Monday, September 28, 2009

Fonterra has been poorly managed, but farmers were right to say no.

Fonterra is down to 21% assets to debt, this is dangerous territory for a Co-op with a redemption clause.I posted earlier in the week about Fonterra and got a few acerbic comments. They remained unanswered. I was simply too busy at work to respond properly and one comment referred to a capital ratio of 21% that needed checking before responding with the facts before me.

Busted Blonde has had now another crack on the basis of those comments. So here is a more considered response. There are fair viewpoints on all sides. I have done a little research and am now clear about why Van der Heyden went. My basic position has not changed in response to Wheelers or subsequent comments from Nigel.

Firstly a bit of a mea culpa in that I had not kept up to date with Fonterra financials in the last few years and assumed they were merrily tracking at around 50 % gearing. But lo and behold they are indeed down at 21% equity to total assets meaning the banks will be all over them.

Nigel refers to "Fonterra is down to 21% assets to debt, this is dangerous territory for a Co-op with a redemption clause." But the notes to the accounts give them a get out.
Payment for the surrender of shares may be made at the option of the Company by:
– the payment of cash; or
– the issue of capital notes.
The Company also has the option to pay the surrender value in special circumstances by the issue of redeemable preference shares.

Meaning if they dont want to give cockies who want their surrender values cash they dont have to. It is a bit of a nucelar option but the option is there.

If you back out their "cash flow hedge" negative reserve and associated liabilities and compare to the position two years ago they have a more healthy but still poor 29% equity.

Given it is fairly obvious bankers selling them complex derivatives and hedges they did not understand is part of the reason for the 21% equity things are in a bad way but by no means close to terminal.
Their inventories have blown out from 53 days to 71 reflecting current poor export conditions. There are a number of other indicators of a company that has tripped heavily.

So instead of a strong corporate looking to move on to the next step in their development internationally this is a temporarily weakened company with a Chairman, Board and Executives in the last chance saloon looking to bail themselves out from their indiscretions.

The farmers rightly assessed that selling out now would be selling out in a position of weakness rather than strength and that the result of saying no to capital raising would be a clear out in board ranks, some over leveraged farmers going broke and the industry continuing to own itself.

What really really surprised me is that Fonterra has less than $4bn of equity. With 11,000 farmer suppliers that is an average implied shareholding of $350,000. Which is quite a substantial investment for the average farmer. It provides them with a very effective retirement fund. And industry self determination, of which more later.

It is now apparent to me that a price bubble has been going on in farm prices and milk payouts over the last few years. Bankers are effectively willing to finance the purchase of shares as part of the land price. The availability of cheap credit, booming dairy prices and Fonterra's willingness to pay out the bulk of those earnings as dividend to finance the increased farm mortgages. Only a fool would have increased the payout from $4.50 per kg of milksolids in 2007 into $7.69 in the 14 months to Nov 2008 with the credit crunch happening. There was no holding on for the rainy day. The financial position of Fonterra reflects poor management rather than a flawed co-op model so far.

To Nigel's point that Dairy Farmers of Britain is in receivership. Precisely the position that will occur when farm suppliers have no international trading and are purely limited to subsidised supply to supermarkets like Tesco. My point exactly as to why farmers should maintain control of their own destiny. Tesco and the other supermarkets chip away at the price until it is simply uneconomic to supply. That turns farmers off the farm and is not a path that should be followed by the dairy industry in NZ which is of such strategic importance.
On to the flaws of the mega co-op model. Nigel again:
They face very poor, in fact perverse incentives, to maximise the return from value add, because value add requires capital, and capital requires Fonterra to hold-back dividend returns.

You can't have both. Its logically inconsistent, and a cash starved, dumb, politically driven beast is the result.
I can agree with Nigel about the poor management that has got Fonterra to where it is now. But it does not change my basic point which is that a well managed co-operative that wanted to grow would keep low farm payouts and increase their market investment in value added activities. My mea culpa is to agree with Nigel this has obviously not taken place to any serious extent. $4.50 to $7.79 indicates fools not investors. Like any company the failure to reinvest will doom the business in the long term. I had heard various noises about Fonterra investing overseas but their financial statements show that is negligible.

On Fonterra being a price taker or a price maker it has the size to take its products directly to the end user international supermarket chains consuming brand products. The farmer owns a part of that. Fonterra has obviously failed to build its brands sufficiently as about 80% of revenue remains commodity or ingredients segment. The dairy market innovation in UK supermarkets is not being lead by Fonterra. Danone and Dairylea are much superior.

So my conclusion is that Fonterra deserves much of the criticism it gets. Poor management is poor management whether owned by a co-op or a corporate.

It is reasonably obvious that the dividend retention should be much higher and that Fonterra needs to buy an international dairy products company that has marketing skills. For that it will need to substantially reduce the dividend for a number of years and/or partially split its marketing arm off and obtain corporate funding for this. I remain completely of the opinion that farm ownership and control of Fonterra is sensible.

Fonterra were taken to the cleaners on derivatives and hedging in the last few years and it is fatuous to think that would not happen again if the same management team has their eyes on the paybacks that corporates offer and Fonterra sells itself to the sharemarket in a time of weakness.

