Fran O'Sullivan: Pressure on Fonterra to lift its game

While Fonterra's top brass is busy trumpeting its vastly improved performance to financial analysts and journalists at the company's Auckland HQ today, the company's 35-strong shareholders' council will be across town on the receiving end of a tough Government-directed message: New Zealand's economic future depends on Fonterra lifting its game - and fast.

Credit where credit is due first. Fonterra chief executive Andrew Ferrier and his team have done a sterling job turning the co-op's fortunes around after the dairy-boom bust and Sanlu disaster severely affected the company's balance sheet.

The dairy payout forecast for 2009/2010 has already been boosted by 55 cents/kg milksolids - an amount that could pull an extra $750 million into the New Zealand economy at current exchange rates. There may be another sweetener when Fonterra confirms its 2008/2009 payout today.

But unless farmers empower Fonterra to get rid of its defective capital structure, its progress will continue to be hindered by the kind of hardball dairy politics thabt critics claim incentivise elected directors to pay out too much to farmers instead of retaining sufficient earnings to grow the company.

Beltway insiders make clear that the Government will not simply endorse Fonterra's requests for the preferential tax amendments - and other so-called "technical changes" - it wants to underpin its three-stage capital development programme.

The Government wants a much more competitive and diversified NZ dairy industry to evolve so maximum economic benefits for the whole country can be achieved. So a quid pro quo will be extracted, probably through significant changes to the Dairy Industry Restructuring Act 2001.

Negotiations are at an early and sensitive stage.

The Government is being very careful not to be seen to be openly bullying Fonterra's 10,500 farmer shareholders. Particularly as those shareholders are now being asked to take what in reality is a series of baby steps on the path towards a more sophisticated capital structure: Separate votes will be held to allow shareholders to hold shares up to 120 per cent of expected/recent production (in effect an additional 20 per cent of "dry shares"); to restrict the fair value share at $4.52, and, finally, to enable farmers to trade shares through a new direct platform rather than transacting through the co-operative.

Agriculture Minister David Carter will make it crystal clear to the shareholders' council today that it is essential Fonterra does achieve the required 75 per cent approval for those steps, that the capacity for redemption risk which has bedevilled planning efforts is removed, and, that ultimately the case is successfully made for additional capital to fund growth opportunities.

Fonterra's retention policy is clearly a matter for directors. But Carter observes (in hindsight) when the dairy payout spikes at $7.10/kg of milksolids - it "would have been prudent to retain more".

Not all Fonterra's farmer shareholders are in a position to pony up for their extra 20 per cent of "dry shares". But the majority will be - particularly as the forecast payout increases will make the proposal much more appealing to their bankers.

Fonterra chairman Henry van der Heyden indicates that the co-op's capital position could strengthen further when/if farmers are allowed to reinvest their dividends - an issue that is under discussion.

Van der Heyden makes the point that farmers look at their Fonterra shares as part of their investment in their overall business. He argues that the average farmer has about $40/kg of milksolids tied up in land; and $4/kg of milksolids in plant and stock. With the Fonterra fair value shares priced at $4.52/kg of milksolids the total investment is around $50/kg of milksolids. On this basis the additional $1/kg of milksolids (or so) to fund the dry shares component represents just 2 per cent of the farmers' overall investment.

In reality Fonterra has been too timid on this score.

The dry shares do not have voting rights attached. The only reason to couple dry share entitlements to production appears to be so Fonterra's strategists can try to convince the Government they should get the same tax treatment as the wet shares (taxed at farmer level not company).

Behind scenes Cabinet ministers are scathing over the clear fact that Fonterra has not lived up to the promises made when two fiercely competing dairy companies, Kiwi Co-op and the NZ Dairy Group, were merged with the NZ Dairy Board into a mega co-op in 2001. The over-blown rhetoric (Fonterra would be NZ's Nokia, or morph into a Nestle-style food giant) has long been buried, with the claim it would grow revenue by 15 per cent annually to reach $30 billion by 2011. At best Fonterra has morphed into a 21st-century style (value-added) commodity trader - where high-value ingredients like clear proteins are sold to industry players like Nestle to use in their own branded products - on top of its traditional milk powder trade base; rather than a food giant with its own clearly defined house of brands.

Behind scenes ministers are asking the 'What if?" questions. "What if" Fonterra had achieved its promise? Would the NZ economy have slipped so far down the OECD rankings if the mega-company had performed to expectations. "How can" NZ close the gap with Australia if Fonterra (which after all was a creature of statute) is allowed to continue to choose its own destiny? And why are the meat and wool sectors are under-performing? Hard questions that need to be asked.

The Government does not see the NZ dairy industry as a complete failure. The internal dairy market has become more diversified and competitive since the Dairy Industry Restructuring Act (2001) effected the merger. Other players like Synlait and Open Cheese Country have evolved.

Sometime around 2010/2011 - two years ahead of earlier expectations - sufficient competition will have emerged to abolish the requirement on Fonterra to supply milk to competitors.

Trouble is ethe Government is not happy with the dairy industry "footprint" that has evolved. A consultation paper will be issued before Christmas asking for th industry's feedback on any transitional measures that should take place.

There is not much time to be wasted. The international dairy industry is starting to rebound. Profitable growth opportunities will not be on the table for too long at depressed prices.

Best the Government makes sure it knows its carrots from its sticks.