Capital Structure Consultation 2021
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A strong Co-op benefits farmers and New Zealand It’s good to remember why we’re a Co-op in the first place. First and foremost, the role of a cost, and over the long run they are For every dollar we earn as farmers, co-operative is to give farmers control incentivised to reduce the price they pay we spend almost 50 cents in our of their own destiny. Because we own for milk to maximise corporate profits. communities. 2020/21 looks set to and control Fonterra, we know that our be another season that our Co-op Having a strong farmer-owned Co-op will collect our milk and work contributes more than $11 billion into co-operative in our dairy industry hard to ensure we receive the best the New Zealand economy through milk is important to every New Zealand possible price for it. Maximising overall price payments. dairy farmer, and for the country wealth of our shareholders is at the core as a whole. Our milk price sets a benchmark in of our Co-op’s purpose. New Zealand, so even those who don’t Specific legislation enabled Fonterra Sharing the investment in our value supply the Co-op benefit from it. to be formed so that an efficient chain between us farmers and having co-operative of scale could lead New Fonterra and Tatua are the two main confidence that our milk is going to Zealand into global markets. Working dairy co-operatives left here. Many be picked up means we can have the together as a Co-op means we are other milk processing companies are, certainty to invest in our individual connected to local communities around or have become, fully or substantially farming businesses. This is an important New Zealand. It enables our efficiency owned by offshore interests. reason behind the efficiency and – from behind the farm gate through productivity that has given us some It’s critical to protect and build on to our manufacturing operations and of the advantages we enjoy today – what we’ve got – for the benefit of all beyond – and supports innovation. advantages that benefit all Fonterra Fonterra shareholders. Ultimately, a The value we create is then returned shareholders. We believe that farmers strong and sustainable Fonterra leads to regional New Zealand, where it are worse off in countries where there to a stronger and more sustainable plays a strong role helping to sustain is no strong co-operative. Corporate Aotearoa New Zealand. local communities and enhance processors look at milk as an input their wellbeing.
What’s in this booklet 1 ON BEHALF OF THE BOARD 2 2 WHY WE’RE PROPOSING CHANGES 4 3 THE PREFERRED OPTION AND WHAT IT WOULD MEAN FOR US 6 Reduced Share Standard with No Fund or Capped Fund 7 How it could work 9 Comparing the preferred option to our current structure 10 Key things to consider 12 Why this is the preferred option 14 4 HOW WE GOT TO THIS POINT 16 A brief history of our capital structure 16 A recap of our strategy 18 How we went about our capital structure review 20 The detailed findings of the review 21 5 THE OTHER OPTIONS CONSIDERED DURING THE REVIEW 24 6 WHERE TO FROM HERE 30 The consultation process and timeline of next steps 30 How to get more information and have your say 31 How to contact us 31 7 GLOSSARY 32 This booklet is for consultation purposes only. requirements, including the Financial Markets circumstances or your holding of shares or The options are not yet fully developed, and you Conduct Act 2013. units, please contact your accountant, lawyer, are not being asked to vote on anything at this Some of the information set out in this booklet financial advisor or other rural professional. stage. If the result of the consultation is that relates to future matters that are subject This booklet is addressed to Fonterra’s there is sufficient support for a change to our to uncertainties. The inclusion of forward- farmer owners, but the interests of other capital structure, then you will have a chance to looking information should not be regarded stakeholders (including the Custodian and the vote on that change and you will receive all the as a representation or warranty by Fonterra or Manager of the Fonterra Shareholders’ Fund) documents needed to understand and assess any other person that those forward-looking have been, and will continue to be, considered the details before you are asked to vote. statements will be achieved or that the as the options have been and continue to be This booklet is not an offer of financial assumptions underlying any forward-looking developed, and these parties will be consulted products (e.g. shares), and no such offer is statements will in fact be correct. Actual as appropriate. currently intended. No money is being sought outcomes may vary materially from those Some of the dollar values in this booklet from shareholders, and financial products suggested or implied. assume (for illustrative purposes) a share price cannot currently be applied for or acquired If you have any questions about the options of $5.00. This is not a representation as to the under any of the options in this booklet. If an being consulted on or would like to clarify your future price of Fonterra shares. Over the period offer of financial products is made as part of understanding of anything in this booklet, of 90 days ending 30 April 2021, the share a change to our capital structure, it would be see Section 6 for who you can contact. For price has varied above and below that level. made in accordance with the applicable legal any questions about your own financial
C APITAL STRUC TURE CONSULTATION 2021 1. On behalf of the Board Dear Farmer Shareholders, Our Co-op has refocused on delivering sustainable value back to New Zealand. I’d like to start by acknowledging that the We do that through a strategy designed temporary cap on the size of the Fonterra to optimise the value of our New Zealand Shareholders’ Fund will have come as a milk, using innovation, sustainability, and surprise. We did not make that decision efficiency to deliver products that are lightly. It is necessary to keep all of our orientated to what our customers and potential options for change open while consumers value. we have a free and frank conversation as owners. Alongside that refreshed strategy, the Board has spent a significant amount Over the past 24 months, our Co-op of time reviewing our capital structure. has been undergoing a cultural and strategic transformation. Change was Both of these pieces of work are founded needed. If we want Fonterra to continue on our belief that New Zealand milk supporting our families’ livelihoods for volumes will likely be flat or declining in another 150 years, we have to keep the long term as a result of environmental evolving it, while staying true to our and other regulatory changes, and Co-operative Principles. alternative land uses. 2
