In my last article I wrote about Fonterra’s capital structure, how it operates, and how it is no longer fit for purpose. This article here explores aspects of how Fonterra got into its structural dilemma.
The starting point is to acknowledge that Fonterra made a fundamental flaw in thinking it could solve its redemption risks by setting up the Fonterra Shareholders Fund, hereafter called the ‘Fund’. Despite the name, this was actually a fund for non-farmer investors to buy units in Fonterra that have economic rights the same as shares, but no voting rights.
The Fund was and is a key part of an overarching scheme called Trading Among Farmers (TAF). This too was a crazy name because the fundamental mechanism was aimed at trading between farmers and non-farmer investors.
The rationale behind TAF was to shift redemption risk away from Fonterra itself and onto the balance sheets of farmers shareholders together with the capital accounts of non-farmer investors.
TAF has indeed achieved this risk transference to the misfortune of both the farmers and non-farmer investors. Both groups are now much poorer as a consequence.
However, what Fonterra has not done is remove its own long-term risks from share redemptions. And there lies the nub in the current environment.
This is because TAF can only work if non-farmer investors are prepared to purchase units. A constellation of events stemming both from Fonterra mismanagement and a forthcoming farm-compliance storm now make unit purchases unattractive.
So how did Fonterra’s experts and their high-priced consultants not foresee this scenario as at least a possibility?
The long journey to TAF from what was previously a more traditional co-operative structure was indeed contentious. It took a good five years of endeavour. However, Fonterra‘s leaders were determined this was a path they were heading down.
Initially, the idea of listing Fonterra on the stock exchange was seen as a way for Fonterra to acquire more capital as an alternative to capital being retained from the milk cheques. That option was rejected by farmers in a 2007 vote because farmers did not wish to lose control.
Over time, the focus then moved away from trying primarily to find new capital to a new focus on the removal of redemption risk.
The 2007/08 Waikato drought gave a big fright to Fonterra’s directors. Drought-stricken farmers no longer needed as many shares and withdrew a net $600 million of share capital. This gave the impetus to once again search for a way to list Fonterra on the stock exchange.
Around this time, I was Lincoln’s Professor of Farm Management and Agribusiness. I was brought in to be part of a project, called the ‘Waikato Project’, driven by Fonterra, but in partnership with Government.
This project was based on the assumption that if we kept looking, we would eventually find somewhere in China where we could recreate the Waikato dairy systems. I was brought in part way through to see if there were flaws in the thinking.
Finding flaws in the glossy consultancy documents was easy, and so the project died. However, what the project did illustrate was how grandiose Fonterra’s plans were, even back then. They wanted to take on China and the World.
This was just before the San Lu debacle. Fonterra was already committed to American-style barn-farming in association with San Lu, but the ‘Waikato Project’ was projected to be something on a much grander scale.
A few months later, the Global Financial Crisis (GFC) had struck and I suspected that Fonterra might be facing a liquidity crisis. I decided to do some analysis on Fonterra’s finances, using public documents.
My calculations quickly showed that Fonterra was highly indebted, with inventories apparently overvalued, and almost certainly running up against its bank covenants.
Rather than putting the analyses into the public arena, on 23 December 2008 I sent my document to Fonterra’s Chair Henry van der Heyden, to Fonterra’s CEO Andrew Ferrier, and to Blue Read as Chair of the Shareholder Council. I asked them if they agreed with what I was seeing.
Within 24 hours, Henry van der Heyden came back to me and said that I must come up to Auckland to talk to their financial team. That meeting happened in the first few days of 2009.
I spent a day with CFO Guy Cowan, who called in various other people to assist with information. Andrew Ferrier rang in several times during the day to see how we were going.
Guy Cowan was very frank. Yes, Fonterra was in a cash crisis. Later I learned that they had been at risk of not being able to pay farmers the previous month. The details are a story for another time.
Yes, all assets, including Tip Top and everything else not needed for basic processing of commodities and ingredients were up for sale. And yes, Guy Cowan found no fundamental errors in my analysis.
