Fonterra's forecast last week of a 12% drop in its milk price next season sent a shiver down the spine of many dairy farmers. A report by investment bank Macquarie Group on the scale of indebtedness of New Zealand farmers may be one reason for that reaction. Agribusiness editor Neal Wallace reports.
Borrowing by dairy farmers has reached such a level that a leading investment bank says some of the most indebted farmers have negative equity and will never be able to repay what they owe.
An analysis compiled by investment banker Macquarie Group and published on the Agricultural Production Economics website said dairy farmers owed more than $27 billion, with the most indebted third accounting for three-quarters, or $20 billion, of that total.
The analysis was critical of bank lending and a continued focus on linking farm viability with capital gains, a trend it said was coming to an end.
It was also critical of Fonterra, saying it had not been transparent in revealing its borrowing, and it was "absolutely dependent" on its milk price.
More than 61% of agriculture's current $43.49 billion of debt was being carried by dairy farmers, with some of the most heavily exposed having debts equivalent to more than $50kg of milk solids (kg/ms).
In a blunt assessment of the state of New Zealand agriculture, the Macquarie report said the days of farm viability being linked to capital gains were over, and it was critical of banks, industry and sector leaders for not seeing the change coming.
It used a model based on changes to equity to determine that, as at March, the lowest indebted third of farmers had borrowed $1.3 billion and had debt servicing of $3.17 a kg/ms.
The middle third of farmers had borrowings of $5.5 billion, which required debt servicing of $12.69 a kg/ms, while the most indebted third had debt of $20.6 billion and debt servicing of $47.59 kg/ms.
The bank said of those farmers, the viability of about 10% was of concern and they would be forced to capitalise interest payments, or they had negative equity, accentuated by decreases in Fonterra's share price, lower dairy cow prices and falling farm prices.
The future could be bleak for those indebted farmers.
If farms were generating earnings before interest and tax (ebit) of 50c a kg/ms, an additional $7.5 billion of debt would accrue against the most indebted farmers by March 2012.
In 10 years, total debt would have risen from $20 billion to $60 billion: "All of it lent against farms already in negative equity and with no prospect of ever repaying debt.
This is where the bulk of lending to agriculture is going."
Such was the level of debt carried by these farmers, the bank report said it would attract an interest-rate risk premium.
New Zealand dairy farmers had twice the level of debt on a per-kg/ms basis as their Australian counterparts.
Production costs have been increasing, with low-intensity systems having costs of about $3.50 a kg/ms, and high-intensity, high-production systems $5.50 a kg/ms.
The bank said the next six to nine months were crucial to dairy farming.
Farm sales have fallen, with 40 sales in the past three months compared with 159 for the corresponding period a year ago, and land prices were falling by up to 30%, in some reports.
Along with the sector's indebtedness and lack of profitability, Fonterra faced a redemption risk and it accused the co-operative of not providing credible leadership, according to the report.
The bank said the sector's credibility had also been damaged by the lack of acknowledgement by credit agencies and banks that Fonterra's future was dependent on the milk price it paid its suppliers, the company having added $4 billion in liabilities to its balance sheet from July 31, 2008, to January 31, 2009, without reporting it, and for raising bonds without publishing its interim financial results.
The sector's credibility had been further tarnished by rural servicing company PGG Wrightson "playing up its increased profitability from lending to agriculture at a time when banks are trying their best to reduce their exposure to the sector".
Fonterra was expecting to gain $400 million in equity, as farmers who previously supplied milk under contract were required to buy shares, but the bank asked where those farmers would get the money to buy the required shares.
It also questioned whether they would want to, given forecasts of future low milk prices.
That declining share price, which has fallen from $5.57 this season to $4.52 next season, could also encourage existing shareholders to hold the minimum number of shares possible.
The initial impact of Fonterra has been significant.
When it was formed in 2001, dairy farm asset value was $16.5 billion for milk production of 1.1 billion kg/ms, equivalent to $15 kg/ms.
At its peak last year, dairy farm asset value had increased to $78 billion for milk production of 1.3 billion kg/ms, or $60 kg/ms.
But, since then, there has been the combined equity-eroding impact of a loss of land value, dairy cow value and Fonterra share value of more than $6 billion.
Farm viability has traditionally been based on asset appreciation, but such was the level of debt the bank said New Zealand agriculture "is on financial life support to cover debt servicing, operating and living expenses" as it grappled with the effects of $44 billion of compounding interest-bearing debt.
The report said the days of farm viability being linked to capital gains were over.
