As you likely know, changes are afoot at Fonterra; changes that are getting a lot of people worried about where the co-operative is heading. For most NZ dairy farmers read: where our co-operative is heading. Last week we gave a (relatively) neutral description of the proposed changes. This week we have let the shackles off our opinions. To hell with the details, what’s the big picture? What does Xcheque think about Trading Among Farmers (TAF)?
- ~ -
Any student of global dairy economics should pay attention to what happens in New Zealand. They should also try to understand how the dairy industry swings on the tension between co-operative based and private market, capital. These two issues will collide very shortly when Fonterra’s New Zealand farmer shareholders vote on a proposal to change the capital structure of the co-operative.
Make no mistake about this. Fonterra’s TAF proposal is not just tinkering at the edges of the co-operative's constitution. It represents a fundamental change to the organisation and the New Zealand dairy industry; no less important than Fonterra’s formation a decade ago. The board and management, however bright they may be, are taking a big gamble - is it worth the risk?
Fonterra’s capital risk
Ironically, Fonterra management want to introduce TAF precisely to avoid risk. They may look like they’re in a pretty safe position, biggest NZ dairy company and all, however they’re anxious about how to protect the co-op against two interrelated risks.
The first is the worry that they won’t be able to keep up their rapid expansion. As we said last week, they want, or in some sense need, to keep growing. While Fonterra have repeatedly denied that TAF is about raising capital, they’ll need capital to fund their expansion.
The other is a risk that is more important for Fonterra than most businesses. Fonterra shares are redeemable. If a farmer decreases milk production, retires, or decides to leave Fonterra and supply someone else, they can then pull their shares out of Fonterra at the current value. Their capital base varies with milk supply and would shrink right down if there was a mass exodus of milk from the co-op. Contrast this with a normal public company where shares are not redeemable. They can be traded to someone else but otherwise owners are stuck with them unless the company makes an offer to buy them back.
While most other co-operatives have redeemable shares, Fonterra’s associated risk is particularly acute. Fonterra are required to pay farmers an exit price that reflects the approximate market or “fair” value of the underlying capital. In most other co-ops the redeemable capital is the amount paid in by the farmer - normally a much smaller amount. Fonterra must also pay farmers in a timely manner instead of within a year or two of the farmer exit.
The bottom line here is that Fonterra’s capital base is limited and according to international accounting standards is not secure. This means that Fonterra finds it difficult to raise additional capital and / or they need to pay a higher premium for borrowings.
TAF to the rescue
The TAF proposal would create a permanent capital base for Fonterra with no more redemption risk. Farmers could still vary their capital holdings in line with their milk production but shares would be traded among farmers and also with outside investors. This trading would occur in two places: (1) The Fonterra Shareholder Market (FSM) - where dry shares could be traded among farmers (2) The Fonterra Shareholder Fund (FSF) - here farmers sell shares to the fund (retaining rights to milk payments and voting). The economic rights to the dividends are then available to be purchased by other farmers or outside investors.
A further key plank of the TAF proposal is the ability of Fonterra to raise more capital than the equivalent milk production. Farmers can now own up to 120 % more shares than their milk production equivalent. This will increase to 200 % under TAF. This is critical to Fonterra’s objectives because (1) it helps to raise more capital than their milk base can provide (2) improve liquidity by promoting trading among farmers (3) create a greater pool of shares and increased liquidity to encourage trading with outside investors.
Shedding redemption risk - Yours, mine and ours
Does TAF get rid of redemption risk?
Currently the cost and risk of share redemption (for whatever reason) is borne by the co-operative as a whole. When a farmer pulls shares out of Fonterra, they as an individual are guaranteed a price that reflects the underlying value of the capital (likely higher than when they bought in). Collective risk; individual security.
What TAF would do is remove redemption risk from farmers as a collective (called Fonterra) and place it on them as individuals. It will do exactly as the acronym suggests - farmers must trade shares between each other rather than with the co-operative. Collective security; individual risk.
