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Posts Tagged ‘Fonterra

A distorted economy

Two graphs that summarise where we are economically as a nation, and without even looking at the tourism numbers, which are bad enough on their own.

First up, real estate prices for residential properties.

Those increases, in one year, are staggering. In dollar terms they exceed any “help” that any government, even one as spendthrift as Labour, can give to young, first-time home owners.

The price to income multiplier increased during the “nine long years of neglect” of National from 5.05 to 6.08. Under Labours stewardship it’s now at 8.61.

It’s been common wisdom for twenty years now that Aucklanders were cashing up and heading to the Waikato and Bay of Plenty. But since when are retired Aucklanders or Wellingtonians cashing up their houses and moving to Gisborne (almost 50% increase) or for that matter the West Coast (33.6% increase). There will be specific reasons for this inflation but they all boil down to factors driving the basic economic law of demand exceeding supply.

In Auckland those factors have been population growth increasing faster than homes can be built – which in turn is based on government immigration decisions on the demand side vs. building regulations and costs, and even more so the land-banking of city planning causing huge lifts in the cost of land, far beyond the increase in house value itself.

But can those factors be driving demand exceeding supply across the whole nation this time? Immigration has been basically zero for the last year and while land-banking and city planning are a nation-wide supply restricting problem there have not been dramatic changes in those factors in the last year, and some areas have always been more relaxed than others. So what’s driving this recent nationwide inflation?

  • Government changes on investment deductibility and the increased time over which the bright-line test can be applied (basically a Capital Gains Tax) mean that investors are deciding now it’s not a great time to sell, reducing the number of listings (supply)
  • Sensitive people are feeling the breeze of general inflation and take positions to protect their own capital base by lifting those sales from the market, further tightening supply. Better to sit on the potential capital gains, increase the mortgage and use that money to buy a new boat. Notice the increase in prices for second-hand boats, caravans and motor homes.
  • Interest rates pushed down in 2020 as the classic mode of Keynesian response to a potential recession. That increases demand, at least for a while.

The government must be hoping that this is just a one-off and that once the housing market has adjusted to a post-Covid world, things will settle down. We should all hope for that but I see merely the results of a “critical mass” of factors that have finally come together at one point in time rather than individually affecting the market at different times. Even if this spike cools down, the ongoing house price increases will still be greater than we can cope with.

Then there’s this:

That’s Fonterra’s share price in the last three months. An awful drop from $5 per share to $2.82 that exceeds the percentage drop in 2018. That last was caused by financial problems at the company. Problems that, like the housing situation, had been bubbling away for years, but which hit critical mass that year.

Fonterra has since cleaned up many of those problems and was looking pretty healthy internally, with a good payout. So what’s happened?

Professor Keith Woodford is on the case as usual with two articles in May that discussed what might be coming.

You can read the details in those two articles . The summary comes to five points, the first two being around proposals only.

  1. Reduce farmer requirements to own shares, with them needing to hold one share for every four kg of Milksolids supplied, compared to the current one share for every kg of supply. That last is a hangover from Co-op days when the shares were a nominal $1 that never changed as farmers joined and exited co-ops.
  2. Shut down or cap one arm of its two-armed share investors world, the Shareholders Fund. This Fund and the related Trading Among Farmers (TAF) scheme allowed a two-way flow of “units” and shares between the Fund and the Farmer share trades, which kept the price of shares and units within a cent or two of each other and supplied vital pricing information to both farmer investors and external investors.
  3. The Fund allows non-farmers to buy shares and get a dividend but with no shareholder voting. While there was talk about enabling the company to raise capital this way without trying to get cash from cooperative members, the real reason was to remove the redemption risk as farmers exited the company. Under the old co-op model they would not have had the cash to pay them out. The Fund and TAF would shift the risk.
  4. The flaw was that the only way TAF could remove the redemption risk should Fonterra lose a major number of suppliers was by taking on a new risk of losing control of the company to non-farmer investors.
  5. The risk now is not from exiting farmers but from a substantial and ongoing reduction in production, perhaps in the order of 10% to 20%, primarily driven by future environmental regulations around herd sizes. That’s one rock. The other is that farmers still want to control the company.