Guy Cowan’s most worrying point was that if I published my document then their big forthcoming bond issue would fail and they would be insolvent.
In the circumstances I decided to withhold publication. A few weeks later the bond issue did float, albeit at a high-risk premium.
A few months later, the global financial crisis was coming under control, dairy prices were now high, and the crisis was averted. But somehow, the message that Fonterra’s sails were set for smooth-water sailing either never got learned or was quickly forgotten. And so, the focus went back to debt-fuelled expansion and the associated problem of risk redemption in the absence of permanent capital.
It took another three years for the current system to be negotiated and accepted by farmers, but there was never any doubt as to where the leadership wanted to go.
Given the abundance of in-house expertise, plus the highly-priced and credentialed consultants, did anyone ever ask whether the chosen path was highly risky? The risks were not hard to see.
In regard to the consultants, the first rule for many consultancy firms is to work out what the client wants to hear. That is the best way to ensure an ongoing flow of consultancy work.
Within Fonterra itself, ever since around 2008, the culture has also been negative towards those who have a questioning attitude. It’s generally better for one’s career to be a ‘yes person’ and sing from the company song-sheet. Those who tried to question typically either moved on or got moved on.
When things go wrong there always has to be a scapegoat. The latest scapegoats are Theo Spierings and late Chairman John Wilson. They cannot escape responsibility. But Fonterra’s internal culture was flawed long before their reign at the top.
At least from 2008, the Fonterra culture was dominated by too many people who had become arrogant about their own abilities. They were not good listeners to alternative perspectives.
I am particularly critical of the external directors who came from the corporate finance world. They did not do their job. They must have known the yacht was set for down-wind smooth-water sailing.
As I write this article, Fonterra is just three days from announcing its 2019 annual results. The details of those results will be crucial in defining which pathways remain open for Fonterra. Rebuilding a strong Fonterra is crucial to the dairy industry, given the broader challenges the dairy industry faces.
*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. Previous article on Fonterra’s challenges can be found at https://keithwoodford.wordpress.com/category/fonterra. You can contact him directly here.
60 Comments
you are awesome Keith but a bit scary at the same time.
Mr Reddell
"In real per capita terms:
mining sector GDP is a bit less than it was at the start of the 90s,
manufacturing sector GDP is just a bit below the level first reached in 1997, 22 years ago,
for all the dairy intensification, forest plantings etc, the same is true of agriculture, forestry and fishing – just a bit below the level reached 22 years ago."
https://croakingcassandra.com/2019/09/20/tradables-and-non-tradables/
Andrewj, I am very cautious of the way that agricultural GDP is measured, with the general principle being that it is only the on-farm 'value-add' that is included. That means that the costs of agricultural servicing companies and their farm inputs are excluded. I am currently seeking clarification from the Statistics Dept. My current belief is that over time less and less of farm gate output is credited to agricultural GDP and that it is a particularly misleadig metric.
KeithW
The word “grandiose” is certainly resonant. Failures when a “corporate” loses sight of its core business and its responsibilities to shareholders is sadly, not uncommon in NZ. Think AirNZ & Ansett. Fletchers & Formica & others. Carters in Chile. Michael Hill & The Wharehouse into Australia. When will they ever learn.
Thats the peril of being in a producer in a cooperative, you never get to learn how the rest of the business works. R&D, forex, shipping, quality control, sales force, it all needs investing in, but producers just want to get paid and buy boats, they don't want to invest.
"(Fonterra CFO) Guy Cowan was very frank. Yes, Fonterra was in a cash crisis....(and he) found no fundamental errors in my analysis..... if I published my document then their big forthcoming bond issue would fail and they would be insolvent."
So the CFO withheld information material to the issue of the Bonds? That strikes me as reckless at best, and illegal at worst?
It also begs the question, "What is the CFO aware of today that's not being published for fear of insolvency?". But I'll guess the RBNZ knows the answer to that, already.....
bw,
Note that the information that I used was all in the public arena. I had no inside information.
It was simply a case of joining the dots, which is my usual modus operandi.
