Thursday, November 1, 2012

Fonterras Trading Among Farmers Launches, But I Still Don't Understand It

I've blogged about TAF before here and here. We now have a bit more information on how it will play out in practice. But to be fair, I still don't really understand it and this view has been expressed by many observers in the media and the industry. It is not fully understood and some of the reason for this is Fonterra themselves don't know exactly how the governance will work, as they are still undertaking a review.

My thoughts;

Will farmers sell some of their shares into the fund?
I think they will, there are lots of farmers who have very high debt levels, the drop in the forecast payout is making many farm budgets drop into the red. I think many of these farmers would sell 25% of their shares into the fund and use the proceeds to pay off debt.

The dividend portion of the shares is estimated to return net 4.2%-5%, farmers will be paying 7%-8% interest on their debt, so they make a greater return by reducing their debt. 

Farmers can only sell 25% of their shares
I think this is because farmer shareholders want to retain control. From my perspective, I felt the ability for a farmer to supply Fonterra without having to buy shares is an advantage of TAF. Lets say I was planning to milk 100 cows with a mobile cowshed. In order to supply Fonterra I will need to buy about $170,000 worth of shares @$4.52/share. Thats $170,000 that I will have to borrow from the bank. If I retained these shares I would receive the full farm gate milk price plus the dividend component of .32 cents/share. On current forecasts that would be a total payout of $5.25. My interest bill on the shares will be 170k @7%/38000kgms = .31 cents/share. The dividend component pays the interest of the shares.

If I could sell my shares into the fund then I would not have to borrow $170,000, but I would only receive $4.93/kgms. From a cash flow perspective the two options are the same. But I would have to forfeit any capital gain on the shares.

I would be prepared to accept that in order to not have to borrow the $170,000, because as a farmer starting out. I don't have the ability to borrow lots of money as I don't have any land to offer as security. By not having to buy shares I reduce the amount I have to borrow by 50%.

At the moment, I would buy shares for $170,000 and sell 25% for $42,500 and only need to borrow $127,500. Which is better than not selling any at all.

Well at least, thats how I interpret TAF to be. I'm not sure if I understand it peoperly though.

Sharemilkers buying shares
Willy Leferink from Federated Farmers said;
Many sharemilkers will be thrilled at the prospect of buying Fund units because units are convertible to shares, should a unit holder go farming in their own right.
It is an innovative means to build and broaden someone’s capital towards the ultimate goal of farm ownership.
If a sharemilker can make 15% on their money, why would they buy Fonterra shares that return 3%-5%. They would be better off to invest in cows.

Are these shares just like bonds?
These shares will probably sell like hotcakes. But I still can't see why an investor would want to buy shares instead of a Fonterra bond. Fonterra Bonds are yielding about 7% gross, which is the same as the estimated return these share will return. These shares have no voting rights and your capital is not secured like it is with a bond. Then investors also have to consider that the farmers (who have control and voting rights) benefit from a lower dividend and a higher milk price, which is 180 degrees opposite to what an outside investor would want. 
On the other hand they have the upside potential of Fonterra increasing its profitability and therefore increasing the dividend amount, which theoretically increases the total value of the shares as well. 

Fonterra consistently say that Trading Among Farmers is not about bringing in new capital, but about reducing redemption risk.

This whole trading among farmers is a ballsy move. I'm not a conservative person and I love change and the excitement of something new, but man, TAF is a complicated, long winded way of solving a problem (redemption risk) that wasn't even a big problem in the first place (in my opinion).

The inclusion of outside investors is common in corporates, but in a co-op I can only see it causing more tension. We've got tension among farmer suppliers and the directors and now they have added another party to the mix whose goals are at odds with the farmers. There are lots of other ways Fonterra could deal with farmers withdrawing or cashing up shares, without such fundamental and structural change.

Farmers are right to be a bit wary of this.

I hope it goes really well and Fonterra get held up as an example to the world.


  1. Glen

    The investors in the fund do a basic calculation.

    32c dividend / yield divided by say 5.5% = $5.82

    This is the potential value of the units at that yield. A lower % pushed the price of unit up. These a blue chip stock as far as the market goes. So maybe people will accept a lower return.

    I will not be selling any shares to the fund. Even if we are viewed as high risk. There is a capital gain to be had and why give that to the fund.

    Enjoy reading your comments.

    Hamish D, Methven

  2. Good point, if the share price goes up then current share holders stand to gain. Average Canterbury farmer would have an increase of about $90,000, if the scenario above takes place. But it means I need an extra $50k to buy shares when I start my 100 cows. Westland & Synlait looking more attractive.

  3. Remember the underpinning value proposition of NZ dairying is our Co-operative principles. Westland is a Co-op with a nominal share price. If I was an original Westland supplier/shareholder I would be asking my board of directors what the cost of growth milk is outside of Westland, eg funding Canterbury growth and allowing the new suppliers in at the nominal share value. We consider Westland all the time. Without bagging individuals I will discuss non-co-ops as a general trend. They are not sustainable as most are finding out. The Chinese are probably happy to make less money as they are making it at the retail end and they are really trying to gaurentee food supply. Other privately owned compnaies are poor business models that rely on paying farmers less to make profits. This model is more than evident in its failing in other parts of the world that have lost their co-ops. Farmers become peasants to the supermarkets. If Fonterra shares were $20 and they were close to self funding I would buy them. Unless of course we loose control of the company (eg TAF going to far), that is a different debate.

  4. I agree, the Co-op is best for industry. I blogged about that But at what point does self interest rank above the good of the industry. It would be better for me to supply a corporate as I don't need shares, but if everybody did that then the industry is in trouble. I thought TAF was going to allow farmers to sell all their shares to the fund. But that's not so.