While only proposals, they did suspend trading before the announcement and they have cut the link between farmer share trading and the external fund, showing the future to investors.

Those investors, the market, have reacted badly to all of this and although it would be easy to say that this is just frippery that ignores the now “healthy” internals of Fonterra, the fact is that share prices tell us what the market thinks of any company’s future.

Clearly Fonterra’s and perhaps the rest of the dairy industry’s future in NZ is not good. What that means exactly for the wider NZ economy is another question, but clearly for some environmental and economic extremists like No Right Turn the message is the same as for the Huntly power station and the fishing industry: Let It Die.

Winter is Coming

Winter – Ivan Shishkin, 1890

Rabobank provides a regular newsletter to its farming clients and the latest one makes for grim reading.

They’re forecasting a milk payout next season (20/21) of $5.60 per kg. Currently it’s at $7+.

Ouch.

The farmers I talk to don’t accept Rabobank’s analysis.

Yet.

And Fonterra, Open Country and other dairy companies are still optimistic that next season’s payout will be well north of $6, even if not at this season’s level. The trouble is that their forecasts have often missed the big swings, notably the $4.30 payout of 2014/15, which came so rapidly after the record $8.40 payout, and I don’t have much confidence in Fonterra in general.

Rabobank allows for some upside points:

  1. Chinese demand, particularly for powders, is stronger than we have baked into our forecasts.
  2. The NZ dollar weakens further than our anticipated NZc 57 average over the forecast period.
  3. Global economic growth is stronger than we have anticipated across 2H 2020 and into 1H 2021.
The first two seem reasonable to me but I would not bet on that last, which ties in with one of the following downside risks they also list :
  1. The European Commission lowers the price floor for intervention buying.
  2. NZ dollar appreciation (assuming US dollar dairy commodity prices fall significantly across 2020 as we expect).
  3. Re-infection in China, causing supply chain and demand disruption once more.
  4. Global milk supply is stronger than the existing modest increase accounted for in current forecasts.
  5. Demand softness is worse than we have anticipated over a longer period of time, as unemployment rises and economies see large falls in discretionary spending.
I’d dismiss points #2 and #4 but given the degree to which the EU holds up agriculture I’d say #1 is a dead certainty, as is #5.
 
The re-infection wave is a possibility not just in China but elsewhere and all of these flu and cold-like diseases go through various successive waves until so-called herd immunity is settled, with the viruses living by not killing all their hosts. How much such a wave will affect any nation’s economy is hard to judge, but I’m not aware of any analysis that puts it being greater than the usual Winter attacks of flu and cold, either in terms of hospitalisations or deaths, and those attacks don’t throw economic demand for a loop.
 
But #5 is almost a dead certainty. There will likely be an explosion of consumer demand after the various restrictions are lifted inside nations, but it will be short and sharp. The medium-term demand does not look good as everybody adjusts to a new world. Perhaps they’ll be more “preppers” than ever and they’ll buy up Whole Milk Powder in vast quantities. 😀
 
But right now I’m leaning towards the Rabobank analysis, which means the spreadsheets are getting a workout looking two years forward. I’m going to cut spending to the bone:
  • Off-farm grazing gone, 
  • Purchased stock food gone, 
  • Reduced herd size to allow pure self-sufficiency (but of course that’s reduced income)
  • R&M only.

That in turn means very tough times coming for all the medium-sized firms that supply us and the people who work for them. I hope they survive.

 
I hope I do!

Based on the comments I thought I would add the following, which is a link to an article published earlier this year on Professor Woodford’s superb blog, Woodford On Farming. The article is, Dairy debt and declining values create an equity pincer:

Based on milk producton for calendar 2019 of 1.89 billion kg milksolids, then the bank debt approximates $21.50 per kg milksolids.

One further snippet of Reserve Bank information on dairy debt comes from the Financial Stability Report of May 2019 which states that around 35 percent of dairy farm debt is on farms where the debt exceeds $35 per kg milksolids. The Reserve Bank perspective at that time was that debt of $35 per kg milksolids was their indicator of high risk.

