So what effect could low payouts have on businesses servicing the dairy industry, and what can they do to protect themselves?
Which industries are affected?
The chart below shows farm expenses by type as estimated by DairyNZ. The largest expense, feed (29 per cent), includes a combination of bought-in supplementary feed and on-farm cropping. Labour (20 per cent) is typically in-house, whereas repairs and maintenance (included in maintenance and running 16 per cent), fertiliser (12 per cent) and animal health and breeding services (7 per cent) are mainly outsourced to third parties.
Depreciation (9 per cent) can be used as a proxy for capital expenditure, such as spending on new milking sheds and farm equipment. The most likely areas for farmers to cut spending are variable costs, outsourced services and capital expenditure.
How are they affected?
Dairy farmers have already slashed costs, begun reducing dairy herd sizes, or are considering changes of use that will affect revenue among companies servicing the dairy industry. PGG Wrightson reported a 19 per cent drop in its first half year profit: "Low dairy prices, and the perceived risk of drought from El Nino conditions led to more conservative spending from PGW's farming customers in New Zealand," said chief executive Mark Dewdney. Skellerup also saw a 13 per cent decrease in earnings from its agricultural division due to dairy farmers deferring spending on "essential consumables".
Low dairy prices, and the perceived risk of drought from El Nino conditions led to more conservative spending from PGW's farming customers in New Zealand.
Suppliers are also likely to find themselves being used as a bank. Stretching payments to suppliers and contractors is another way for dairy farmers to manage their cash flow. Indeed, Fonterra's recent announcement that it is extending payment terms from 30 to 90 days will have a significant impact on supplier and contractor working capital requirements, which will need to be funded from retained earnings or new borrowings.
Given the importance of the dairy sector to the rural economy in particular, the falling dairy payout has also hit consumer confidence, affecting the wider economy. Smiths City's retail division reported a loss in 2015 that was driven by a downturn in confidence in the provinces and rural towns following bad news out of the dairy sector. MYOB reported in its latest Business Monitor update that 21 per cent of small businesses have been hurt by the dairy downturn. Similarly, Xero reported that invoices more than a month overdue had risen from 24 per cent to 40 per cent over the past year.
The last time milk prices were over $6.00 was in July 2014. The cumulative effect of low payouts is likely to be taking its toll on the financial position of companies reliant on the dairy sector.
What can be done?
It would be dangerous to assume that farm expenditure will revert back to historical levels out of necessity. Certainly, some costs, such as pasture maintenance, can only be deferred in the short term. But some farmers are culling herds to reduce costs, meaning a sustained reduction in inputs required. And farmers may be driven to find new ways of farming with new technology or cheaper/alternative suppliers, permanently affecting certain suppliers: necessity is the mother of invention.
So what can businesses exposed to the dairy sector do?
1. Control cash
Try not to let the farmers' problems become your problems, by chasing overdue payments. However, if you are a supplier to Fonterra, there is unlikely to be much you can do about the extended payment terms, so make sure you have the working capital available to fund this. Another option is to renegotiate payment terms with your own suppliers to align with the extended terms being sought by farmers and Fonterra.
Although it seems unlikely there will be many farm receiverships or liquidations, it also pays to make sure your PPSR registrations are up to date and accurate. This will give you the best chance of recovery in the event of a farm insolvency.
2. Right size
Match the size of your business to the reduced level of turnover through cutting costs at all levels: manufacturing, administration, staffing etc. Consider mothballing, disposing of, or closing non-core business units that are only profitable at higher payout levels.
3. Mergers and acquisitions
Realise economies of scale through horizontal acquisition or merger with competitors or complementary businesses. Alternatively, look for vertical integration opportunities with supply chain intermediaries, cutting out the middle man to improve margins. Significant savings can be achieved through operating from one premises, with one set of overheads and potentially more cross-selling opportunities. PGG Wrightson acquired turf irrigation business Advanced Irrigation Systems Limited last year to complement its PGW Water business and provide synergies with PGW Turf.
4. Diversify
Diversify into other industries, perhaps servicing other agricultural sectors such as sheep and beef, horticulture, viticulture, aquaculture, or the latest hot topic, apiculture to generate Manuka honey. Think outside the box: for example, could an irrigation company consider adapting its filtration systems to clean fish farms, reduce pests and improve yields?
5. Exit
If you do not have a sufficiently robust balance sheet to survive continued losses, the best option may be to exit now while the business is still viable. This may involve selling all or part of your business exposed to the dairy sector, or a managed wind-down of the business.
Which option is best for a specific business depends on numerous factors and requires a full understanding of a company's key drivers, risks and opportunities. Volatility of the kind currently facing the dairy industry can present unique opportunities to expand market share. But whatever you do, be sure to do something, or you may be forced into an undesirable outcome. Doing nothing is not an option.
Andrew Grenfell and Conor McElhinneyrs are partners at McGrathNicol.
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McGrathNicol assists Boards, CEOs and their senior executives to clearly define, articulate and implement strategy. We use our deep commercial expertise and analytical focus to help organisations plan, review, implement and monitor outstanding strategy. Andrew Grenfell and Conor McElhinney are Partners at McGrathNicol. The views expressed in this article are the authors' alone.
