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Fonterra Dairy Shares simplified

Much is written, a lot is talked but many people still do not really understand the issues around Fonterra Dairy Shares, their surrender, contract supply, and so on.

Having been brave enough to write the philosophy on "Dairy Equities Simplified" it is time to tackle "Fonterra Dairy Shares Simplified".

To supply Fonterra you need one share per kilogram of production.

Fully shared supply means you have enough shares, fully paid up, to supply your milk to Fonterra.

Now you can also supply Fonterra under contract supply. You only need 1,000 shares at the current price of $7 per kg or $7,000. But contract supply is what it says. You are signing a contract and the contract is binding for 3 years.

You can change the volume up or down but each time you do Fonterra will want to resign a new 3 year contract. That's fair enough too.

You can go from contract to fully shared supply at any time. You can't, however, at the same time notify Fonterra you are going to cease supply. You have to complete that season, notify them in February and get paid out the following July.

Now contract milk does impact on the capacity adjustment. You have to pay $5.40 per peak litre which works out at about 30¢ per kg. This is not a lot of money but it's part of the balancing mechanism that Fonterra has.

Pay-out Comparison between Shared Supply and Contract Supply

This Season: Shared Supply $7.30
Contract Supply $7.08
Value Add = 22¢ per kg
Last Season: Shared Supply $4.46
Contract Supply $3.87
Value Add = 59¢ per kg

This season looks great for contract supply but there is a push by Fonterra to get the Value Add, or the differential between shared and unshared supply up to 80¢ per kg.

This would show a return on the shares of 12.5%. The current differential of 22¢ is only a return of 3.14%.

So looking at the numbers. The return on shares at the moment is low but it is expected to increase. Historically the return on the shares has been around that 12%.

Redemption Risk

This has been a major concern to Fonterra.

Fonterra is concerned that many farmers may decide to cash in their shares and go and buy baches at the beach, run-offs etc.

The redemption risk depends on the perception of the suppliers. If the shares are expected to rise in value and/or show a reasonable return then farmers will hold them. If their perception is the value of the shares will fall and the return will stay down then farmers are likely to cash them up.

Tactical Pricing

Fonterra has identified that in an area where there is strong competition and the opposition company has actually made an offer, then Fonterra may consider tactical pricing.

Tactical pricing is calculated by Fonterra on the value of the milk to them. The price that they will pay depends on the particular farm. Tactical pricing could vary from 8 - 30¢ per kg milk solids.

Factors which would influence Fonterra's tactical pricing will include:
    Volume
    Size
    Fat/Protein ratio
    Proximity of factories
    and so on.
Tactical pricing is not available to everybody and is considered on a case by case basis where there is competition.

It is easy to see it from Fonterra's point of view. Loss of supply increases the unit cost of production right across their business.

So back to shared supply and contract supply.

To break contract supply you have to fully share up, do a season and then notify Fonterra that you want to go. If the farm is sold within the 3 year contract period then that is okay too. Fonterra will allow you to exit the contract.

So you can sell the farm and break a Contract Supply Agreement.

Under contract supply Fonterra agree to continue to collect all your milk.

Stay with Fonterra. Just because you decide to cash in your shares is not a reason to leave Fonterra. My recommendation is you stay with Fonterra under contract supply.

Summary

So in summary, there are a lot of issues around Dairy Shares. Understanding them and the issues is crucial. Fonterra prefers to maintain fully shared supply. If you or your clients are going to contract supply there are issues that need to be considered. Contract law is very clear and binding in this country.

And if you are in areas being courted by other processors tactical pricing may also be involved.

Whatever you or your clients do ensure that all matters have been considered and realise that contract supply is what it says.


 

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