So there is no suggestion on my part that information was withheld.
I suspect that at the time the Government was providing some guarantees, and I am confident that Fonterra and the new National Government were liaising closely, but I have no proof of the specifics.
KeithW
This very brief article suggests information (your analysis) was withheld by the CFO, as it would prejudice the Bond Issue. I'm sure it's just the way it comes across in your outline. For the CFO to suggest 'you don't publish' for fear of financial consequences was the way I read it.
Good financial analysis relies on expert people 'joining the dots' of available information for those who otherwise won't, or don't have the expertise to do it themselves. Yes, it's caveat emptor, but all information must be put before investors if they are to have confidence in our capital markets.
You further suggest "I suspect that at the time the Government was providing some guarantees", which cover the closing thought of my first post " ...the RBNZ knows the answer to that, already", and we'll get some idea of that with this weeks OCR decision.
I can provide some insight here as an official.
I smelt a rat and I had friends in financial markets at the time that told me a huge rat existed.
I escalated but my managers were not able to get anything out of Ferrier.
I knew this was bollocks as only about 8 people mattered in the entire industry and I had 6 of them on the Nokia.
So I knew Fonterra was in trouble.
When Fonterra finally came clean I briefed English - explaining what I called at the time was the lack of balance sheet separation.
The problem was simple: in a coop with payout subordination the same dollar was promised twice to the same bankers, and thanks to stockpiling there was no dollar at all.
And US dollar credit markets had dried up.
I don’t know what conversations were had at a political level, so I won’t speculate there.
What I can say that when Fonterra turned up 10 months later with TAF - and tried to roll me via a direct appeal to the PM and MoF I ended up rolling them and Minister English was not playing the role of good cop.
Talk over a beer.
Always enjoy your contributions;
https://thespinoff.co.nz/business/24-09-2019/the-700m-bombshell-that-co…
One of the must read more recent ones.
Previous management and board members; Henry and Wilson, had hidden agendas that were not aligned to co operative ownership. The die was cast with the KPI of the Chief Executive, to maximise the cashflow in the short term. A bunch of inept board members bought into this, and are still there.
In my experience, directors that have previously been private advisors are less than useless. They build their profile by appointing themselves to committees, then become lapdogs to either the executive or controlling directors; some of which came from the same boat as them.
As an external advisor, I was always too busy with work to devote volunteer time to build a profile to enter the boys club. This explains everything around why our public companies struggle. Most directors wouldn't be able to organise a piss up in a brewery. The yes culture, which has obviously permeated the employees of Fonterra too.
Fonterra has been not unlike Local Authorities, which attract poor quality board members, that in turn attract poor quality Chief Executives, which attract poor quality staff.
The best board members are those that have had a proved track record in managing related businesses. Advising businesses is a whole different ball game. Advisors game is generally stealing intellectual property from other businesses they do tax returns and advise to; well most advisors anyway.
The fifth through to third from last paragraphs say it all, and this problem is not unique to Fonterra. it is endemic in big egos who get paid big dollars and seldom if ever get held to account for their failures. Usually because they have already moved on and pulling back some of the exorbitant pay is just too costly. Politics kills the careers of any who don't sing the company song and that tune is set by the leadership, and this is what we get when they are corrupt!
"[CFO] Guy Cowan’s most worrying point was that if I published my document then their big forthcoming bond issue would fail and they would be insolvent." And you add later, "I suspect that at the time the Government was providing some guarantees, and I am confident that Fonterra and the new National Government were liaising closely, but I have no proof of the specifics."
These comments go to the heart of Fonterra's business practices and those of its industry acolytes: pretend, pretend and pretend, while stringing the country along. There is no responsible professional behaviour without acceptance of accountability. And in Fonterra et al accountability is always avoided.
It just gets better!
"Fonterra partner ,Beingmate, wants to change its name. It is currently described as "Beingmate Baby & Child Food Co" reflecting its historic business of infant nutrition, but it proposes to drop the "Baby and Child" reference to become simply Beingmate Co Ltd. This is because it says it plans to move into property development and health care. One positive piece of news is that Beingmate has avoided being delisted, following large scale losses in 2016 and 2017. It managed to report a $9m profit last year but the earnings were mainly driven by selling assets, including equity from subsidiaries, and receiving government compensation."