If we apply a 20 percent decline to the DairyNZ asset values, then some 13 percent of farmers now have negative equity. Another 28 percent of dairy farms have equity less than 25 percent of assets, with some of these close to zero.
 

Should asset values decline a further 10 percent from 2018 values, then around 24 percent of dairy farmers would have negative equity.

 

Written by Tom Hunter

April 12, 2020 at 8:37 pm

Fonterra’s cows did a double backward somersault while mooing the "Star Spangled Banner"

Translated that meant, So long, and thanks for all the payouts.

It was around 2011 that I concluded that Fonterra was never going to be able to successfuly execute all those grand strategic plans from the turn of the century.
I looked at it pretty simply: the idea of having a dividend from shares as a supplement to the actual milk-solids income sounded good; it meant the company would be focused on all that “value-added” stuff that’s been a mantra in NZ at least since the 1980’s. As that factor improved over time the dividend would steadily increase, which would also increase the value of the shares, thereby making it easier for Fonterra to raise capital and borrow. In effect, each Fonterra farmer would be a microcosm of the company itself; a declining proportion of basic commodity business and income, with a rising share of “value-added” product business and income.

As Agricultural professor Keith Woodford describes:

By chance, today I was looking at a 2007 document from Fonterra which set out how in the 2006/07 year Fonterra paid a milk price of $3.87 plus a value add component of 59c. Back then the value-add component was significant. The fair value share was valued at $6.79. Fonterra had 12 billion of assets and equity of around 8.46 billion (6.79 X 1.246 billion kgMS). The particular document I was looking at was Fonterra’s first document to farmers proposing bringing in non-farmer investors

So to be fair, it looked like it was working – for a while.

But by 2013 I was really done, and the following two seasons, with a terrible global commodity market and resulting record low payout, was simply a confirmation of Fonterra’s strategic failures. Sure, the zero-interest emergency loan was nice, but such should not have been needed if the original strategies had worked.
My only regret is that I did not move fast enough. I did escape in 2018, after the share price had dropped to around $5.46, down from $6.50 in January 2018, and certainly I escaped ahead of the looming disaster of $3.17. But it was still a hit to debt-reduction plans and as I’ve been saying to people, while I’ve managed to escape a bomb-laden building to stand perhaps 100m away, and will not get killed in any explosion and collapse, the question is whether I’m far enough away to escape the resulting shrapnel and debris?

For example, while private companies have long said they will pay prices for milk that are competitive with Fonterra, the thinking was only on the upside. If Fonterra starts going down will “a competitive milk price” be interpreted by those companies as following Fonterra’s down? Why would they not drop their prices when they’re operating in the same commodity world (obviously not talking about the likes of Tatua). What proportion of their suppliers would they be willing to allow to go to the wall if the result is simply a stronger base of suppliers who’ve managed to buy up the dying ones cheap? Same volume of supply for less cost! What would be the problem from their perspective?
And of course none of this will change the long-term trajectory of NZ dairy farms becoming fewer, larger and more corporate , as they have in the USA:

The number of farms selling milk has decreased from around 50,000 in 2012 down to 39,000 at the end of 2017. Another 1800 farms have dropped out in the 15 months through to March 2019. Go back some 20 years and there were 100,000 dairy farms.

The average American dairy farm now has about 250 cows but averages can mislead. Sixty-five percent of farms in 2017 had less than 100 cows and produced only 11 percent of the nation’s milk.  Fifty-seven percent of the nation’s milk was produced on less than 2000 farms, with each of these having more than 1000 cows. The biggest American farm owner that I know has 60,000 cows on multiple farms.

The trajectory here in NZ has not been quite as steep, with numbers of dairy farmers dropping from around 20,000 twenty years ago to between 12-14,000. That’s mainly because NZ company farms don’t have the immigration labour advantages of the US:

On the big farms, often with several thousand cows, all the workers are likely to be Hispanic. The language in the milking parlour is always Spanish.

Many of the immigrant workers lack documentation.  However, that is just a hindrance rather than a defining problem. The system works because agriculture has a dispensation from online registration of workers. False documents are easily obtained, and with a paper system it takes many months for the Government to catch up with things. The next day the worker produces a new set of documents under another name.

