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Fonterra capital structure rejig to speed through Parliament, Damien O’Connor says

Agriculture Minister Damien O’Connor says he will assist Fonterra’s board in speeding through change needed to dairy industry law to accommodate a capital restructure.

Fonterra’s board hopes to put a proposal for significant capital structure change to a vote by the company’s farmer-owners around November annual meeting time, but it will also require an amendment to the Dairy Industry Restructuring Act (Dira) which oversees New Zealand’s biggest business and the $10 billion dairy industry.

O’Connor, a fierce critic of Fonterra’s current capital structure when it was introduced in 2012 under a scheme called Trading Among Farmers (Taf), told the Herald when he first discussed the company’s capital structure review with its leaders, he saw a need for urgency in amending the legislation once final decisions were made.

Fonterra directors next week start one of two planned rounds of consultation and meetings with farmer-shareholders around the country over change proposals unveiled this week.

The proposals, to significantly relax Fonterra’s share standard to give farmer entrants and exiters more flexibility in their capital commitment to the cooperative, and to cap or axe the Fonterra Shareholders’ Fund, will require two 75 per cent support votes – one from farmers and one from unit holders in the fund – as well as the legislation tweak.

The proposals aim to address Fonterra’s concerns about losing scale and efficiency if its lifeblood milk supply dwindles.

“I understand the dilemma they face and I’m not surprised given my consistent view that Taf was always going to fail the cooperative,” O’Connor said.

The pressure on milk supply is from a range of influences including rising environmental compliance costs, emerging competitors which unlike Fonterra, don’t require shares to supply milk, and land use change – and ultimately, dairy sector observers say, Fonterra’s lacklustre financial performance.

Share-buying farmers have invested $8 billion in Fonterra in the past 10 years for disappointing returns on capital.

The company, which is the world’s fifth biggest dairy company by revenue and its largest dairy exporter, two years ago launched a new business strategy under new management.
It focuses on the premium value of New Zealand milk instead of costly and largely loss-making global milk pools.

The balance sheet is recovering from heavy losses in 2018 and 2019, and an almost new board of directors says it wants a structure that aligns with strategy.

New chairman Peter McBride has said Fonterra’s future hinges on it performing as a farmer-owned cooperative and to do that it needs a sustainable milk supply.

Nearly 20 years on from its controversial creation from a dairy industry mega-merger enabled by the special Dira legislation which also deregulated dairy exporting, Fonterra still collects and controls the lion’s share of New Zealand’s raw milk supply. On formation in 2001, it controlled 95 per cent.

O’Connor said he couldn’t make a judgment on the proposals yet.

But given the new board’s effort “to maximise the value of New Zealand milk, retain its cooperative status and the need for it to grow successfully, I fully understand what they’ve done”.

Taf’s introduction in 2012 followed years of debate and controversy among farmer-shareholders. Milk production was soaring and Fonterra farmers were convinced by their leaders of the time that the cooperative needed to guard against “redemption risk” – a run on capital as farmers exited with cash to join new competitors which didn’t require share purchase.

O’Connor, in Opposition at the time, claimed the Taf legislation was rushed and Fonterra executives “were incentivised through their salaries to have an increasing share price … basically a flawed concept and driver for a cooperative company”.

Only farmers can own Fonterra shares. The Taf scheme, voted in by farmers once they’d been convinced they wouldn’t lose control of their company, created a hybrid capital structure.

One part is the present farmer-only share trading market, and the other the Fonterra Shareholders’ Fund. The fund offers sharemarket-listed units in farmer-owned shares. These can be bought by farmers and the public. The units offer access to Fonterra share dividends, but not voting control.

O’Connor criticised the capital structure as recently as 2019, when he was reported saying Fonterra’s leaders had been distracted from their job by the need to please outside unit investors.

Taf requires the share price and the unit price to be close, something chairman McBride says has resulted in the unit price dictating the share price. If the share price gets strong, that makes it harder for new farmers to buy into Fonterra.

However, as market analysts have noted, that hasn’t happened often because of Fonterra’s disappointing performance, which has seen outside investor interest in units fall off.

As at May 4, the fund had about 107.2 million units on issue and a market capitalisation of about $493 million.Most units are understood to be owned by farmers anyway.

The board’s preference is to axe the fund or cap its size through a unit buyback and bring securities trading back within Fonterra. A restricted trading market would likely result in a fall in Fonterra’s share price, at least initially.

McBride agrees that could be a short-term result but one that will challenge shareholders as they consider the board’s proposals.

But for Fonterra’s longer-term future, the relaxed share standard with either no fund or a capped fund proposal was the board’s preferred option for capital structure change, he said.

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