Tuesday, June 19, 2012

The Case for Converting to Dairy

Swiss academic Jeremie Forney, has been studying the non-economic reasons why Southland sheep and beef farmers converted their farms to dairy. I found his study interesting and was not at all surprised at the conclusions outlined in thenewspaper.
Jeremie found that the main reasons given by farmers for converting to dairy were farm succession and recognition of good farming.
But I can't help but feel at least one of these reasons is in fact a financial reason. In my experience the biggest reason a sheep or beef farmer convert their farm to dairy is to aid farm succession. The biggest hurdle for sheep and beef farmers in respect to passing the farm down to the next generation is cash flow.
The average sheep and beef farmer makes an operating profit of $500/Ha, on a 230 Ha property that equates to a total of $115,000. The farmer must then make principle and interest payments, tax, depreciation and drawings out of this figure. According to NZ Beef & Lamb over the last 10 years the average sheep & beef farm made a before tax profit of $65,000.
On the other hand a dairy farm makes an operating profit of about $3,000/Ha, so on the same size farm of 230 Ha the operating profit is $690,000 compared to $115,000. These two figures are the reason we have seen a shift from sheep/beef to dairy across the whole country but particularly in the South Island.
I don't really believe there is any other reason than this for a sheep farmer to convert to dairy. It’s purely financial. I don't think there is a “non-financial” reason.

The average age of a sheep and beef farmer is 58 years of age. When the time comes to pass the farm down to a son or daughter, cash flow becomes the issue.
With an income of $65,000/year to work with, it’s clear that there is not the cash flow to support the parents and the son/daughter. The issue is further complicated when there are more than one sibling. Even if the farm can support one sibling, and they go on to take over the farm where does that leave the other children? The children who do not take over the farm may feel that the sibling who inherited the farm has received preferential treatment, if the farm is put into a trust for example, and ownership split between the children this can cause the farming sibling to feel they are working hard for the benefit of the off farm siblings. It’s not really an option for one sibling to buy out the parents, because the amount of money needed will be in the millions.
Every case is different, but the farm succession issue is a big problem facing an industry of farmers who are nearing retirement age.
While families are dealing with the issues of how to pass the farm down fairly, it's easy to see that there are three options, 1. Make no change (as above) 2. Sell to a dairy farmer 3.Convert to dairy

1. As above this option can work, but cash flow may be an issue.

2. Sell to a dairy farmer
This is the path chosen by so many farmers. In Southland for example a sheep farmer could sell their 230 Ha for $25,000/Ha and get $5,750,000. If we assume they have $750,000 of debt, that they pay off, allow $1,000,000 for a new house in Central Otago, $3,000,000 to invest and live off the proceeds ( 4% return = $120,000/yr) and then split the remaining $1,000,000 amongst the children. If there are three children for example that means each child will get $333,333. Which is enoughto buy an average home debt free.
That is quite an attractive option and one many have taken. But the big downside is that the family farm is now gone, and it will be very unlikely that any of the children will ever get into farm ownership.

3. Convert to dairy
The other solution to the cash flow problem is to keep the farm and convert all or part of the farm to dairy. This option is more complex, but increases the options to bring the children onto the farm. But it is not plain sailing. It involves increasing the farms debt levels and running a dairy farm is very different to a sheep/beef property.
If we use the 230 Ha property from above as an example, the farm could carry 690 cows (3cows/ha). The farm has $750,000 of existing debt , they will need to convert the farm by building a cowshed, creating lanes, new fencing, improved water system, additional housing etc. This is likely to add up to $1,500,000. Then they will need to buy 690 cows at $1,800/cow, this equates to $1,242,000 and then on top of this Fonterra shares will need to be purchased. 690 cows producing 380kgms/cow = 262,200kgms *$4.52=$1,185,144.
So to add all this up:
Existing debt                    $750,000
Conversion costs              $1,500,000
Cows                                 $1,242,000
Fonterra shares                $1,185,144
Total Debt                        $4,677,144

So the new farm will now be close to the limit that most banks would lend up to. Most banks will lend about 60% of the value of the whole operation. This new operation will have an interest bill of about $300,000/year, which still leaves $390,000 to pay drawings, tax depreciation etc.
The skills required to run a dairy farm are quite different. Most sheep/beef farmers would not employ many staff. A 690 herd dairy farm would need about 5 full time staff. Managing staff requires some skill and secondly the lifestyle change cannot be underestimated.
On a sheep farm you can work hard all week long and then everyone can take a 3 day weekend to go and do whatever they want. The sheep can be just left in the paddock for a few days. But a dairy farm needs to have people on it every day to get the milking done. This aspect is what can make dairy farming difficult.
The never ending need to have enough people on the farm.

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