Sharemilking and contract milking in NZ still have flexibility advantages over the NZ corporate model even as the numbers of traditional family owned and run dairy farms continues to fall away.

But the economic pressures driving all this are similar globally. Basic food commodities continue their centuries long trend of becoming ever cheaper, while costs steadily increase, usually in the form of new burdens, even as old costs drop in areas such as equipment. What these two trendlines mean is that for any given dairy farm, a point is reached where it is no longer an economic unit.

This is nothing new. Our farm was an economic unit with sheep only up until the mid-1950’s. Then it was ok with mixed sheep and an Angus stud. Then with additional land and mixed sheep, stud and non-stud cattle. But by 1980 the writing was on the wall for this model as well, unless you doubled in size, which meant shifting elsewhere. So dairy farming it was, in which our neighbouring farms of just 50Ha were doing perfectly well.

Interesting note on that last: in 1974, one of the worst rural recessions saw two neighbours sell their drystock farms of some 150-200Ha to the Labour government, who split them up into these small dairy units – that have now recombined almost exactly along the old boundaries, to be three times the size of their government-established 1970’s ancestors.

Just another example of how you can’t fight such basic economics on commodities where it’s close to the Free Market model of many producers pumping out much the same stuff, with minimal profits, as the American dairy giant Dean Foods has been the latest to discover:

Wrestling with debt and struggling to adjust to consumer demands, ​America’s largest dairy producer filed for Chapter 11 bankruptcy protection [in mid-November 2019].

Dean’s business is largely fluid milk and ice cream — two categories that have declined. Fluid milk per capita consumption has dropped from 247 pounds in 1975 to 146 pounds in 2018, and regular ice cream consumption dropped from 18.2 pounds in 1975 to 11.8 pounds in 2018, according to USDA.

Plant-based dairy is in demand, with oat, almond, soy and other beverages gaining popularity.

Think about that while noting how much Fonterra still relies on a product even lower on the commodity chain than fluid milk – Whole Milk Powder (WMP)!

One of the standard economic results of such a situation is that producers desperately increase production to try and stay ahead. Another tell of Fonterra’s problems was that they pushed their farmers hard to do exactly that, which would not have been such a bad idea if the basic commodity was being turned into products of ever-higher profitability. After all, as the first report about big US farms notes:

Despite this decline, milk production keeps going up.  This is in part because it only takes one big farm to replace many small farms. Also, milk produced per cow continues to rise by around 1.3 percent each year.

Which is linked to the Dean Foods report:

According to USDA data, per capita dairy consumption in pounds per person has increased from 539 pounds in 1975 to 646 pounds in 2018, with more consumption of yogurt and cheese.

In other words, even with plant-based milks on the rise the real problem is not dairy products as a whole but unprocessed dairy. Obviously Fonterra has long known this, with talk of cheese, yoghurt and so forth: equally obviously it’s a problem they haven’t cracked. I can’t think of one product they make, let alone a new product, that could equal, let alone replace their revenue streams from WMP.

While the problems of Dean Foods had some unique aspects, there’s enough commonality there to worry Fonterra. Even aside from the markets, the following aspect of Dean’s growth sounds awfully familiar as they started in 1925 and slowly grew by taking over small, local operations and focusing on operations and finance – until they were taken over by Suiza Foods Corp in 2001:

[Suiza’s] leadership was primarily marketing professionals who were all about growing, buying and acquiring market share. They were not as focused on operational or financial management.

Witness Fonterra’s aggressive expansion into Australia, China and South America, all of which now seem to be stranded assets that are proving tough to reform or get rid of. The Fonterra-owned Aussie outfit did gain farmers, but only because a huge competitor, Murray Goulburn, ran into its own problems. The Chinese Beingmate and China Farms operations have huge writedowns but have not yet been sold after almost two years of Fonterra shopping them.

Chile is another problem – but has not yet caught the public eye. Chilean farmers and shareholders have accused Fonterra of overmilking the Chilean cash cow.

