Interest rates and thunder clouds

In a surprise move the Reserve Bank has reduced the Overnight Cash Rate (OCR) by a quarter of a percent to 2.25%. That was unexpected, given the domestic economy is performing quite well, but takes into account international “risks” according to the Governor of the Reserve Bank.

Those risks are emerging as thunder clouds on the horizon. Graeme Wheeler made particular mention of the outlook for dairy prices, the slow down in China, and greater lending risk in overseas markets.

The outlook for dairy prices is not good, and Fonterra is coming in for growing criticism on multiple fronts. Just seven weeks ago Fonterra was forecasting a payout of $4.60 per kg of milk solids for the current season. A week or so later that was lowered to $4.15 and last week it was reduced again to $3.90. Such volatility in the forecasts has some wondering about how much reliance can be placed on Fonterra’s predictions. It also makes it very difficult if not impossible for farmers, banks and advisors to forecast cash-flow.

According to farming experts the average operating cost of a dairy farm is $3.75 per kg of milk solids, before debt serving costs of about $1.40kg. In other words, even farmers that are debt free are likely to be only marginally profitable, and those with debt (which is most) are paying the bills by selling assets, taking on more debt, or earning off-farm income.

Total dairy debt in the banking sector is now $37.9 billion, up from $30 billion five years ago. The deepening debt levels is confirmed by Federated Farmers who say 11% of dairy farmers were being “managed” by their banks, compared with 7.6% in November and 6.6% in August.
Primary Industries Minister Nathan Guy described dairy farming debt as being in the “severe scenario” and he encouraged banks to “stand by farmers”. That is fanciful thinking but typical of politicians who are unwilling to admit to the increased costs government regulation has imposed on the farming sector. Banks are in business and will make the best decision in the interests of their shareholders. If the best decision is to “stand by farmers” then that’s what they will do. If the best financial decision for them is to call in the debt and sell up farms, then that’s what they will do. It’s unrealistic to expect anything else.

Fonterra is also coming under the blowtorch for other reasons. Some commentators have drawn attention to its own burgeoning debt level, in particular investment commentator Brian Gaynor who recently produced these facts and figures:

“Fonterra…has a market value of $8.9 billion…However, its total borrowings of $7.56 billion are also well above the three largest listed companies, which have the following comparative figures:

• Auckland International Airport has a market value of $7.4 billion and borrowings of $1.8 billion.
• Spark has a market value of $6.3 billion and $0.8 billion of debt.
• Meridian Energy’s figures are $6.2 billion and $1.2 billion respectively.

There is a strong argument that infrastructure companies, telcos and electricity generators with relatively stable earnings can have much higher debt levels than commodity producers. However, it is the other way around in New Zealand as Fonterra has much higher debt levels, both in relative and absolute terms, than Auckland International Airport, Spark or Meridian Energy.”

In my view Fonterra’s debt level is excessive, and the rate at which it is increasing debt is a serious issue for the company and the industry. Given Graeme Wheeler’s forecasts for a slow recovery in dairy prices (which I believe are more credible than Fonterra’s forecasts) it is likely to be some time before the industry returns to profitability.

The other problem Fonterra faces is farmers shifting their milk supply to competing dairy factories. Often these are overseas owned with direct access into retail chains. This higher value model is producing better returns for farmers but it is a big ask for Fonterra to change tact and adopt a similar strategy, given the huge investment it has in existing plant and infrastructure and the lack of equity in its balance sheet.

In my view, another two years of low dairy prices would have very serious consequences for Fonterra and the dairy industry. Probably a crisis can be averted by entering into some equity raising arrangement to restore the balance sheet, like tapping into local or overseas capital (as has Silver Fern Farms).

The small reduction in the overnight cash rate is not going to offer much relief for farmers, at least directly. More benefit may come indirectly from a lower kiwi dollar which fell almost one and a half cents (or 2%) against the US$, but the kiwi will need to fall a lot lower yet to alter the fundamentals of the dairy industry.


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