Tuesday, 25 March 2014

The price of milk

Keith Woodford has been thinking about Fonterra. If I read it right, he reckons that Fonterra needs external capital to invest efficiently.

This doesn't ring true, and I suspect that the milk price manual might be at the bottom of the confusion. Keith says:
Fonterra's solution for 2013-14 is to siphon funds from the theoretical milk price, as calculated using the rules in Fonterra's Milk Price Manual. 
It is true that this season's payout is lower than what the Manual suggests, but the (claimed) reason for that lies in the difference between Fonterra's actual business and the notional business modelled in the Manual, as I discussed earlier. Now it could be that Fonterra are just bullshitting us (that has happened before) but the following passage makes me think its more likely that Keith is perhaps not fully across the details of the Manual.

Determining the milk price under Trading Among Farmers (TAF) was always going to be a challenge. Given the absence of a competitive market, it was always going to be the outcome of complicated back-room calculations. Realistically, these new rules are still unlikely to give retained profits of more than $500 million after paying out dividends of about another $500m.
In fact, the model is deliberately aimed at giving Fonterra a modest return on the capital needed to produce commodities (plus depreciation). The milk price is the difference between the world price of commodities and the costs of an efficient and low-risk manufacturer. In other words, the Manual is deliberately designed to maximise the milk price, which is after all exactly what would happen if rival processors were competing for raw milk.

Setting that NZ commodity business aside, Keith correctly notes that shifting up the value chain into branded consumer products requires more investment. Fine, but Fonterra has other profit centres from which to gather that capital. Around 1/3 of its raw milk is sourced outside New Zealand and therefore doesn't fall into the scope of the milk price Manual. It has branded consumer products on sale in many other countries, such as Anchor and Anlene. It also sells lots of ingredients that go beyond the basic commodities in the Manual.

These other lines of business should provide the cash for growth. I think we should be pretty careful about before concluding Fonterra needs to expand its externally provided capital base.

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