Waiting for the problem to be at our feet will limit our options and likely increase the cost of addressing them, at the expense of future opportunities for us. PETER MCBRIDE – CHAIRMAN Our Co-op’s financial performance will Throughout the process we have focussed In Section 5 we detail the alternative always be the main determinant of our on addressing three key issues: structures that were considered and share of that New Zealand milk. But we the reasons why they are not our 1. Maintaining financial sustainability also know that our rigid compulsory current preferred option. We are of our Co-op capital structure makes it difficult for keen to hear your views on these new farmers to join and is a key factor 2. Protection of farmer ownership different variations as part of in farmers’ decisions to leave. A more and control the consultation process. flexible capital structure that caters for 3. Flexibility for farmers’ invested We will seek to cater for the diversity the diversity and different aspirations capital that helps farmers to be part within the shareholder base, but we will within our Co-op would be valued by of our Co-op at every stage of the all need to be pragmatic if we are to find farmers and support a sustainable farming lifecycle and ensures we a way forward together that is in the best future milk supply. maintain a sustainable milk supply. long-term interests of our Co-op. Within that context, our review has found Having narrowed down the options, we Once we hear your views, and if the that our current capital structure could believe the best option for our Co-op appetite for change remains, we will create challenges over time. is to move to a structure that reduces do further work to refine the preferred 1 – ON BEHALF OF THE BOARD 1. Under the current structure if milk the share standard so you have greater option(s) and have a second round of volumes reduce, the number of flexibility, and either removes the Fund consultation. If we decide to seek a dry shares will increase and could or caps the Fund from growing further change to our capital structure, then you exceed the thresholds that were to protect our farmer ownership and will have a chance to vote on that change. put in place to protect our farmer control. We’re referring to this as a As some aspects of our current capital ownership and control. Our Co-op “Reduced Share Standard” with either structure are reflected in the Dairy would need to take action to stay “No Fund” or a “Capped Fund”. Industry Restructuring Act, a successful within these thresholds – such as Under this option, the Fund would either vote would likely be conditional on buying back shares or units. Buy- need to be bought back and removed any necessary changes to legislation backs could impact our Co-op’s from our capital structure (No Fund) or being passed. balance sheet and investment in remain in the structure but with no ability new opportunities that increase I appreciate there is a real sense of to exchange shares into units so the Fund performance. Conceivably, buying optimism in the Co-op with our improving size would be capped (Capped Fund). back shares or units to ensure that we financial performance and how we are retain ownership and control of the A key outcome of this change is that travelling generally. But there is a sense Co-op could cost shareholders up to shares would be bought and sold of urgency with this review. Waiting for $1.2 billion over the next ten seasons. between farmers in a farmer-only market. the problem to be at our feet will limit I want to be clear with you that we expect our options and likely increase the cost 2. An alternative to buy-backs would this change to impact the price at which of addressing them, at the expense of be to increase the thresholds for the shares in our Co-op are traded, and that future opportunities for us. Fund size, to allow a greater degree there may not be as much liquidity in of external investment. the market. We don’t think either of these are ideal Ngā mihi Ultimately, the price of our shares would outcomes, so we have been looking at Peter be determined by the performance of our other options for change. Exactly what Co-op and trading between us farmers. that change could look like is what we want to consult with you on now. Currently our share price moves in line with the price of units in the Fund. In that To give those conversations some sense it is influenced by unit holders, who structure, the Board has shared its have a different investor profile to that of current thinking. It is detailed in us farmers – a farmer’s cost of capital is Section 3 of this booklet. typically higher. We have arrived at this point after To cater for share flexibility, some reviewing a wide range of capital farmers would inevitably have more structure options from co-operatives shares than others. We believe this is around the world – both within and a more sustainable proposition over outside the dairy sector – as well as the longer term than the alternatives options to evolve our current structure. we are confronted with. 3
C APITAL STRUC TURE CONSULTATION 2021 2. Why we’re proposing changes Getting our capital structure right is The environment in which we’re This is due to factors such as climate critical to helping ensure the financial change impacts, regulatory changes sustainability of our Co-op. operating has changed a lot and alternative land uses. These factors since Trading Among Farmers might not have fully impacted us yet, but We’ve evolved our structure before, and it’s important we keep evolving (TAF) was implemented. we expect this to change over the next five to ten years. it as things change. Our current structure was put in place in 2012 when New Zealand’s milk supply Having a sustainable milk supply is critical This section summarises why we believe was growing rapidly. for us continuing to deliver on our current it’s time to evolve our capital structure. strategy, which is all about prioritising The issues outlined are covered in Now, we face a different reality where New Zealand milk. more detail in Section 4 “How we got we need to be prepared for a flat to this point.” or potentially declining milk supply There are elements of our current environment across New Zealand structure that are challenging for a in the coming years. number of farmers now, or that may create challenges for our Co-op in a flat or declining milk supply environment. These are explained overleaf, and in more detail on pages 22-23. NZ MILK SUPPLY (KGMS MILLIONS) 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 New Zealand Milk Supply Fonterra Milk Supply 4
