Monday, July 2, 2012

TAF Revisited

Obviously we all know that TAF was passed a few days ago. It's been interesting watching the debate from both sides.
I hope it works well, we won't know if it’s worked for another 5-10 years though.
The reaction from the fund managers is mixed. Some saying it’s a great opportunity; others like Brian Gaynor are a little hesitant. But what they all have in common is they are all going to wait and watch how the market is working. Which is prudent I suppose.

The other thing everyone is in agreement on is that no one knows what the shares will be valued at. This is what concerns me, will it be higher or lower than the current $4.52 per kgms. Who knows?

I’m in favour of a low share price. I think a high share price creates a large barrier of entry for up and coming farmers and it encourages farmers to supply rival corporate milk processors, that don’t require farmers to buy shares. Which is a bad thing as the strength of the NZ dairy industry is that the farmers are united. I would hate to see the dairy industry end up like the meat industry!

Redemption Risk
TAF has not got rid of redemption risk it has simply shifted that risk from the co-op (the collective) on to the individual farmers. Which isn't necessarily a bad thing because now Fonterra can supposedly do what it wants to do to implement its plan which will hopefully increase growth and profitability.

But if you are an individual farmer and you are decreasing production due to a bad season or you want to quit Fonterra, you have to go to the market and sell your shares to either another Fonterra supplier who is increasing production or to the fund that is made up of the outside investors.

If demand for shares is high then there is no problem, the farmer should have no trouble finding a buyer for their shares. The problem arises when demand is low for Fonterra share. What if there is not the demand from outside investors or if lots of other Fonterra shareholders are selling shares at the same time due to a major drought or something similar. Then the share price will be low. Which is what a market is, supply and demand etc.

That risk is now on the individual farmers balance sheets. If the price of the shares drops to be lower than the current $4.52, then hundreds of thousands of dollars will be wiped off individual farmer’s balance sheets and this will have implications on a farmer’s debt level and borrowing capacity.

If the industry continues to grow at 3-4% then there should be good demand for shares from existing farmers as well as from outside investors. The true test will be what happens when things are not all rosy. What’s going to happen in an environment of a falling payout. I would expect dividends to fall, therefore a falling share price which in turn means the value of a farmer’s assets are lower and one could expect a call from the bank wanting to discuss a revision of your loan to value ratios.

Maybe I’m being a little pessimistic, but what TAF has done is remove redemption risk from the Co-Op to the individual farmer. Farmer’s need to be aware of this additional risk and ensure their financial position is secure enough to withstand a reduction in the share price.

I’ll be interested to see what the banks are doing and saying about this issue, and whether they are adjusting their lending accordingly.

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