TOP's Geoff Simmons channels Peter Fraser, and joins the dots between a co-operative under existential pressure and the environment. Are we now thinking about a dairy industry without Fonterra as we know it?

Outspoken economist and ex-public servant Peter Fraser has long been a critic of how Fonterra was set up. With the recent sale of Westland Milk to Chinese buyer Yili, Fraser reckons that Fonterra is on the same track. 

The Argument

In brief, Fraser argues that Fonterra has been overpaying for milk right from the start. In fact, he thinks this was the true intention of the farmers who lobbied for it. The lobby asserted that Fonterra had the potential for value added and could become New Zealand’s Nokia. 

But this mystical value added has not materialised. In Fraser’s view, this was deliberate. Fonterra has underinvested in value added at the expense of paying out to farmers, ensuring an artificially high milk price. And since Fonterra sets the milk price for the whole country, it has effectively stopped all companies from adding value. 

This high milk price has been capitalised into farm values, which farmers love because it leads to… untaxed capital gain! It has also seen large swathes of the country converted to dairy (such as the McKenzie country), most of which has been an environmental disaster and could end up an economic one, too. 

But now, Fonterra’s share price is tanking: falling from $6 when it launched to well below $4 (and still dropping). This is because the dividend has been so poor, since all the money has been propping up the milk payout. 

Farmers don’t care about this because their payout is the milk price, plus the dividend from shares. But shareholders have been leaving in droves. 

So where to now? 

Fonterra needs to start retaining more of the milk payout to shore up its balance sheet and (ideally) make those long-awaited investments in value added. 

However, Fraser argues that Fonterra won’t be able to do this, because the payout is set by a formula that is biased towards the farmers. Instead, he predicts that the payout will stay high, Fonterra will keep selling down assets, and the share price will keep falling. 

And there is no problem if it falls to zero: Fonterra is a cooperative. But if farmers start leaving the cooperative for better returns elsewhere (i.e. companies that do have some value added), then Fonterra will be left with factories it can’t use. That would spell certain doom. Either the Government (or the Super Fund) would need to step in, or it would end up being sold overseas like Westland. 

The Red Herrings

The recent Dairy Industry Restructuring Act (DIRA) review concluded that the big issue facing Fonterra was its ability to control new farmers joining the cooperative. So Fonterra can now disqualify suppliers for poor environmental standards, which environmentalists have hailed as a win. Of course, it’s unlikely that it will crack down on any but the worst offenders. 

But Fraser argues that Fonterra was always able to refuse new farms setting up in distant places like the McKenzie Country and yet has been encouraging greater milk production volume for years. His view of the recent reform is more sinister: that Fonterra wants to be able to refuse new suppliers to punish farmers who stop supplying the cooperative by telling them they can never come back. This, they hope, will prevent the death spiral described above. 

What is Needed?

The base milk price (BMP) is currently set by Fonterra, in line with a process outlined in the Milk Price Manual – also authored by Fonterra. This process is monitored by ComCom, which can only declare whether or not it is consistent with the legislative objectives. ComCom can signal problems, but doesn’t have the power to do anything. It’s transparent – but also a ringside seat to a bank robbery.

Fraser thinks the Government needs to rethink the DIRA review. It should cancel the silly changes to regulated milk and open entry, rename the BMP ‘the hypothetical industry benchmark price’ (HIBP), and have it set independently. Fonterra would be able to set its own farm gate price at or below the HIBP, like all other providers, and that should allow it to retain another 20–24 cents.

Fraser also sets Fonterra some homework:

1. Take at least 50 cents off this season’s milk price to retire debt.
2. Announce revised gearing (i.e. debt reduction) targets for the coming 4 years.
3. State that the 2019/20 dividend will be no less than 20 cents.

This would not make Fonterra great, but it would enable it to survive and others to get on with creating value. 

No matter how things pan out, some farmers who are banking on the milk price staying high (particularly those who recently set up in the McKenzie Country) look to be in for a rude shock.