The level of investment If we provide more We have choices to make to be part of our Co-op is flexibility, the Fund size around how we could address challenging for a number could grow significantly. these challenges, and we want 2 – WHY WE’RE PROPOSING CHANGES of farmers. Our Co-op has constitutional thresholds to talk with you first. We all have a lot of capital invested in the designed to balance the interests To stay within the thresholds, our Co- Co-op. While it’s important for each of us of farmer owners and the interests op would need to take action such as to have skin in the game, we’re hearing of external investors in the Fund. buying back shares or units. This creates there’s a desire for greater flexibility. Exceeding those thresholds could put an uncertain demand on our capital, farmer ownership and control at risk. potentially impacting our ability to This has come through in your feedback We know that’s not something any invest in strategy and growth. Under the and we’ve heard it from farmers who have of us want to see. scenarios that we’ve modelled, buy-backs left in recent years. If we provide more flexibility to reduce could cost shareholders between $500 The investment that’s required to supply the level of investment for farmers to million and $1.2 billion over the next ten the Co-op is making it challenging for be part of our Co-op, without making seasons. new farmers to join and can be a key any other changes to our current capital We’ve looked at a wide range of options. factor for existing farmers in deciding structure, our thresholds could be No structure is perfect, and all options to leave so they can pay down debt or exceeded relatively quickly. have trade-offs. What we’re not willing to invest their capital in other things. This That’s because farmers would be able to trade off is farmer ownership and control can be a real challenge for succession, hold less shares and non-farmers would of our Co-op, which protects our interests forcing difficult decisions when be able to invest more through the Fund. as producers. farm businesses transition from one generation to the next. Therefore, providing more flexibility Exactly how our capital structure evolves would need to be combined with making is a conversation for us as owners and is At a share price of $5.00, a farmer changes to the Fund in order to protect what we want to consult with you on now. supplying 150,000 kgMS would have $750,000 invested in our Co-op. farmer ownership and control. Strong performance only increases this investment requirement. As our earnings The Fund size could also grow increase, so too should the share price, if milk supply declines. which increases the capital investment to Under our current structure, when milk join, and the capital for those who leave. supply declines, the number of wet shares In short, we believe our capital structure on issue decreases and the number of is tilting the playing field against us when dry shares increases by a corresponding compared to other processors – the vast amount. Those dry shares can then majority of which are corporates and be exchanged into units at any time, don’t require any capital investment increasing the potential size of the Fund. from farmers who supply them. If we make no changes to our capital What we’re hearing is that providing more structure and milk supply declines, flexibility would be valued by farmers and we expect current thresholds relating go a long way to supporting a sustainable to the Fund size to be exceeded within milk supply. a few seasons. 5
C APITAL STRUC TURE CONSULTATION 2021 3. The preferred option and what it would mean for us Our aim has been to find options that This indicates our current thinking, We’ve spent a significant give you more flexibility when you but we are open minded about adjusting amount of time looking need it but still protect ownership that direction based on your feedback. at a wide range of and control, without compromising The other options we considered, alternative structures our financial sustainability. including staying with our current as well as options to evolve We prioritised a couple of structures structure, are outlined in Section 5, our current structure. that we thought could best meet the and we will discuss them during the objectives of the review and after closer farmer meetings. Your feedback on analysis, we have a preferred option – any or all of these is welcome. to adopt a Reduced Share Standard with either No Fund or a Capped Fund – which is explained in more detail in this section. 6
3 – THE PREFERRED OPTION AND WHAT IT WOULD ME AN FOR US REDUCED SHARE STANDARD WITH EITHER NO FUND OR CAPPED FUND Our preferred option at this stage is for This involves reducing the share standard a Reduced Share Standard, with either so that the minimum requirement for No Fund or a Capped Fund. In this section farmer owners would be one share we walk through how this could work, for every four kgMS supplied to the some key things to consider and why Co-operative (1:4), rather than the this is our preference. current share standard ratio of 1:1. FROM (BEFORE TEMPORARY CAP) TO Limited flexibility: Increased flexibility: » Share standard of 1 share/1 kgMS (1:1) » Share standard of 1 share/4 kgMS (1:4) » Maximum shareholding of: » Maximum shareholding of: – 2x supply; or – 4x supply; or – For shares held in excess of supply, up to 5% of the – No change Co-operative on a look-through basis Minimum shareholding requirements based on milk No change. supply over a rolling three-season average. Dividends are discretionary and paid in respect of each No change. share held. Farmer owners have 1 vote per 1,000 kgMS supplied No change, so long as you continue to hold shares on a 1:1 in the previous season to the extent the supply is basis relative to your supply in the previous season. If you backed 1:1 by shares. choose to only hold the minimum required shareholding of 1:4, you would have fewer votes than a farmer who holds 1:1. See also the scenarios on pages 10-11. Shares traded on the Fonterra Shareholders’ Market Shares traded on the FSM (or a similar farmer-only (FSM) (or a similar farmer-only market) and able to be market) only. Fund bought back or capped, so no ability exchanged into units in the Fund. to exchange shares into units. Share price set by reference to public unit market Share price set in a farmer-only market. alongside the farmer-only market. Share-Up Over Time and MyMilk contracts. Share-Up Over Time and MyMilk contract supply options would be phased out (although all existing commitments would be honoured). The Co-op can deduct, for tax purposes, dividends Under current tax legislation, the amount of dividend paid on supply-backed shares, so shareholders are that can be passed through to farmers pre-tax would paid a pre-tax dividend on those supply-backed shares. reduce. However, the Co-op would be able to impute Farmer shareholders are then required to pay tax on these dividends with income tax paid by the Co-op after these dividends. tax losses are used. See further discussion on page 13. 7