This was likely done to boost things for the NZ supplier-shareholders, but given that suppliers and market share are being lost in Chile this was short-term thinking:

“…whereas some Chileans still admire Kiwi dairy farmers, we never found one farmer who had a good word for Fonterra. Fonterra is strongly disliked as a consequence of the way it has treated its suppliers. Farmers say that never again can Fonterra be trusted.”

To be fair, Fonterra is not the only dairy company that talked big and failed to deliver, as this Australian report discusses.

But even in being fair, all that those other dairy company problems show is that Fonterra has got a very steep uphill climb even if it successfully dumps its failures. While it’s good that Fonterra has finally recognised all these problems – having given up on the idea of becoming another Nestle and setting a strategy of focusing on being an efficient commodity producer – you still have to wonder whether Westland Dairy, who decided to go it alone in 2001, is where Fonterra is headed, and for much the same reasons on a smaller scale:

  • Big plans for expansions that did not work out.
  • Not funded by sufficient capital contributions from farmers.
  • Large-scale borrowing instead.
  • Ignoring the A2 milk revolution.

That last issue was for me, the crowning glory of Fonterra’s strategic stupidity, as it was for Westland, who by now could have been producing more than 50 million kg A2 Milksolids per year. The a2 Milk Company is making a profit well in excess of $300 million from about 20 million kg A2 per year.

Now that’s value-added thinking.

Fonterra’s share price has recovered somewhat, to $4.02 as of today. But while that might mean that its new strategy is working its far too early to say, given all those overhanging problems from the past – and it also has the best global dairy prices seen in a decade. We went through this in 2013/14 with $8.40/kg payout, during which some moronic corporate dairy conversions ran their business model on $8/kg payout well into the future – while their moron banks gave them the credit to do so, which leads to:

When Fonterra states its debt ratio it uses a formula of interest-paying debt divided by this same debt plus equity. What gets left out of the equation is some billions of liabilities to famers and trade creditors, which at any time total some billions. An alternative metric which I have never seen Fonterra use is net assets divided by total assets. That ratio at the end of 2017/18 was only 35 percent.  Conversely, total liabilities were 65 percent of total assets.

Fonterra may not use such metrics publicly but you can bet the banks and agencies that rate Fonterra’s risk do. Not to mention non-farm shareholders: the little guys have likely hung on but the institutional ones are gone for good. A possible silver lining here is that this may present an opportunity to re-visit the unique and strange mechanism that forces the farmer and non-farmer shares to have the same price.

The drop in share prices and other factors such as Orr’s ideas in the Reserve Bank, have led to increased pressure on farmers to reduce their debt levels, with capital re-payments in addition to monthly interest. Fonterra thus has to worry about the viability of those debtors as well as itself: yet another tough balancing act.

Fonterra may survive with its new strategy, but even if it does, for all the talk and the billions of dollars spent over two decades, it will be as something little more than what we had before Fonterra.

Addendum (because this story really needs more coverage)

Fonterra’s Company Culture is the heart of the problem:

A few months later, the Global Financial Crisis (GFC) had struck and I suspected that Fonterra might   be facing a liquidity crisis. I decided to do some analysis on Fonterra’s finances, using public documents. My calculations quickly showed that Fonterra was highly indebted, with inventories apparently overvalued, and almost certainly running up against its bank covenants.

Rather than putting the analyses into the public arena, on 23 December 2008 I sent my document to Fonterra’s Chair Henry van der Heyden, to Fonterra’s CEO Andrew Ferrier, and to Blue Read as Chair of the Shareholder Council. I asked them if they agreed with what I was seeing.

Within 24 hours, Henry van der Heyden came back to me and said that I must come up to Auckland to talk to their financial team. That meeting happened in the first few days of 2009. I spent a day with CFO Guy Cowan, who called in various other people to assist with information. Andrew Ferrier rang in several times during the day to see how we were going.

Guy Cowan was very frank. Yes, Fonterra was in a cash crisis. Later I learned that they had been at risk of not being able to pay farmers the previous month. The details are a story for another time.

If I’d known that story at the time or soon after I’d have bailed as soon as the shares became tradable in 2013 rather than even waiting until 2017.

Written by Tom Hunter

January 1, 2020 at 6:00 pm