Keith. Once again I enjoy your analysis of Fonterra. Please don't let it slide into a "I told you so" attitude. We all know they screwed up. We do justify an explanation if only so we don't repeat the mistakes. What I look forward to is intelligent comment on the way forward from here. If we were fully shared up our family business would have lost over $1 million over the past two years in share equity alone, not including falling land and cow prices. So these are serious amounts of money.
Wilco,
I expect to have something tosay on the way forward. But it may not be immediately after the annual announcements. My experience is that I typically have to spend quite a few hours making sure I understand what is said and what is left unsaid in the annual report. At this stage it is very clear that Fonterra is constrained in terms of the path forward. But it is not fully clear as to the extent of those constraints, and which escape paths remain open. The key metric is probably a realistic value of equity, and the concern will be whether all of the dead rats have been identified. Until I am confident of that, I cannot assess how many assets might now need to be sold and how much new capital needs, one way or another, to be brought in. In recent articles my objective has been to lay the foundations for understanding the current situation as an essential prelude to moving forward, once we have been provided with realistic numbers as to where things are at.
KeithW
The way forward is critical, but I suspect and comments support that farmers see that as about strategy. I think this article highlights it needs to be primarily about culture. 3 Vs had taken the business to the brink, mainly because of flaws in execution, that are cultural. The arrogance, power politics, and PR driven culture you refer is for real and insiders add the very low disciplines on use of capital. Essentially, the business focuses on its PR to suppliers v performance for shareholders. The passive farmer response to the current situation indicates shareholder scrutiny is still not intense enough, and it will bumble through this crisis. I am pleased I dropped exposure to it when I realised there was no intention to become a real business.
Colin Armer has his own weaknesses and was never going to be a saviour - maybe Greg Gent could have been but as soon as Spierings sacked Jonathon Mason the very good and competent CFO for not agreeing with his grandiose plans and bought in his mate from a euro booze company who did not have the required intellectual capacity and was unable to disagree with his mates plans, the inevitable outcome was set.
Great article, Keith. Do you think that Fonterra is engaged in Reverse Factoring, a controversial financing technique that played a major roll in the downfall of the UK construction giant, Carillion. It can be used to hide the true magnitude of debt owed. A good article on the Wolf Richter blog Wolf Street in regard to reverse factoring today in regard to Australian Engineering Group UGL
Corporate culture is most easily changed by changing managerial staff. Those lower down in the milking order might then be able to contribute the ideas which they undoubtedly have for the myriad of small internal improvements which ease costs and increase cashflow. But this still doesn't solve the groupthink at the top which Keith describes, if the replacements are simply inducted into the same old, same old. Sounds like they need a Nitpickers Division, devoted to pointing out What could Possibly Go Wrong....
'Guy Cowan’s most worrying point was that if I published my document then their big forthcoming bond issue would fail and they would be insolvent.
In the circumstances I decided to withhold publication. A few weeks later the bond issue did float, albeit at a high-risk premium.'
That is a bit troubling to me. I understand that there was no duty to publish, but the linkage to getting the bond issue through, was playing into the Company's hands, was it not ?
I admire your letting us know this background now.
SmoKey,
As commentators we tread a fine line as to what and when to say things. And it was not my responsibility to to advise the financial markets. One has to be careful not to get sued.
In fact, I think the premium yield on the bonds (LIBOR+5% from memory) was probably a fair premium for the risk, and the bonds have worked out well. Those bonds have all been redeemed and Fonterra's current bonds are also still regarded as very low risk given that they stand ahead of milk payments to farmers.
Fonterra were probably justified in wanting to avoid a public debate which once started, and during that very volatile time of the GFC, could be difficult to keep objective and could easily go off track and run wild. And people who bought the bonds should have been relying on their own professional advisers who, if they were competent, could have done the same anayses that I had done. It was also a time when sound financing projects did fail because of extreme competition for funds.