C APITAL STRUC TURE CONSULTATION 2021 Reducing the share standard would make it easier for new farmers to join our Co-op and give more flexibility REDUCED SHARE STANDARD REDUCED SHARE STANDARD No Fund Capped Fund to existing farmer owners who may want to free up capital or who are EXTERNAL working through succession. In line FARMERS FARMERS INVESTORS with the Co-operative Principles, the financial benefits and obligations Tradeable Units Tradeable that arise from capital invested would shares shares 1:4 share 1:4 share still be allocated in proportion to standard standard FSF shareholding. Control and voting rights would be based on share- backed supply in the same way as today. The caps on share ownership are intended to protect against significant levels of concentration No Fund Capped Fund of individual ownership within the » Removing the Fund would involve an » A Capped Fund would involve the farmer owner base. offer by Fonterra to unit holders to Fund remaining part of Fonterra’s buy back their units at a fixed price. capital structure and listed on the However, reducing the share standard The approval of at least 75% of unit NZX/ASX, but with one key change in would result in more shares that don’t holders entitled to vote and voting that farmer owners would no longer need to be held by farmers to supply would be needed for the offer to be able to sell any further economic the Co-op – or “non-compulsory” be accepted. rights of shares into the Fund. Shares shares. If exchangeability with the would be tradeable in the FSM only. Fund remained in place as in our » The offer amount would need to be current structure, farmer owners acceptable to unit holders, fair to » As at 31 March 2021, the Fund could sell the economic rights of farmers and would need to make had 105 million units issued, which these non-compulsory shares into more sense to the Co-op than the comprised 6.5% of total Fonterra the Fund (i.e. exchange shares into Capped Fund alternative. shares. Capping the Fund would units to sell those units), causing mean that it could get smaller, but the Fund size to grow and exceed it would not get bigger, other than the thresholds that protect farmer in limited circumstances such as ownership and control of the Co-op. where a distribution reinvestment plan is offered. Because of this, if we want » Members of the public and other to provide more capital investors, including farmer owners, flexibility, then we expect that sharemilkers, retired farmers we would need to take one of and non-farmer investors, could the following actions in order continue to trade units in the to protect farmer ownership NZX/ASX with units continuing to receive distributions in line with our and control: performance. Farmer owners would » Buy back and remove the Fund also still be able to exchange any (No Fund); or units they hold for shares in the FSM. » Stop the exchangeability of » This means that the size of the Fund shares for units in as a proportion of our Co-op could the Fund and thereby cap the size not increase materially, but it could of the Fund (Capped Fund). decrease if farmer owners exchange units they buy or hold into shares. Both these options would be effective Fonterra could also potentially buy it at protecting farmer ownership and back in the future – partially or fully. control of the Co-op. » There could be an ongoing price difference between the traded price of shares in the FSM and the traded price of units in the Fund, for the reasons described in the key things to consider on page 12. 8
3 – THE PREFERRED OPTION AND WHAT IT WOULD ME AN FOR US HOW IT COULD WORK: Below is our current thinking on how a Reduced Share Standard structure could work, having looked at different options for some of the features, such as the 1:4 share standard and the 4x cap on shares. We are keen to hear your views on these points over the course of the consultation process. » New members joining the to the existing limit on shares that if you only held the Co-op and farmers that are in excess of supply, being 5% of minimum 1:4, you would have sharing up would need to buy total shares on issue on a look- fewer votes than if you held 1:1. shares to match 25% of their through basis. See also the scenarios on supply at a minimum. pages 10-11. » Shares would continue to be » Shared-up farmer owners would traded on the FSM (or a similar » The Share-Up Over Time and be able to sell down to 25% of farmer-only market) with either MyMilk contracts would be their supply. This might only be No Fund or a Capped Fund. This phased out and replaced with a allowed in stages – potentially means the implications of a standard period for all farmers over several seasons. farmer-only market outlined on to share up to the Reduced Share page 12 would likely apply. Standard when joining, and to » Any vouchers would be cancelled sell their shares when exiting. (as holders would not need them » Dividends would be discretionary We suggest extending the to count towards the Reduced and paid in respect of each share share-up and sell-down periods Share Standard). held (as they are today). to five seasons (up from three » Minimum shareholding » Voting rights would remain as seasons today). requirements would be based on they are today, in that farmer » We would continue to honour milk supply over a rolling three- owners would have 1 vote per all existing Share-Up Over season average (as it is today). 1,000 kgMS supplied in the Time and MyMilk previous season so long as you » Farmer owners would be able contractual commitments. continue to hold shares on a 1:1 to own up to four times their basis relative to your supply in supply in shares, but still subject the previous season. This means 9
C APITAL STRUC TURE CONSULTATION 2021 COMPARING THE PREFERRED OPTION TO OUR CURRENT STRUCTURE FOR FARMERS Every farmer’s situation would be unique indication of how things could change if we were to evolve our structure at different stages of your business life to a Reduced Share Standard with cycle. Note that these are on the basis either No Fund or a Capped Fund. that any transition to the preferred But the hypothetical scenarios below option has been completed. are designed to give you a high-level SCENARIO CURRENT STRUCTURE PREFERRED OPTION FIRST FARM OWNER » Minimum shareholding requirement: » Minimum shareholding requirement: » Planning 80,000 shares 20,000 shares to produce » Maximum shareholding: 160,000 shares » Maximum shareholding: 320,000 shares 80,000 kgMS » Flexibility: » Flexibility: » Holding no shares – Purchase 80,000 shares over three seasons – Purchase 20,000 shares over five seasons or units during the share-up period during the share-up period – Apply for a Share-Up Over Time contract – Invest further in the Co-op and hold up and commit to supply the Co-op for to 320,000 shares the term (e.g. 6 years), and pay a contract » Voting: 20 votes if 20,000 shares held; fee (currently 5c/kgMS) for 80 votes if 80,000 or more shares held non-share-backed supply – Supply MyMilk under contract with no shareholding requirement, and pay contract fee on all supply (currently 5c/kgMS) for up to five seasons – Invest further in the Co-op and hold up to 160,000 shares » Voting: 80 votes if 80,000 or more shares held GROWING FARM » Minimum shareholding requirement: » Minimum shareholding requirement: OWNER 160,000 shares 40,000 shares » Average production » Maximum shareholding: 320,000 shares » Maximum shareholding: 640,000 shares on first farm is » Flexibility: » Flexibility: 80,000 kgMS – Purchase remaining 60,000 shares for – Sell up to 60,000 shares to free up capital, » Second farm second farm over three seasons during (e.g. for second farm investment) expected the share-up period – Invest further in the Co-op and hold up to produce 80,000 kgMS – Apply for a Share-Up Over Time contract to 640,000 shares for 60,000 kgMS, but would need to » Voting: 40 votes if 40,000 shares held; » Holding 100,000 commit to supply for the term, and shares 160 votes if 160,000 or more shares held contract fee (currently 5c/kgMS) for non-share-backed supply – Supply MyMilk from second farm under contract with no shareholding requirement, subject to contract fee (currently 5c/kgMS) and potentially sell 20,000 shares to free up capital for on farm investment – Invest further in the Co-op and hold up to 320,000 shares » Voting: 160 votes if 160,000 or more shares held 10
