Optimism gives way to uncertainty

It is the speed with which unbridled optimism has turned to fear and warnings to curb spending that has surprised dairy farmers.

For the past two years, Fonterra single-handedly grew New Zealand's economy (if you remove the contribution from borrowing to spend), but in the space of four months the global credit crunch and reaction to excessive product prices have hit it head-on like express trains.

From talk of expansion and unsatisfied global demand for dairy products, just four months later Fonterra is stockpiling product waiting for international prices to recover.

Fonterra says its inventory levels are no worse than usual, but in the past few months they have been approaching food companies in the search for additional warehouse space.

The immediate impact has been a slashing of the milk payout in New Zealand and Australia, land prices have subsequently fallen more than 20% and falling cow prices have eroded sharemilker's equity.

Cows they paid $2500 for last season are now worth $1800.

And the news was only expected to worsen this week, with Fonterra reviewing its forecast payout for the season with some expecting the final payout to be between $4.80 and $5.20 kg milksolids (kg/ms).

Last season, they received $7.90 kg/ms, of which 24c kg/ms was retained, and the initial forecast for this season was $6.60 kg/ms, but in November it was lowered to $6 kg/ms.

A cut of 1c kg/ms equates to $12 million less in export earned income circulating through the economy.

There were clear signs last week of the difficult trading conditions when it lowered by 32% the milk price paid to its Australian suppliers between February and June, which represented a 9% cut over the full season.

Usually, forecast milk prices start low and end up higher, not the other way round as has happened this year.

Farmers have told the Otago Daily Times that they feel this has been mismanaged and poorly communicated to them, in contrast to the good news coming out of the Auckland head office.

A year ago, Fonterra was telling shareholders they were about to enter a decade of above long-term average payouts, but the reality has been a sharp and rapid downward correction which shows no sign of bottoming out.

Last July, it announced that dairying accounted for a quarter of New Zealand's export earnings and in the 14 months to May 31 it had generated $19.5 billion in revenue.

Part of Fonterra's current problem is that it faces a conundrum.

As a co-operative, its role is to maximise the payout to shareholder suppliers which, in the current environment of falling product prices and eroding balance sheet strength, is counter to some tough economic decisions it has to make.

It has tried to fulfill all roles - maximising the payout, growing the business and being financially prudent in the knowledge shareholders could cash in their shares and shift supply to the proliferation of new dairy companies.

There was evidence earlier this year of the pressure on Fonterra's balance sheet when it announced a $300 million debt issue to fund working capital.

This pressure could prompt the board to have another hard look at its capital structure - ditched a year ago in the face of shareholder resistance to the idea of a public float of part of the company.

But Fonterra needs access to outside capital while also retaining the support of shareholders and the all-important milk flows.

The board faces some tough decisions which may not please its shareholder suppliers.

Shareholders also have concerns with the way the company has been run.

Some are questioning whether the country's largest company has prepared well enough for the inevitable market correction, and some question if Fonterra managers have the skill and ability to successfully navigate the global recession.

As one farmer said to the Otago Daily Times: "It was easy to market milk in a strong economy; the challenge was to do it when conditions were tight."

Some shareholders spoken to were also questioning whether chairman Henry van der Heyden should continue in the role he has held since September 2002, adding that it could be time for fresh ideas, a new approach and a new perspective at the top of the company.

Fonterra has always said its performance should be compared with other dairy companies, and on that measure last season it came up short.

Tatua Co-op Dairy paid its shareholders $8 kg/ms and Westland Milk Products $8.29 kg/ms, and while Westland looked like halving that this season, it was substantially better than Fonterra which had a similar product mix.

It was obvious that whole milk powder at $US4500 ($NZ8518.7) a tonne was unsustainable and markets would start balking at the sudden doubling in price.

While markets pay what products are worth, questions have been asked whether Fonterra should have concentrated on its strength of sourcing, processing and selling New Zealand dairy products rather than sourcing overseas products.

Instead, it embarked on what some have called a global domination strategy - which was financially costly and, in the case of its Sanlu investment in China, the melamine contamination proved damaging to its reputation.

Fonterra appears to have tempered its plans for international expansion, its latest business plan focusing on on regions it was already active - Australia, New Zealand, Asia, Africa, the Middle East and Latin America.

Some in the dairy industry believe Fonterra moved too quickly away from its core functions, that it relied too heavily on powder at the expense of the other 900-odd added-value products that can be made from milk.

Not enough attention was placed on strengthening its balance sheet given the unprecedented demand and returns.

Its balance sheet was likely to come under even more pressure as a result of poor cashflow as product was stockpiled in the wait for the market to improve.

Suppliers got an advanced payment of $4.05 kg/ms a month this season, which Fonterra has to fund.

Its balance sheet debt has increased from 63% in the 2006-07 financial year to 70% in the year to July 31, 2008, and total shareholder's equity fell 14% over the same period due to greater finance lease liabilities.

Its new business plan reportedly addressed the debt issue with a targeted debt-to-equity ratio of 40% to 45% compared with the current figure of 55%, that increase reportedly due to higher inventory costs.

The plan aimed to reduce costs by $175 million, improve the supply chain with an injection of $750 million, fund growth initiatives out of cashflow and to pay down debt - a big ask given falling prices and powder being put in storage.

It also placed renewed focus on the value-added contribution to the milk payout.

This measure of profitability from branded products has been heralded as a shareholder dividend and Fonterra now wants to more than double its contribution from cents a kg/ms this season to 80c kg/ms by 2012.

The best it has achieved was 59c kg/ms in 2006-07, but the business plan suggests the definition of value-added could be widened to include profits from ingredient sales, global trading, offshore milk sourcing and processing and surpluses from New Zealand processing operations.

Adding to farmers' concerns was a second consecutive fall in its fair value share and the impact that would have on their and the company's balance sheets.

In the 2007-08 season, the fair value share fell from $6.79 to $5.57, and then last December it dropped a further 20% to $4.47.

There was also some anger at the GlobalDairyTrade auction system at a time when international prices were plummeting.

As one farmer said: "You wouldn't want to sell your house at auction in today's market."

Some of that anger could be confusion from farmer ignorance at how the system operated, but that raised the point of whether the benefits of the auction had been properly communicated.

Equally, some Fonterra shareholders welcome the outcry from competing dairy companies claiming the auction is driving down prices, saying they have benefited from Fonterra's marketing and contacts and subsidised milk it has to supply them under Dairy Industry Restructuring Act.

The auction has certainly left no-one in doubt as to what was happening in the market, but Fonterra needed to assure its shareholders and the public that GlobalDairyTrade was not contributing to the falling prices.

There is little doubt Fonterra has been in uncharted territory at both ends of the spectrum in the past 12 months.

Last year, sheep and beef farmers were the poor cousins to dairy, with incomes falling and morale low.

Now dairy incomes have started falling, it was announced last week that higher lamb and beef prices would see sheep and beef farmers' incomes increase $500 million compared with a year ago.

Dairy farmers have been a cash cow in recent years, spending up large but also buying land and going through the costly exercise - up to $20,000 a ha - of converting it to a dairy farm.

All that money has flowed through rural communities, but will not be there in the coming season.

Orders for new dairy sheds have been cancelled and falling land prices show dairy farmers are not as active in the market.

The dairy sector will continue to be a major source of export dollars, but the current difficulties are likely to force Fonterra to make some tough economic decisions, including reigniting the capital restructuring debate it canned a year ago.

There is little doubt the co-operative is struggling with the multiple roles expected of it, the need to raise capital and making tough financial decisions while not alienating its supplier base.


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