One of the revealing facts about the dairy industry, New Zealand’s largest exporter, is just how well it has done over the years to maintain the real payout to farmers despite a burgeoning quantity of milk supplied. The graph illustrates. There wouldn’t be many industries around that can maintain price when supply does what it has.
The obvious question here is who deserves the credit? Is it Fonterra and its predecessor the NZ Dairy Board or does the graph just tell us how strong a global industry this really is? If the latter, then imagine what the potential could be if the industry’s capital was deployed efficiently? That the potential for the industry is indeed stunning, is in large part evidenced in the very low income yield farmers are prepared to accept on the financial investment they sink into their dairy farm (or put alternatively, how high a PE ratio they’re prepared to pay for land).
It follows from this reality of investor confidence, then that any mis-pricing inherent in the current value of dairy farms could end up costing/benefiting one generation of dairy farmers immensely when it is finally unwound. What might be the source of such unsustainable -pricing?
For the farmer-supplier all of the income return (from his sales of raw milk and from the dividends of the downstream Fonterra businesses) comes via the milksolids price. And the individual farmer has but one way to increase his income – to increase the volume of raw milk produced to the point where profit is maximized.
Under the bundling arrangement it is difficult for the farmer to forgo income as is necessary when Fonterra holds back earnings for investment in its downstream activities. The consequence of the bundling arrangement is that the milksolids payout is the single price signal and from that the farmer makes the decisions on on-farm investment. This happens even to the extent that when the lift in payout reflects only higher returns from the downstream value-adding businesses rather than any increase in the value of raw milk, the signal to the farmer is to raise production. Kilograms of raw milk production effectively become mere certificates of entitlement to the investment returns from downstream activity.
CEO Andrew Ferrier has recently expressed the view that the company is short of equity capital in its downstream businesses – an outcome convincingly predicted by the critics of the so-called reform of the dairy industry at the time Fonterra was born. It is hardly surprising given that the market measure of success of the company is the level of the milksolids payout as opposed to two separate signals – the price of raw milk and the dividend from Fonterra companies.
In short, critical information for efficient investment decision making is lost because of the bundling. And from that we see now have the result for all to see – over-investment on-farm and under-investment downstream. To the extent that the downstream businesses cannot get the equity capital it is able to make a competitive return on because of being the ‘poor cousin’ within the Fonterra supply chain, the New Zealand dairy industry – one given its monopoly originally by public fiat through regulatory protection – is held back.
So far, the industry has simply morphed into a vehicle for generation of wealth for a class of land-owning, milk-producing suppliers whose deployment of capital is well below the potential the industry has to generate income for New Zealand. Effectively this class has privatised a protection paid for by generations of taxpayers. Inefficient deployment of capital (too much on-farm, insufficient off-farm) condemns the industry to a state below its potential. Of course this of little interest to the privileged farmers who received this transfer of wealth courtesy of the bungled re-engineering from full taxpayer protection.
From a net national economic benefit perspective, much but not all is lost. To the extent the Fonterra companies suffer from their inability to access equity capital and invest sufficiently in new processes and technologies, the dividend component of the milksolids payout will suffer and the annual Fonterra payout to farmers will fail to surpass that paid for raw milk only by other companies – such as the likes of Tatua and Westland Dairy. The Fonterra suppliers will realise that they could switch suppliers, keep their land but release their equity in Fonterra – as on exit that company is obliged to pay out their share of the Fonterra equity (at least a certain number of exits are allowed each year).
Mr Ferrier has signalled the problem. Unless farmers make the income sacrifice, the bundled Fonterra dividend will falter and the value of Fonterra shares with it. Some farmer-suppliers might already be inclined to agree, decide the chances of income sacrifice being agreed is zip, and the chance of opening up to outside equity even slimmer, and therefore seek to exit now.
It’s a tricky equation. In order to justify the ongoing share value Fonterra needs equity for investment. That can only come from farmers sacrificing income, there being no conduit for outside equity capital. Farmers then face the whole risk of the off-farm business. If the deployment of capital downstream by Fonterra fails to succeed, the farmer will find his shares hit hard in value and exit would have been the better choice. But Mr Ferrier is indicating that unless they do it that value will falter anyway. Only two scenarios work for the farmer-supplier. They turn the Ferrier approach down and Fonterra manages to keep returns up on its processing processes anyway, or they accept the Ferrier logic, sacrifice payout now and pick up the benefit once the downstream investments come off.
Obvious question. How on earth is a farmer supposed to know which is best?
Of course Fonterra is the dominant buyer of raw milk, competitors are minnows. So in reality the ability of Fonterra-suppliers to effect even a rational decision to exit the Fonterra alternative now is hugely limited. For most, the only alternative is to leave the industry totally and deploy alternative land-use. This lack of free exit and free entry means that this very substantial industry has an inordinate dependence upon the ability of the Fonterra management to deliver an ongoing satisfactory return on its capital.
The CEO is saying farmers need to take the long view and have faith that the income sacrifice will end up being worthwhile. The industry’s iteration toward an economic efficient deployment of investment resources is dependent on farmer-suppliers agreeing only in numbers that reflect the reality of the industry’s prospects (it’s risk-adjusted return).
Depending on markets getting it right eventually, is of course the fulcrum of market economics and economic rationalism. But when impediments are placed in the path of free entry and exit of capital to an industry, “eventually” can end up being an eternity. That means that for all intents and purposes, the industry won’t realize its potential.
In the case of New Zealand’s dairy industry it’s incongruous that such an important sector would be so risked. Such is the pragmatism of self-interest politics of course. Without freeing up the industry’s sources of capital it’s difficult to envisage the risk being reduced. Any logjam of sellers down the track would have exciting consequences for the industry’s capital value.
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