SCENARIO CURRENT STRUCTURE PREFERRED OPTION 3 – THE PREFERRED OPTION AND WHAT IT WOULD ME AN FOR US ESTABLISHED FARM » Minimum shareholding requirement: » Minimum shareholding requirement: OWNER LOOKING TO 200,000 shares 50,000 shares INVEST CAPITAL » Maximum shareholding: 400,000 shares » Maximum shareholding: 800,000 shares » Average production » Flexibility: » Flexibility: is 200,000 kgMS – Invest further in the Co-op and hold up to – Invest further in the Co-op and hold up to » Holding 200,000 400,000 shares 800,000 shares shares » Voting: 200 votes if 200,000 or more » Voting: 50 votes if 50,000 shares held; shares held 200 votes if 200,000 or more shares held RETIRING FARM » Minimum shareholding requirement: » Minimum shareholding requirement: OWNER LOOKING TO 120,000 shares 30,000 shares RELEASE CAPITAL » Maximum shareholding: 240,000 shares » Maximum shareholding: 480,000 shares » Average production » Flexibility: » Flexibility: is 120,000 kgMS – Sell up to 30,000 shares to free up capital – Sell up to 120,000 shares to free up capital » Holding 150,000 » Voting: 120 votes if 120,000 or more » Voting: 30 votes if 30,000 shares held; shares shares held 120 votes if 120,000 or more shares held 11
C APITAL STRUC TURE CONSULTATION 2021 KEY THINGS TO CONSIDER Impacts of a farmer-only market » In a farmer-only market there may owners would be required to trade » If we moved to this structure, shares be lower levels of trading (liquidity). shares to at least comply with would be traded within a farmer-only While we would retain a “market the Reduced Share Standard and market, either with the No Fund maker” – the registered volume some farmer owners may choose option or Capped Fund option. provider who is active in making bids to buy shares over and above their and offers on a minimum number of individual minimum requirements. » The biggest implication of trading shares in the FSM – the share price in a farmer-only market is that » The Fund also provides a mechanism could move more on small volumes farmers will set the price for for those with connections to the of trading in a farmer-only market. shares through trading amongst Co-op such as sharemilkers, contract themselves. This is likely to be » If we reduce the share standard and milkers, employees and retiring different to how outside investors more farmers wish to reduce their farmer owners to invest in the Co-op. value units in the Fund today. shareholding than those looking to With the No Fund option, this would increase, there could be sell-side no longer be available. » You may hear the potential price pressure, which could negatively difference in a farmer-only market impact the share price. This may referred to as a “restricted market Flexibility in how this structure be more apparent under certain discount”. Restricted market discounts could work circumstances. Examples include are commonly observed in any during transition to a reduced share We have put forward some of the market where participation is standard (if many farmer owners mechanics for how a Reduced Share restricted (in this case, to farmer choose to sell down), during a period Standard structure could work and owners). A restricted market already of milk supply decline and farmers we hope that these will help guide exists in other New Zealand who are reducing their volumes or our discussions during consultation. agricultural companies you may exiting sell their shares, or in times However, many variables are flexible, be invested in. when all farmer owners may be and we welcome your feedback. » We can’t be certain what the price negatively impacted by common » The Reduced Share Standard is difference might be, but the advice events such as low milk prices or intended to provide meaningful that we have received is that in widespread droughts. flexibility for farmers to reduce their normal trading the share price is » The impacts of a farmer-only shareholding while ensuring there likely to be in the range of 20-25% market could be different to what is sufficient ability for other farmers lower than if the current structure happens during the temporary cap to hold a greater number of shares was retained. If there are times we have implemented in order to without giving rise to a significant when there is stronger sell-side enable consultation. This is because concentration of ownership. We pressure – for example if farmers all compliance obligations are on propose that a share standard are experiencing financial pressure hold during the temporary cap ratio of 1:4 with a 4x maximum or otherwise need to sell shares and because we are consulting shareholding cap (or for shares (for example if milk supply falls) on potential changes so there is held in excess of supply, 5% on a – then the discount is likely to be a degree of uncertainty about look-through basis) strikes a good greater. our future capital structure. If a balance. A higher share standard Reduced Share Standard structure is ratio of say 1:2 might not provide implemented, then that uncertainty enough flexibility for new and young would no longer exist – some farmer farmers. A ratio of say 1:10 that 12
3 – THE PREFERRED OPTION AND WHAT IT WOULD ME AN FOR US allowed farmers to lower their share farmers are likely to hold more Tax impacts ownership even further would mean shares in proportion to milk supply » Currently the Co-op can deduct, the 4x cap would need to be higher than other farmers. for tax purposes, dividends paid so that there would be enough on supply-backed shares and » While all farmers would have some buyers in the farmer-only market. shareholders are subject to tax on equity in the Co-op through the This could potentially give rise to too these dividends. Reduced Share Standard, some may much concentration in ownership have greater equity than others. » The number of supply-backed shares with a small group of farmers, or Retaining the payment of dividends would reduce under a Reduced Share some farmers not having the level of on a “per share” basis and voting on Standard, so there would be a tax connection to the Co-op that keeps a “per 1,000 kgMS backed by shares” impact under current tax legislation, us strong together. basis, as they are today is