I emphasise that I am definitely not suggesting any malfeasance on Fonterra's apart. What I am emphasising is that there was plenty of evidence that Fonterra was desperately short of capital at that time but that the lesson was either not learned or quickly forgotten.
KeithW
Agree.
But wondering whether this revelation (without too many specifics) could have been made after Fonterra went back to its bad ways, a few years after the bond issue, just to bring attention to the bad management at the Company, including suppressing adverse analyses.
Anyway, now it is too late and only postmortem is left for us to indulge in.
Bail out is coming, so let us prepare for that, by hiding our money ?
Smokey,
At my own site there are 73 articles about Fonterra written since 2010.
https://keithwoodford.wordpress.com/category/fonterra/
I admit to surprise that I have written that many times about Fonterra, but it reflects my perception as to the importance of Fonterra both to the dairy industry and to NZ.
Also, some earlier articles (pre 2010) will be found at various sites through a Google search.
Amongst other things, I did note that Fonterra's liabilites comprised 79% of book-value assets back in January 2009 (that was written in 2010). And of course at that time in the middle of the GFC the book values would have been wobbly.
And in those days I also wrote on multiple ocassions about the risk of unintended consequences with TAF.
What I did not foresee were some of the specifics of the ongoing incompetence associated with Fonterra's international endeavours. It is that incompetence combined with the debt-fueled expansion and inadequate retention of profits that has brought Fonterra to its current sorry state.
KeithW
So right Keith,
the funds they found in Great Britain during the GFC cost a fortune and, I believe, still are as the deal could not be broken.
The culture IS the problem in there, the executive that held sway under Ferrier and Spierings are still largely there - some of them were more junior then but have managed up during the years to get to the top and are overpaid, arrogant and largely incapable of managing a company like Fonterra.
If the mgmt team at a very senior level are not cleaned out now then we know that change will not happen - my bet is that they clean out levels 3 and 4 to pretend that they have made big decisions when they actually have not.
The lifeboats are being launched, Fonterra has no access to debt right now and may be a few months from needing saving from an external company or agency.
p.s. the consultants to restructure Fonterra during Spierings rein cost over $ 250 Million!
The savings were not met, lots of staff moved on and rehired as consultants on double the pay and Spierings and the exec team getting huge payouts and bonuses - it shows unbelievably poor governance and mgmt and many of the same people are there......including Miles Hurrell and John Monaghan and the most powerful man at Fonterra - Mike Cronin.
Excellent article Keith.
Keen to have a chat over a beer sometime - I’ll buy.
Anyway, some reflections from me - as I was running MAF’s dairy desk between 2008 and 2010.
Three take outs:
1. The Waikato Project was complete madness and something my part of MAF (Sector Policy) was initially excluded from (International did all the running with MFAT and NZTE). However, once I did get involved it didn’t take me long to kill it - it was my briefing that went to Helen Clark - after which she declare the entire project ‘a dog’ - and I don’t think that helped.
2. Thanks to the GFC, I was really worried about Fonterra throughout the last quarter of 2008 - as commodity prices were tanking and we were at the height of the season.
Then Fonterra floated a £250m bond issue at some ridiculous rate.
This told me they were in all sorts of trouble.
And after lots of denials Fonterra rode into town and told us they were stockpiling powder and about to run out of money.
Cue a story about emergency briefings to Bill English, contingency plans (which is where the idea of divesting Tip Top came from), meetings with Guy Cowan, and tripping around the banks with the RB and Tsy in tow.
Lots more here, but the crisis was only averted when Fonterra did a NZ dollar bond issue in early 2009 and GDT recovered - but it was skin-of-the teeth stuff.
3. You are correct that TAF actually solved nothing (and arguably made matters worse by creating a moral hazard issue at board level).
In my initial briefing to David Carter, I explained that from the government’s perspective TAF did nothing as it did not raise any new capital.
So zero ability to move beyond the status quo.
