative portrayal of the dairy giant in the media.

The latter group usually state that they are happy with the farmgate milk price and, as far as they are concerned, this is the most important issue.

This week's column focuses on the naive attitude that the farmgate milk price and co-op dividends are the key issues for dairy farmers, and why this focus is a major contributor to the poor performance of their company.

Co-op shareholders have three major sources of wealth: the price they receive for their product; the dividends they receive from the co-op; and the capital appreciation of these co-op shares.

Numerous readers asked why last week's column portrayed Kerry Group as a more successful entity than Fonterra when Ireland has almost the same farmgate milk price as New Zealand.

The average monthly Irish farmgate milk price over the past year has been €0.355 per litre, which converts to €4.08 per kg of milk solids (kgMS). In New Zealand dollar terms, the average Irish price has been $7.10 per kgMS compared with Fonterra's forecast range of $6.30 to $6.40 per kgMS for the 2018/19 season.

These figures are not far apart because the Irish price is an unweighted average and milk prices are lower than the yearly average in the northern hemisphere's April to July period when production is higher.

Milk is essentially a commodity and prices don't vary dramatically between countries, particularly since Fonterra introduced Global Dairy Trade, an international electronic trading platform, in 2008.

Co-op shareholders usually state that they are happy with the farmgate milk price and, as far as they are concerned, this is the most important issue. Photo / File

Added value and wealth creation mostly occurs through the companies that convert milk into consumer products. A2 Milk is a good example of this as its NZX company shareholders, rather than its milk suppliers, have been the main beneficiaries of the company's success.

Thus, we need to look at the added value performance of the co-op, in addition to the farmgate milk price, to determine overall dairy farmer returns.

The net profit, dividend and retained earnings in the accompanying table, which are compiled from the Statement of Changes in Equity, give us an insight into the strategies of Fonterra and Kerry Group.

The Fonterra figures on the left-hand side show that the company has recorded net profits after tax of $2740 million over the past six-and-a-half years and paid out dividends of $2805m.

Thus, a company with ambitious global growth aspirations, and almost no ability to raise new equity, has paid out 102.4 per cent of its net earnings in the form of dividends over this period.

This is a bizarre, high-risk strategy that has resulted in the following outcomes since the end of the co-op's 2012 financial year:

• The co-op's retained earnings have declined from $1078m to $1013m
• Its total equity has also fallen, from $6655m to $6580m
• Meanwhile, total assets have expanded by $5024m, from $15,117m to $20,141m
• Total debt has increased by $2820m, from $4991m to $7811m.

In other words, 56 per cent of Fonterra's asset expansion has been funded through debt, with most of the remainder financed by trade creditors and suppliers, in terms of money owed to these two groups.

By comparison, Kerry Group's figures over the same period have been as follows:

• The company has distributed 21.4 per cent of its net earnings in the form of dividends compared with Fonterra's 102.4 per cent
• Its retained earnings have expanded from €1682m to €3933m
• Total equity has grown from €2104m to €4187m
• The Irish company's total assets have expanded by €3584m, from €5350m to €8933m
• Total debt has increased by €809m, from €1500m to €2309m.

This means that Kerry Group's global growth strategy has been 63 per cent funded through additional retained earning, with most of the remainder financed through borrowings.

Fonterra's high-risk, debt-fuelled global expansion strategy might have worked if it had made astute investment decisions, but last week's announcement of massive write-downs in the value of its China, Brazil, Venezuela, Australia and New Zealand investments shows this has not been the case.

The NZ co-op's balance sheet will look far worse when it releases its results for the 2019 year.

Its share valuation has also been hammered, with the dairy co-op having an implied sharemarket value of only $5.5 billion at Thursday's closing market price compared with Kerry Group's $33.1b (€19.0b).

NZ dairy farmers receive almost the same milk price as Irish farmers and Fonterra has paid higher dividends than the Kerry Group. However, Kerry Group is worth $27.6b more than Fonterra in terms of sharemarket value and the NZ company won't pay a dividend this year. The NZ co-op's future dividend policy is also uncertain.

The $27.6b valuation gap between Kerry and Fonterra compares with an estimated $10b paid to NZ farmers for their milk in the 2018/19 season.

Fonterra CEO Miles Hurrell. Photo / File

It is difficult to understand how the Fonterra board could have distributed over 100 per cent of earnings while adopting an aggressive debt-funded global expansion programme.

Most listed companies raise new equity when they adopt this strategy but Fonterra's farmer shareholders want to continue to own 100 per cent of the co-op without being willing to contribute new capital.

They have drained the co-op almost dry in terms of milk prices and dividends and have left it in an extremely vulnerable position. This has resulted in a massive loss of shareholder value through the Fonterra share price.

This is a hopeless situation that can only be resolved by Fonterra adopting one of the following business models:

• The co-op becomes a commodity producer only, closes all its global added value operations, slashes staff numbers and moves to Hamilton to save costs
• It separates its traditional co-op operations from its added value activities and lists the latter on the NZX after raising capital from non-farmer shareholders
• Fonterra adopts the Kerry Group model and lists its total operations on the NZX with external shareholders.

Meanwhile, Fonterra's performance should be assessed against the new Statement on the Purpose of a Corporation released by the US Business Roundtable this week and signed by 181 major US company chief executives.

The statement generated significant media attention because it downgraded shareholders to fifth position and contradicts the late Milton Friedman's belief that the one and only objective of businesses is to increase their profits.

The 181 US Business Roundtable CEOs have committed to:

• Delivering value to our customers
• Investing in our employees
• Dealing fairly and ethically with our suppliers
• Supporting the communities in which we work
• Generating long-term value for shareholders.

These guidelines should be imprinted on the walls of the Fonterra boardroom as the co-op's recent performance indicates that its main objective has been to maximise the short-term returns of its farmer shareholders through the milk price and overly generous dividend payments.

- Brian Gaynor is a director of Milford Asset Management.