intended in that the amount of dividend » We have maintained some variables to recognise this. that can be passed through to from our existing structure for shareholders pre-tax would reduce. » When it comes to voting rights and simplicity and continuity, such as the potential for concentration of » This would have the effect of the three-season rolling average, ownership, it’s important to note increasing the Co-op’s annual tax and dividend and voting rights as that because voting rights would be charge, but is not expected to have we do not think these would need “per 1,000 kgMS backed by shares”, a cash impact for the Co-op in the to change if we reduced the a farmer who continues to hold short term due to current tax losses share standard. shares on a 1:1 basis relative to their the Co-op can use. » We do not yet have firm views on supply in the previous season will the timeframe to share-up and retain the same voting entitlement » Once the Co-op has used those share-down to the new standard. as today, and a farmer who holds tax losses ($1.52 billion as at We are very open to your thoughts additional shares over the 1:1 basis 31 July 2020), the Co-op would on what you would like to see here. (up to the maximum shares at 4x start paying tax on earnings on Our current view is that we would kgMS supplied) would only have behalf of shareholders, and want to see any timeframes captured voting rights up to the 1:1 level, not shareholders would receive in the Constitution rather than their full shareholding. imputation credits to pass on through Share-Up Over Time the tax paid. » We welcome your views on contracts. At this stage, we have » The ability of individual farmer whether there should be any other suggested five seasons to share-up owners to utilise imputation mechanisms to support greater on joining the Co-op and five seasons credits to offset their tax expense alignment between farmers. to share-down on exiting the Co-op. would depend on their individual tax circumstances. Timing of Transition Co-operative alignment » We may want to transition to a » A Reduced Share Standard structure Reduced Share Standard over allows farmer owners to have multiple seasons by gradually different levels of capital invested reducing the share standard, rather in the Co-op relative to their milk than reducing it all at once. This supply which might mean that would help reduce supply-side farmers have different interests pressure in the farmer-only market. in the Co-op. For example, some We welcome your views on this. 13
C APITAL STRUC TURE CONSULTATION 2021 WHY THIS IS THE PREFERRED OPTION We prefer the Reduced Share Standard structure over the other options outlined in Section 5 for several reasons. » Overall, we think this structure measures well against the design principles for the review while remaining aligned with our Co-operative Principles. It supports a strong Co-operative and sustainable milk supply but still requires all suppliers to become farmer owners with “skin in the game”, and all farmer owners have exposure to both milk price and some earnings. » It is preferable to a Dual Share structure (outlined in Section 5) at maintaining a strong balance sheet for our Co-op. This is a high priority for us and was also reflected in farmer feedback. This is because retaining a single share would mean that all share capital is rated as equity (which would not be the case under a Dual Share structure where one of the shares may be partially classified as debt by ratings agencies). » We think it would be more straight forward to implement than other options. We have also reached a preliminary view that having No Fund would be preferable to a Capped Fund because it simplifies our Co-op. However, if we cannot reach an acceptable arrangement to buy back the Fund that 75% of voting unit holders support, then a Capped Fund would also work. In other words, we would only seek to remove the Fund at a reasonable price that was acceptable to unit holders, fair to farmer owners and made sense to the Co-op compared to the Capped Fund alternative. 14
Capital structure is an important conversation for us as owners. We want to hear your feedback on any or all of the topics discussed in this booklet. Do you think that there is a clear rationale for What do you think about the variables within this moving away from the current structure? structure such as: – the share standard ratio of 1:4 – the maximum cap on shareholding of 4x supply – the timeframe to share-up and share-down of five seasons – phasing out Share-Up Over Time contracts and/or MyMilk contracts – whether we transition to a Reduced Share Standard over 3 – THE PREFERRED OPTION AND WHAT IT WOULD ME AN FOR US several seasons, or if we change all at once What do you see as the benefits and challenges with a Reduced Share Standard structure? Do you see reducing the share standard as being effective at creating flexibility for farmers? Do you What are your views on how we support alignment believe that this will make it easier for farmers to between farmer owners on items like voting join and stay with the Co-op? rights? For example, should voting remain linked to share-backed supply, or should some other mechanism be considered? What are your views on moving to a farmer-only market and the potential impacts? Should sharemilkers and others working toward farm ownership be able to directly participate in the Fonterra Shareholders’ Market? 15
C APITAL STRUC TURE CONSULTATION 2021 4. How we got to this point A BRIEF HISTORY OF OUR CAPITAL STRUCTURE 1. THE FONTERRA SHAREHOLDERS’ MARKET (FSM) When Fonterra was formed in 2001, This is the farmer-only market where farmers trade shares in our Co-op Co-operative shares were issued to between themselves. The introduction of this market and the other TAF farmer owners in proportion to supply. amendments in 2012 meant that our Co-op no longer had to issue and Our Co-op redeemed the shares of redeem shares. exiting farmers and those who reduced supply for cash at a value that was set annually by an independent valuer. 2. THE FONTERRA SHAREHOLDERS’ FUND (FSF OR FUND) When a large number of farmers exited or reduced supply (e.g., during periods This is a managed investment scheme under the Financial Markets Conduct of drought), our Co-op had to redeem Act. It is listed on the NZX Main Board and on the ASX, and units in the those shares and pay out the value – FSF can be bought and sold by the public in the same way as any other known as “redemption risk”. listed security. In 2012, we implemented the current Units in the FSF give the holder access to the economic rights in a share Trading Among Farmers (TAF) structure, (such as distributions or dividends). Like any member of the public, primarily to manage redemption risk. farmer owners can also trade units in the FSF. There are two key parts to TAF, which are illustrated on the right. 16