Long story here, but cutting to the chase Jonathan Mason’s counter-argument was whilst I was correct, having a listed unit meant Fonterra needed to have a dividend policy - and part of that was the ability to retentions policy.
And retentions would transform the company.
But at the same time they were changing milk pricing to the system based on the imaginary friend, which means everything was paid out to farmers and there were no retentions to keep.
And the Nats changed the law to enable all of this madness.
The arguments we made then have been remarkably prescient.
Keep up the good work.
A much appreciated view from the inside, PF. If, as you say, the same $ was offered twice as collateral, then that's malfeasance and most probably indictable. Although possibly not at this distance from events - limitations etc. But a thoroughly discomforting story. Nothing less than a thorough house-clean, with zero golden parachutes, is gonna get F back on the rails. Your opinion as to whether such a re-railing is now even possible would be enlightening.....
Hi Waymad
The situation was basically payout subordination in action - but the money flow had been switched off.
Think of a two by two matrix with strong Fonterra/weak Fonterra and strong farmers/weak farmers.
The situation in 2008 was weak-weak, which by the way, is not a million miles from the current situation.
"Fonterra needed to have a dividend policy - and part of that was the ability to retentions policy.
And retentions would transform the company.
But at the same time they were changing milk pricing to the system based on the imaginary friend, which means everything was paid out to farmers and there were no retentions to keep."
Your reference to retentions and dividend seems to overtlap dividend and milk price. TAFs design was to separate the shareholders from suppliers so surely any retentions need to come from profit and not the milk price. I bang on about this because if retentions are from milk prices it forces many non shareholders to prop up shareholders, the largest of these groups then being milked are sharemilkers , along with Mymilk suppliers and numerous others.
Agree, in any company or business longevity is a function of making profit and retaining funds to cover capital requirements.
Fonterra was set up to fail from the start with DIRA and the creation of a fair value share which has resulted in a complicated capital structure undermining cooperative principles crucial for strength and unity, reflected in the culture of excess and failure.
Hi Redcows.
Nice to see someone likes an alternative to the black and whites.
The point is the whole lot is connected.
Yes, Fonterra -as a coop- had a redemption issue, but I thought this was way over blown.
As long the the milk supply was growing they would have net inflows and weather conditions were managed in the 2009 decision to allow farmers up to 20% dry shares.
That was a buffer.
And if milk supply went down then, as Keith correctly argues it all depends on investor demand for units: and this comes down to a dividend policy.
And explains why investors don’t want a bar of them.
So if farmers redeem and there is no counter party things get very sad very fast.
And Fonterra has a stranded asset problem to manage.
I am less worried about that in the NI but is scared the bejesus out of me in the south.
Now the HEC. By pricing the milk 50 cents above what the actual Fonterra can pay means there simply isn’t sufficient funds left for retentions once a dividend is paid.
So even if they wanted to they can’t.
This is the noose that will kill them.
So Mymilk suppliers and sharemilkers actually do extremely well out of the HEC.
Oh, so the trucks have to go Takaka-Blenheim (ascent 5285m according to Mapometer), Blenheim - Kaikoura (ascent 2738m), Kaikoura-Christchurch (ascent 1197m) and Christchurch-Temuka (a mere 171m), totalling ascents, that's 9391m. Just imagine the diesel, the RUC, the wear and tear.....that's a special breed of crazy all right....
And of course the cost of the wear and tear to the local roads is largely paid for by taxpayers and ratepayers. Another subsidy - same, if not worse for logging trucks.
And while I'm at it - when will we start charging rent for the leasing of surface water for aquaculture - they presently occupy their paddocks for free.
The fact there are cows there are all is mad
Yes! I do wonder in terms of the recent DIRA changes, whether Fonterra will price differentiate based on geography/fuel efficiency in respect of climate change and sustainability standards?
Clarify that Fonterra’s terms of supply can relate to, and price differentiate on the basis of, various on-farm performance matters, including environmental, animal welfare, climate change and other sustainability standards.
https://www.mpi.govt.nz/law-and-policy/legal-overviews/primary-producti…
Or is that already done for these remote locations?
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