So the answer is ‘sort of’. Redemption risk will be transformed from a collective into an individual burden with farmers creating the buy and sell market between them rather than with Fonterra.
You might object that this is just shifting the risk from farmers as a whole (Fonterra) to farmers as individuals. The share price will be set by an external body - the market - and there’s no guarantee that the price might not be significantly lower when they sell out than when they bought in. It is likely however that this won’t be a huge problem. A farmer will be able to own up to 200 % of their capital requirement, which will be calculated on a three year rolling average. This should give farmers a relatively large amount of flexibility so they won’t be forced to sell at a bad time. They also have the chance to buy for the future when they think the time is right.
What’s interesting is that it’s not TAF as such that’s providing the security here. It’s the introduction of measures like a three year rolling average and being able to own above your required capital. These changes alone, plus the ability to pay farmers out at their discretion and/or at the same price they bought in, would likely to be enough for Fonterra to mitigate redemption risk. In a practical sense, permanent capital isn’t required for capital security.
Two kinds of owners
Whilst management of redemption risk can be considered a necessary action underpinning the future and sustainability of Fonterra, we are not so sure about the secondary implications of TAF. Notwithstanding the preservation of Fonterra’s co-operative based shareholder voting structure, TAF is very clearly decoupling ownership, and the economic benefit (and risk) of capital, from milk supply.
In the beginning, the number of shares held by Fonterra farmers was directly proportional to milk supply. Fonterra developed a complicated process for splitting farmer income between milk payments and share dividends. The split was however somewhat notional. Most farmers received a similar income per kilogram of milk solids by virtue of the compulsory shareholding requirements.
Implementation of the the first stage of the TAF proposal in 2009 allowed farmers to purchase and hold up to 120 % of their capital requirements as determined by milk supply. The current round of constitutional changes will increase this to 200 %. Even with limits on the total number of ‘dry shares’, it will substantially enlarge the share-pool. This is a neat trick when coupled with the removal of redemption risk - more capital and less risk - but who will buy this additional capital, at what price, and who is the winner?
As someone starts to own more capital than is required by their milk supply, their economic interests begin to slide towards capital rather than milk. The logic is simple and irrefutable - if all farmers get the same amount of money per kg milk in milk payments, and a subset of farmers get proportionately more of Fonterra’s income pie via their additional shareholding, then the second group of “super shareholders” will very likely be better off if more of the income distribution comes from share dividends than milk payments.
For the super shareholders there is also a second very important driver for redistribution of income away from milk payments to dividends. The capital value of shares is directly related to their future income potential - in other words the cash flow from dividends. If Fonterra systematically reduces dividends the share value will drop and the reverse will happen if dividends increase. Super shareholders will almost certainly be putting pressure on Fonterra to maintain or increase dividends and the value of Fonterra shares.
The big question for Fonterra’s shareholders isn’t about insider-farmers vs outsiders-investors; it’s about ownership via capital and ownership via voting rights and milk. TAF is creating two kinds of owners - the low capital milkers and the high capital super shareholders. Both of these groups are Fonterra dairy farmers, and both of them are entitled to vote.
The alarm bells are ringing loud and clear here; and this is before consideration of the FSF and the involvement of outside investors.
Selling the farm
New Zealand dairy farmers are for the most part heavily geared. This is a result of the combination of ongoing growth and investment in farms and in Fonterra. The capital supply and milk price shock of 2009 put something of a brake on this borrowing. Banks are now less inclined to provide loan funding backed by the expectation of expected capital gain on land values. Funding remains tight and farmers are being called upon to repay debt.
Fonterra want more capital for debt relief and growth (despite insisting that TAF is not about raising capital). They are creating a mechanism to increase the current base. The current gearing level of New Zealand farms suggests that this additional capital is unlikely to flow from farmers and this is where the FSF comes into play. TAF is providing external investors with a kind of shadow equity in Fonterra. It is a huge step from the current loans and bonds and once taken there is almost no turning back.