4 – HOW WE GOT TO THIS POINT To be part of our Co-op, the current Farmers can buy or sell shares on the 20% of our total shares on issue, and minimum requirement is to hold one FSM. Farmers can also sell the economic an Aggregate Threshold of 15% for share for every kgMS supplied. This is rights of shares into the Fund (except the number of dry shares as a proportion based on a three-year rolling average when a temporary cap is in place). In of total shares on issue. As at 31 March supply. Farmer owners may, but are not this case, the farmer-owned Custodian 2021, the Fund size was 6.5% of our required to, hold additional shares, up holds legal title to the share and a unit total shares on issue and the Aggregate to 2x the minimum shareholding. For in the Fund is issued, which is then sold Threshold was 14.0%. If these thresholds any farmer choosing to leave the Co-op, on the market. Apart from two supply are exceeded, our Co-op would need there’s a requirement to sell shares offers early in the establishment of TAF, to take action to get back under the within three seasons at a minimum rate farmers have only been allowed to sell thresholds again. The most likely action of one third per season. the economic benefit of dry shares, not to achieve this under the current settings wet shares, into the Fund. Farmers can would be for our Co-op to allocate The number of shares that are matched also exchange units back into shares. capital to buy back units or shares. to milk production are known informally In this case the unit is cancelled and the as “wet shares” while the shares that TAF helped to address some of the Custodian transfers title to the underlying are held in excess of the wet share challenges we faced when it was share back to the farmer owner. requirement are known as “dry shares” implemented in 2012. – although they are in fact all the same When TAF was implemented, certain But it has been important to look at single class of share. protections were put in place in relation whether it will support our financial to the Fund size to help protect farmer sustainability into the future based on ownership and control. These included how much has changed since then. an Overall Limit on the Fund size of 17
C APITAL STRUC TURE CONSULTATION 2021 A RECAP OF OUR STRATEGY Capital structure helps us execute our what we needed to do to both reset our strategy successfully over the long- business and achieve sustainable value term, so it’s important we’re all clear over time, by responding to changing on where we’re headed as a Co-op consumer, customer and market needs. before implementing any changes to our We made some big decisions about the structure. Our 2019 refresh considered kind of Co-op we want to be. Recap of changes made in 2019 strategy refresh FROM TO Volume Value Global Milk Pools Prioritise New Zealand Milk + complementary components Maximum volume into consumer Focus on key categories to deliver superior value Dairy only Supplement with non-dairy where makes sense Partner with cash investments Partner with IP and skills and lift R&D Debt funded growth Conservative balance sheet Global giant with HQ in New Zealand Celebrate Aotearoa New Zealand and take it to the world Divest non-core businesses and focus where we have a Invest widely based on aggressive growth plans competitive advantage 18
SUSTAINABLE VALUE CORE FOOD PAEDIATRICS SPORTS MEDICAL DAIRY SERVICE & ACTIVE & AGEING Prioritising New Zealand milk Innovation Efficiency To create superior value Unlock greater value from for our customers and our scale efficiency and our Co-operative Sustainability focus on execution 4 – HOW WE GOT TO THIS POINT To do what’s right for the long term good and meet consumer and community needs OUR STRATEGY PRIORITISES NEW ZEALAND MILK Our strategy is about prioritising Raising additional capital is not We’re building good New Zealand milk and growing demand for it by understanding our customers, the purpose of this review. momentum and we are and differentiating our Co-op’s milk Having adequate and sustainable access well positioned to make the through innovation, sustainability to capital to fund our strategy is always most of future opportunities. and efficiency. front of mind, and raising additional capital is not the purpose of this review. We have been making good progress We are focusing on five categories We will fund our strategy through a across the Co-op, including improved – Core Dairy (cream, butter, cheese, strong balance sheet, cashflow, and business performance, a stronger milk powder), Foodservice, Paediatrics, through leveraging our IP and innovation balance sheet with reduced debt levels Sports & Active and Medical & Ageing. capability to partner in new products and and dividend payments being resumed. categories where it makes sense. Our strategic direction, combined with We already have a competitive advantage a diversified portfolio, has positioned in some of these five categories and This capital structure review is us well to navigate through a period of in others we are drawing on our dairy about prioritising New Zealand milk, unprecedented global uncertainty as a know-how and innovation capabilities protecting farmer ownership and result of COVID-19. While there is still to strengthen our positions. supporting a sustainable milk supply more work to do, we remain on track to The Co-operative Difference is over the longer term. deliver our targets. building on the work farmers have Our strategy is dynamic, and we will done over recent years to earn more always be reviewing our portfolio – premiums for our products based on asking ourselves what each asset is worth their New Zealand provenance and to us now and into the future. We will sustainability performance. continue to turnaround key parts of our We measure success on how we’re portfolio and divest non-core businesses progressing towards our three to support new investments as necessary. interconnected goals – Healthy Our focus is on maintaining a strong People, Healthy Environment and balance sheet to support growth. Healthy Business. 19
C APITAL STRUC TURE CONSULTATION 2021 HOW WE WENT ABOUT OUR CAPITAL STRUCTURE REVIEW We were clear from the beginning about of design principles. We shared these our objective: to have a capital structure with you after our annual results in that ensures our Co-op’s financial September 2020. sustainability so we can deliver value The wide range of alternatives that we for this generation and the next. looked at were assessed and prioritised We started by identifying what the key based on how well they met the objective elements of a financially sustainable and design principles outlined below. Co-operative are and developing a set Design principles Does the structure preserve farmer ownership and control of the Co-operative for Ownership & Control the long term? Does the structure support our ability to attract and retain high quality, sustainable Sustainable Milk Supply milk and provide financial flexibility for farmers? Does the structure protect value for current Co-operative members and allow farmers Protect Value to transact their membership / shareholding in a way that is fair? Does the structure