Wednesday, July 6, 2022

Opinion – Serving up milk on a plate

Fairlie dairy farmer Leonie Guiney is visiting Ireland. She looks at the Irish and our dairy industries, makes some comparisons and draws some conclusions.  In the middle of a compelling supply offer from Fonterra, it is timely to look forward. Charlie Munger once said at a Berkshire Hathaway (Warren Buffet’s empire) annual meeting it is very onerous and expensive to insist on learning from one’s own mistakes rather than from the mistakes of others. Then he put it more succinctly. “One shouldn’t have to piss on an electric fence to know the consequences.”

Now we are farming in a TAF environment the relevance of the limits we voted for on fund size come into clearer focus.

To date there has been no trading among farmers, only trading among investors who now set our share price.

So, the supply offer is an attempt to get farmers to trade.

Judging by what investors are prepared to pay for units, at $7.98 as I write, there are only two possibilities.

1 – Investors do not understand they have access only to the economic rights of a co-operative share, the dividend of which should experience downward pressure with increasing milk price or;

2 – The investors or their advisors perhaps do understand what they have invested in but are very confident the cumbersome existence of the co-operative with its purpose to serve milk price first is only temporary. Before long, they believe, dividend and share price will become the priority which justifies the high price they are prepared to pay now.

They could be forgiven for making this assumption by observation of the economic drivers that are now in place to help farmers de-mutualise their own co-operative.

The supply offer makes it extremely attractive to sell the economic rights to 25% of our wet shares. The dividend most certainly doesn’t justify holding a $7.80 share with interest rates at 6-7%.

The share price makes it extremely unattractive to join the co-operative unless shares are further delinked from milk supply with all sorts of contract milk type arrangements.

Unfortunately, relinquishing the ability to value our share as a co-operative share has increased the incentive to fragment ourselves, irrespective of fund size. 

Protected 

If you recall, we voted in some protections to stop this fund running away on itself. It was called resolution two at the June vote.

Summarised, in Sir Henry van der Heyden’s words, there were three parts to the resolution:

1 – limiting fund size to a maximum of 20% of shares on issue;

2 – control mechanisms if the fund size hit 12% of shares on issue including buying back of units and consultation with the council and;

3 – Limiting the number of wet shares any individual can sell to the fund to 33% of shareholding.

Our board therefore concludes that because we need a 75% vote for constitutional change to alter any of this we are completely protected.

What they miss entirely is that we have now made a fundamental change to the co-operative logic.

Long term stewardship of our co-operative comes under pressure when carrots are dangled before farmers enticing them to use their co-operative share to cash flow the business or simply take a compelling profit.

With investors now valuing a co-operative share as if it’s already a public listed company and farmers being pushed to view our co-operative as an investment vehicle ahead of its original purpose, we have created supply redemption risk.

Perhaps now, in the midst of this supply offer, farmers will better see how this can happen, unless we have leadership absolutely determined not to let this fund grow beyond those voted limits.

Economic circumstances or carrots you simply can’t refuse can very easily create an environment where the pressure will come from the farmers to increase fund size.

This is where the Irish experience is relevant.

I read the New Zealand rural papers covering the scramble for meat industry aggregation.

Overcapacity and local supply competition haunts the meat industry and punishes the farmer. 

Windfall 

Our dairy industry had solved this issue and organised its processing capacity to the extent that it can respond to market signals secure in the knowledge they have the supply – until now.

We long ago recognised our competition was offshore, not within New Zealand.

Until our board in their wisdom decided we needed investors to “discover” our share price, making it attractive to fragment the supply again.

This week in Ireland, the Cork Examiner reports a “windfall” to Kerry co-op farmers who will transfer a further 20% of their co-op shares to the PLC, gaining significant value overnight.

This is the seventh such exchange since 1993.

The price offered since Kerry’s original partial float was irresistible at each share exchange in 1993, 1997, 2002, 2006, 2007 and 2011.

A vote in 2011 (I mentioned it in a Dairy Exporter article during the TAF debate) by Irish farmers allowed the co-op’s board to lower its previously negotiated priority regulatory shareholding bottom threshold in the PLC from 20% to 10%.

