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Friday, November 30, 2012

High Fonterra Share Price, Not Good For Young Farmers

I had expressed earlier that I was not sure if investors would want to invest in Fonterra's units. I've been proven to be totally wrong, as the offer was well and truly over subscribed.

These are the thoughts that have been going through my mind over the last few days.

What will the Fonterra share price end up at, once shares begin trading later today? I'm worried the price will go higher.

A higher share price is great if you are an existing Fonterra supplier. They have already made a capital gain after Fonterra announced the issue price will be $5.50 per share, which is $1.00 higher than the current $4.52 price. A 300 cow farm doing average production of 350 kgms equates to a $102,900 capital gain.

Many share holders are happy and some are expecting an even higher price once the market begins trading.

I view the Fonterra share price as a barrier of entry into the dairy industry. The higher the share price the lower the cash return is for a farmer from the milk payout.

If farmers received a payout of $6.00/kgms and the share price was $4.52 then they make a higher return than if the share price is $5.50 per share, simply because they have to pay or borrow more money in order to receive the same payout of $6.

My concern is that the share price will eventually rise to around $7.00/share or higher. In this situation a farmer with 300 cows doing 350kgms, will need to buy shares at a value of $735,000 in order to receive a payout of $6.00. Compared to $474,600 when the share price was at $4.52. 

The reason I think this could happen is that different investors have different expectations in regard to returns. At the moment the share valuation at $5.50 with an estimated dividend of .32 cents/share equates to a 5.8% return.

I don't claim to be knowledgeable about how investment markets operate but I look around and I see that government bonds around the world are paying less than 2% return and New Zealand government bonds are trading at 2.85% for a 5 year term. Many company bonds are around 3%-4%.

I wonder if some of this international money may look for a home in the Fonterra shareholders fund. The concern is that these large international investors may deem Fonterra to be a low risk investment and therefore be happy to receive a return of 4.5% or lower, this would equate to a share price of $7.00 based on a .32 cent dividend.

Which leads me to ask, why is the price of the farmers market shares the same as the shares in the shareholders fund, that the outside investors trade? These are two totally different investments with different motives behind the purchase. 

Farmers buy shares because they have to, in order to have their milk picked up. The outside investors are looking for a return. One has voting rights another does not. The two purchasers have different motivations.

But the biggest difference between the two funds is the number of potential purchasers. The shareholders fund is open to any super fund, hedge fund, institutional investor or Mum and Dad investor around the world. The business models of these investors is different to a farmers business model and it concerns me that professional investors will be setting the share price based on their expectations and business needs. For instance, some large investors may just want to place cash into a safe place where they can simply beat the rate of inflation. If this happens then these investors have dictated the price that up and coming farmers need to pay for a share, which has the potential to alter the dynamics of the NZ dairy industry. 

I suppose what might happen is over the years, investors will see that Fonterra is a safe investment and then begin to bid the share price up over time. 

The result could be, dairy farming makes another move away from focusing on cash flow and instead relies on capital gain of the land and now the shares. An appreciation in the value of land and Fonterra shares just make it more difficult for the next generation to break through.

Maybe we will get a situation where existing Fonterra suppliers sit on their shares and the new young farmers supply Synliat, or Open Country Daries. Which would not be ideal for the industry over the long term.

I wonder what the share value will be in 12 months time?

That's just a few of my thoughts as I wait for the the cow bell to ring in 30 minutes time.


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