Fonterra are keen to point out that external investors are being offered the economic rights to shares and not voting rights. There are however other ways to influence decision making without voting.
Expansion of the Fonterra share pool must create offsetting savings in borrowing cost, or increased value created from capital invested. If that doesn’t occur the share issue will necessarily result in dilution of the dividend pool (and devaluation of the share value) or the need to transfer value from milk payments to dividends. This is a pure economic equation that the external market understands very well - the value of shares is a function of future cash flows in dividends and a risk premium. And what is the market rate and risk premium for Fonterra? Who knows where it will settle but most likely it will be above the rate set for loans and bonds. The external market will factor in issues such as commodity volatility, liquidity and the uncertain behaviour of the farmer shareholders.
If outside investors are not kept fat and happy - given high enough dividends - then they’ll try to sell their shares, resulting in a market devaluation. If the market sets the value of Fonterra shares lower than the price that current shareholders have paid, this will destroy the wealth of all Fonterra farmers. The dividend must be high enough to avoid this.
The amount of capital expansion that will occur, the savings and value created from the capital expansion, and the market valuation of Fonterra shares is almost impossible to predict. In our view however, it will be the external market that makes these determinations and not Fonterra’s farmer members. Fonterra is inviting a hungry beast into the milking shed and it will need to be fed.
Between a rock and a hard place
So why not scrap the FSF and place even tighter limits on farmer trading and owning of dry shares? Because the way Fonterra have engineered TAF, there must be demand for, and supply of, shares that isn’t linked to milk production.
People who want to own shares for the sake of owning capital, whether they be farmers or not, will provide much needed liquidity in the market. Without that you could end up with a situation where most farmers want to buy and sell shares around the same time, leading to artificial short term price fluctuations (the three year rolling average and ability to own 200 % of your capital requirement will also mitigate this).
Fonterra has to balance the need for liquidity with wanting to limit a drift towards capital and the creation of two kinds of owners. It’s a damned if you do, damned if you don’t situation. If they muck it up they’ll fall off the tightrope.
Rolling the dice
As has been emphasised, Fonterra are taking a huge risk with TAF - In our view here’s why:
Redemption Risk Transferred - Not Removed. While we can understand why Fonterra wants capital security, we believe this can be achieved without moving to permanent capital. The current TAF proposal will give capital security to Fonterra as a whole but it unnecessarily burdens individual farmers with the risk of a loss of share value or a high cost for growth. There are better ways to do it.
Two Kinds of Owners. The biggest problem with TAF is not that it will give non-farmers a chunk of Fonterra but that it will create two kinds of owners within the co-operative. There’s a very high chance that a large voting block will be created whose interests lean towards income from capital rather than income from milk. In our view that is not what a milk co-operative should be about.
Capital Devaluation Risk. Currently the value of Fonterra shares is set administratively. There is the risk that the market valuation of Fonterra shares will be lower than the current and historical value. This would destroy the wealth of many New Zealand dairy farmers - an unacceptable situation for the farmers and their bankers. The solution will be to increase the proportion of income going to dividends. This again undermines the prioritisation of milk price over capital returns - and that is a slippery slope for co-operatives.
Are the views expressed here philosophical concerns rather than rather than certain predictions of the future? Who’s to know. What we do know is that good decision making is about weighing up the risks, costs and benefits - and there are a lot of risks associated with TAF. If Fonterra don’t get it right they are gambling away the future of their co-operative as a co-operative. It doesn’t seem like a risk worth taking.
- ~ -
 While there isn't space to deal with this issue in any detail, there are many other workable co-operative structures beyond what Fonterra currently have or are proposing
 Both the total number of dry shares and the size of the FSF will be respectively limited to 25 % of total shares.
 A further point to note here is that members of the FSF will have the right to be 'consulted' about the appointment of the independent members of the Fonterra Board.