Until that sixth exchange in 2011 co-op members had sold down over those years to a 22.8% stake in the PLC.

The 2011 vote brought their shareholding down to 17.1%. Last week’s offer reduces their shareholding further.

Each sale has been a “windfall” for the Kerry farmers, every offer too good to refuse.

There is no question the farmers who owned the original shares have benefitted hugely from this process.

There is also no question the milk price of Kerry farmers in future is now dependant on the price the next most efficient Irish co-operative can offer.

Kerry, at its initial partial float, was nothing like Fonterra. It was a tiny co-operative, capital constrained and supplied by relatively inefficient, quota-restricted farmers on Ireland’s most challenging land for dairying. 

Relevant 

Kerry needed to float, in my opinion. Fonterra by contrast, when our leadership decided we needed investors to “discover” the share price was neither small nor capital constrained nor supplied by inefficient, production-constrained farmers.

So why is the comparison relevant?

I want New Zealand farmers to understand how easily economic incentives to sell, under the structure we now have, can be too compelling to resist.

Fonterra is not the sophisticated food ingredients business that Kerry is.

Our strength in marketing our commodities is dependent on being the preferred co-op to supply and the most efficient producer of that commodity.

This was further emphasised to me when I recently got the opportunity, courtesy of the ASB bank, to observe the extremely tough trading environment that is China.

While the Kerry farmers are benefiting hugely from selling out to a PLC that enjoys exceptional leadership, the Irish Farmers Journal is full of calls to Irish co-ops to aggregate their dairy industry to compete against us in China.

If there was ever a time when our collective strength is envied by the world it is in very sharp focus now, in the scramble for Chinese consumers’ dollars.

New Zealand dairy farmers have already achieved what everyone else wants to, via great leadership and co-operation over 100 years.

We are on the cusp of dismantling that for short term individual gain.

Take your short term profits on the supply offer but be prepared for a constitutional vote one day suggesting we relax the limits on the fund size, with an offer that will be too good to refuse.

I hope farmers will stand firm on keeping this fund small so the next generation of dairy farmers sees the profits delivered to the farm via the milk price, first.

Unfortunately, having traders, who profit from volatility, value our shares creates strong incentives to cannibalise our envied structure, irrespective of fund size. Must we piss on that fence to understand the consequences?

New entrants competing for milk supply, like the Chinese company Yili in South Canterbury, see their opportunity has never been better to secure any new supply coming on stream from the irrigation developments in Canterbury. 

Pressure 

I noted they announced their intentions to invest in Canterbury immediately after the share price hit $7 in January. This was their assurance they would secure the supply that would otherwise have been Fonterra’s.

Add a little pressure on over-leveraged farmers for a bit of debt repayment by the odd bank, throw in a North Island drought and see how long it takes for farmers to complain they can’t access the profits being taken by the unit investors because there are too many restrictions on farmers ability to trade.

Expect the next offer, allowing farmers to sell up to 33% of their economic rights, before long.

This new structure, with the share price completely unrelated to the purpose of the co-operative share, invites farmers to put pressure on Fonterra to allow us all to further delink share ownership from milk supply.

It is analogous to the generation that inherited the farm (rather than the one that built the business) selling off bits of land for lifestyle blocks, gradually undermining the business potential but looking after themselves in the short term.

Fonterra will argue we are completely protected from demutualisation or to extend the analogy – the carving of the whole farm up into lifestyle blocks – in our own constitution.

I argue only if the leadership’s goals are aligned with those of farmers does your constitution offer any protection.

Aggressively selling TAF to farmers as a solution to redemption risk leaves this supplier unconvinced those goals are aligned.

We need leadership that intends to protect our collective strength and long term on-farm profits.

The new start-ups will, of course, pay competitive milk prices initially to secure supply.

They just need patience to see enough fragmentation until they can shift the emphasis from milk price to company profit.

Fonterra has delivered the opportunity to them on a plate.

We are protected by our constitution only if we know what we want to protect.

And clarity in what will best serve New Zealand farmers, in the long term, comes first from appreciating what we already have.

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