A timely reminder

Fonterra dropped a bombshell last week when it announced its latest consideration on its farmgate milk price.

For farmer shareholders in New Zealand's largest company, it had been shaping up to be a particularly merry Christmas, with economists suggesting the milk price could be lifted as much as 40c.

Elevated prices, which have defied predictions and remained at very high levels - the GlobalDairyTrade price index was just 7% below its April high and about 50% higher than a year ago - raised expectations for the forecast to rise.

So the announcement that Fonterra's board was leaving it unchanged at $8.30, while slashing the dividend from 32c to 10c, came as a shock.

The board took the unusual step of using its discretion to pay a lower farmgate milk price than that specified under the milk price manual, which would have resulted in it rising to $9.

Fonterra has reached a limit in being able to take advantage of strong global milk powder demand, constrained by its processing capacity.

It is investing in increasing production capacity - including spending $235 million to develop a third milk powder drier at its Pahiatua site - but that is too late for this season.

The dairy giant also signalled earnings before interest and tax would fall to about $500 million-$600 million in the July 2014 year, down from $1 billion a year earlier, mostly due to the higher costs to the co-operative imposed by strong dairy prices.

Fonterra farmers are unlikely to be crying into their milk vats - a forecast payout of $8.40 is still a record.

But the issues surrounding the board's decision - along with those high milk prices - does serve as a reminder for why New Zealand needs to have a strong primary production sector right across the farming spheres and not rely on one sector, nor one market.

The Reserve Bank last week held the official cash rate at its record low of 2.5% but stressed there were rising concerns over the effects of strong global dairy prices.

Reserve Bank governor Graeme Wheeler has expressed reservations about New Zealand's increasing concentration of exports into China. China takes about 25% of the country's dairy exports, putting a high concentration in one part of the world. A Chinese downturn is a big threat to New Zealand's economy.

Another new phenomenon is the effect on Fonterra unit holders, with the advent of the controversial Trading Among Farmers.

Fonterra now has to balance the interests of its farmers with the interests of investors in the Fonterra Shareholders Fund.

The market responded swiftly to the forecast announcement last week, with units dropping as low as $5.48, below last year's issue price of $5.50.

The dividend forecast cut - from 32c per share/unit to 10c share/unit - will impact unit holders to a greater extent than farmers.

Of what farmers receive from Fonterra in total, the dividend typically represents about 5%-10% of that, but for the Fonterra unit holders, the dividend is 100%.

So it was good for farmers wanting to share up; not so good for farmer sellers or ordinary unit shareholders.

Dairying is a heavily indebted sector. Dairying debt is about $32 billion of a total of about $50 billion in agriculture.

One only has to look at what has happened with the housing market - escalating prices, people borrowing more (which dairy farmers are also doing to expand their operations) - to wonder what would happen if the bubble burst?

The dairy sector might be enjoying record export prices, but farmers need to continue a cautious approach. Debt reduction must be a priority when it comes to spending the payout.

The sector is vulnerable to a decline in commodity prices and while the near-term outlook for commodity prices is positive, exporters cannot rely on that lasting forever.

As Fonterra Shareholders Council chairman Ian Brown says, volatility is the only certainty in the dairy industry.


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