Fonterra - Proposed Changes To Capital Structure

Proposed Changes To Capital Structure

In November 2007, the board of directors announced a two-year consultation programme regarding their preferred capital re-structuring option: putting the business operations in a separate listed company, with the co-operative maintaining a controlling interest. The aim was to give more access to funds for global growth.

Praised by some as a bold move which would allow better access to outside capital, the proposals encountered significant opposition from both farmer shareholders and the government (who would be required to pass enabling legislation). Despite including a range of safeguards, farmers were clearly concerned at the risk of losing control; in what was sometimes described as a demutualization.

The board responded in 2008 by shelving the November 2007 proposal and continuing consultation and discussion with farmer shareholders. In September 2009, the board announced a three-step process to revamp Fonterra’s capital structure. The new approach abandoned thoughts of a public listing of Fonterra shares and retained 100% farmer control and ownership of the co-operative.

A key goal of the capital structure changes was to stop large amounts of money washing in and out of Fonterra’s balance sheet each year as milk production fluctuates. Under the previous structure, farmers matched their shareholding with their milk production by owning one co-operative share for each kilogram of milksolids (kgMS) produced annually. If their milk production dropped in any season, they could redeem shares back to the co-operative, which was required to buy the shares back off them. Consequently, Fonterra faced the risk of losing large amounts of share capital through redemptions during times of declining milk production. For instance, after milk production fell during the 2007/08 drought, Fonterra had to pay out $742 million of share capital to farmers via redemptions.

The capital structure changes also sought to provide greater incentives for farmers to increase their investment in Fonterra shares, helping ensure Fonterra has sufficient share capital to fund profitable business opportunities and drive a higher payout to dairy farmers.

The first two steps of capital structure change received good support from farmer shareholders at Fonterra’s annual meeting in November 2009. The first step allowed farmers to hold” shares above their level of annual milk production; farmers could now own an additional 20% of “dry” shares (i.e. up to a maximum of 1.2 shares per kgMS). There were also enhanced incentives for farmers to hold shares even if their production falls. The rules about the pricing of end of season share transactions were also tidied up.

The second step changed the way Fonterra shares were valued to reflect that share ownership is restricted to farmers only. Previously, Fonterra shares were valued on a theoretical basis as if the shares were freely traded like a public share. An independent valuer subsequently assessed that the restricted market value should be at a 25% discount to the freely traded value.

The third step, titled "Trading Among Farmers", involves more far-reaching change to Fonterra's capital structure. The co-operative would no longer be obliged to issue or redeem shares at a price established via an independent valuation process. Instead, farmers would buy or sell shares among themselves at market prices through a farmer-only share trading market. This would have the effect of making Fonterra shares permanent capital, providing the co-operative with more confidence to invest in long-term projects without fear that some of its share capital might be needed to fund redemptions in future years.

As part of the changes, farmers would have greater flexibility with their Fonterra shareholding. The maximum shareholding would be 2 times production (up from the 1.2 times approved in step one) and farmers would have up to three years to comply with shareholding rules when entering/exiting the co-operative or increasing/decreasing their milk production.

Additionally, Fonterra would set up a special fund that would financially help farmers purchase shares (or retain shares they would otherwise have to sell). The fund would pay farmers for the right to receive dividends and the gain/loss from any changes in value of some of their shares, but the farmer would still be the owner of the shares. The fund would raise the money it needed to pay farmer shareholders by selling investment units to investors. Fonterra would require the fund to target "friendly" investors such as sharemilkers, retired farmers and offshore Fonterra suppliers, although the public and institutions would also be able to participate.

The "Trading Among Farmers" proposal went before a special meeting on 30 June 2010 and received 89% support from farmer shareholders voting, easily exceeding the 75% threshold required for a favourable vote. Fonterra is now progressing implementation of farmer share trading with the new system possibly taking effect from mid 2011.