UPDATE: OK, now I understand. The long term, and I mean 5-10 year interests of shareholders and management are misaligned.
From the notes to the Financial statements
Long term incentive plan
For certain key executives, Fonterra operates a Long Term Incentive (“LTI”) Plan. This plan is by invitation only and is designed to motivate,
reward and retain key executives.
The plan has the following features:
• The plan sets a Total Shareholder Return (“TSR”) target over a three year period
No amount is earned if Fonterra’s TSR is less than 11%
• A new 3 year cycle commences each year
So management have an incentive to starve the business of capital for new investment in order to ensure they get a bonus. Establishing new markets that make such profits may take 5-10 years. So a 3 year horizon explains why they are undercapitalised.



6 comments:

Adolf Fiinkensein said...

Where does one ever see such robust commentary in the Antique Media?

Oh well, off to Adelaide for a few days.

JC said...

From memory Fonterra looked to take the company public several years ago, but the shareholders turned it down.

Whilst that is maybe not an unreasonable thing to do it did indicate they weren't looking beyond their noses. Dairy farming these days is about managing shockingly high priced land and a product nowhere near capable of sustaining such a price.. ergo it has to be supported by diversification into realty, tourism, science and innovation and other non farm activities not dependent on a commodity price.

Does that sound like Fonterra?

JC

gomango said...

various noises about Fonterra investing overseas Remember Sanlu?

The choices are actually really simple and boil down to:

1.Farmers retain control. Farmers must stump up more capital either directly or by lower payouts.

2. Farmers don't want to put in more capital. Farmers control gets diluted.

There are no other choices. I think you are off the market on your comment about Fonterra being sold derivatives they dont understand. The problem is way more basic than that - Fonterra have done a generally poor job on currency hedging. Nothing more complicated than them not making the right decisions. And yes hindsight is wonderful.

Farmers may be right to say no, but that also means open your check book.

Fonterra is also managed by engineers. When the choice comes down to building a really fancy stainless steel plant in the Waikato or investing in a value added marketing spend in Asia, the engineers go for the easy thing. And risk aversion after Sanlu wont help in the future.

The other structural difficulty they have to deal with,but are too scared to, is the equality (in terms of payment) between (say) farmers in the Waikato/Tarankai/Southland and farmers in more dairy industry remote areas.

thedeityformerlyknownasnigel6888 said...

Pretty astute commentary there.

As Adolf says, your blog is getting the best analysis on the net of this topic of vital importance to NZ.

I don't claim original thought here, I was amplifying Brent Wheeler's masterful analysis, so credit where credits due.

I think you are right to point out that all of the capital earned by the dairy industry over the last decade has been capitalised into land values. Imagine what that could have achieved if invested in an international consumer foods company?

I still think you underplay how fundamental the incentive problem is.

Supplier owners get their return from getting the maximum possible price for their supply. I think we all agree on this.

Food companies earn their returns from selling consumer goods in markets. They have to keep all of the value chain costs as low as possible - this means keeping the price of supply and costs of production as low as possible, so as to maximise the margins.

I think we agree on this too.

Where it gets tricky is where the ownership of both parts of the business rests in the same person.

He or she is conflicted. Maximising the consumer business requires sacrificing the price of supply. Maximising the cost of supply means starving the consumer value-add business.

This is where the incentives problem sharpens up: Do we sacrifice return from the bit of the business we understand, to capitalise the value-add business, which we don't understand.

To illustrate, imagine this conversation at the next AGM: "This year Fonterra consumer brands has negotiated a real tough deal with Fonterra bulk milk supply, its been great for the business. (subtext: Oh yeah! We bent them over, and we screwed them good").

Oh, and sorry about the payout cheque, but its all for the good of the company and you'll come to respect us in the long-run".

We all know how long the Director who gives that little speech will last.

So, I don't think its entirely down to poor management, even though you rightly point out the weird incentives on management. I just don't think Fonterra can work.

So while the owners may have been right to vote no on the proposal (which I disagree incidentally) what would be a good proposal to put to them?

sagenz said...

gomango- "Fonterra is also managed by engineers. When the choice comes down to building a really fancy stainless steel plant in the Waikato"
Like the recent announcement they built the worlds largest milk powder dryer in Edenvale. A sure sign the engineers and commodity focus rules.

On Sanlu, their writedown was $139m on equity of over 4$bn. In what is effectively the largest market open to them. If they had been serious about investing overseas the writedown would have been substantially higher as a result of having a larger business.

As for being sold derivatives they don't understand. Their notes state they don't engage in speculation and then have a number of contorted paragraphs about treatment when contracts are deemed not a hedge. I have seen a number of New Zealand companies suffer from getting into derivative contracts that neither the buyers nor the bank dealers really understood the implications of.

jimmie said...

Half of Fonterra's problems stem from a flawed belief over the last several years that the internatinoal market was going to stay high in the long term and so borrowed heavily to invest in a number of overseas ventures. They seemed to have had a long term positioning of a high price, high value company. Unfortuantely along came reality and the usual swing and roundabout of fluctuating prices and they have had to readjust to a lower cost model. Pretty dumb that a large number of highly paid executives could get it so wrong but it seems the more highly paid often the dumber the decision making