align incentives between shareholders, unitholders and Align Incentives management, to maximise value? Does the structure manage redemption risk and economic shocks in a way that makes Build Resilience the Co-operative resilient? Is the transition to a potential new structure affordable, achievable and fair to Transition Effectively unitholders and farmer shareholders? Does the structure preserve balance sheet strength and provide access to capital at Access Capital a reasonable cost in the future? Is the structure simple to understand and simple to operate for both farmers and Simple the Co-operative? We listened to farmer views. While we would have liked to have been sample of 350 farmer owners, as well as out on the road discussing options the online survey available to all farmers It was clear from the outset that with you earlier, we have gained useful from January to February 2021 where we consultation for this review would be insights from farmer workshops on had around 1,800 responses. more challenging than last time because capital flexibility that were held in 2019, both shares and units in the Fund are Your feedback has very much helped to the roadshows after annual results and traded securities and we are legally shape the direction of the review so far. interim results, a phone survey we did required to comply with financial market in December 2020 of a representative continuous disclosure rules. 20
WHY WE HAD TO IMPLEMENT A TEMPORARY CAP ON THE FUND At the same time as launching this consultation process, we announced that we’d be temporarily capping the size of the Fund by suspending shares in the FSM from being exchanged into units in the FSF while we consult with you. We’ve done this to ensure that all options remain open to us as we have this conversation. As we progressed the review and started looking into options that included buying back the Fund, we identified a risk that, if we started consulting on options for change without temporarily capping the Fund, the Fund size could have grown significantly and taken the option of buying back the Fund off the table before you even had a chance to consider it. Some of the options have the potential to see differences emerge between the price at which a share trades in the FSM compared to what a unit in the Fund trades at, with units trading at a higher price than shares. If the temporary cap was not in place, anyone holding dry shares would be able to exchange them into units in the Fund. This could more than double the size of the Fund and make options that include buying back the Fund unaffordable in the context of our current balance sheet targets. That’s why we had to temporarily cap the Fund at its current size before consulting on options. This was necessary to enable full discussion with you without ruling out options that potentially buy back the Fund. It’s important to note that pricing under the temporary cap may not reflect pricing of shares in a farmer-only market. THE DETAILED FINDINGS OF THE REVIEW We heard what’s most asked you to select up to three areas The survey results are similar to the most important to you, and you can see feedback we’ve had from farmers who important to you. in the graphic below the percentage have left the Co-op in recent years. 4 – HOW WE GOT TO THIS POINT The online survey results confirmed that of respondents who put the following Essentially, the lack of flexibility in there is an appetite for change, with 62% factors in their top three. our current structure means that it’s of respondents either strongly or slightly challenging for new farmers to join Those areas in dark blue are the supporting a change. and can be a key factor for existing standouts, but we also heard that our farmers in deciding to leave the Co-op. The results also gave us an insight into capital structure should make it easy for what you consider are the main priorities new farmers to join the Co-op and for when it comes to capital structure. We existing farmers to have more flexibility. Maintaining farmer ownership and control of the Co-op 82% Making sure Fonterra has a strong balance sheet that is resilient 65% to changing milk supply & climate or economic shocks Providing a good return on investment 53% Making it easy for new farmers to join the Co-op 30% Giving farmers more flexibility about how much 18% they invest in the Co-op Being simple to understand 18% Providing growth in the capital invested in the Co-op over time 14% Aligning incentives between shareholders, unitholders 7% and management to maximise value Having a high share price 6% Being able to raise capital from non-farmer investors 4% 21
C APITAL STRUC TURE CONSULTATION 2021 HOW DOES OUR CURRENT STRUCTURE CONTRIBUTE TO US HAVING TO INVEST SO MUCH CAPITAL? The features of our current capital structure that influence the level of investment include: 1. The share price is partly set by reference to the value of units traded in a public market. Investors in public markets may value shares differently than farmers. On the whole, farmers are less diversified and have competing priorities for their capital – their investments are more focussed (i.e. in farming operations) and therefore it’s not possible to ‘diversify away the risk’ like an investor. Therefore, it is likely that farmers require a greater return from a share to make holding the share worthwhile. This means investors in the Fund may be more willing to pay a higher price for a unit than farmers would otherwise be willing to pay for a share. 2. The single class of Co-op share bundles together your right to supply the Co-op and the requirement to invest in its business, including value-added activities. This together with the current share standard means our farmer owners have little choice about the level of exposure they have to Fonterra’s value-added activities, and little flexibility around the level of investment required at various stages of their business life cycle. In addition to this, when our earnings increase, the share price should increase – so when our Co-op is doing well, our capital structure means it costs more for new suppliers to join and for existing suppliers to increase supply to our Co-op and the higher share price may also be a key factor for existing farmers to leave our Co-op. Overall, we believe that our capital structure is tilting the playing field against us when compared to other processors – the vast majority of which are corporates who don’t require any capital investment from farmers who supply them. We found that our current In the chart below: capital structure could create » Scenario 1 represents environmental changes, land use changes, and changes in challenges over time. productivity, and assumes that our market share continues to change at half the rate of the past five seasons. This scenario could result in a decline in milksolids Our current capital structure was put in collected to around 1,300 million kgMS in the relevant period. place when New Zealand milk supply was growing rapidly. Today, we have to be » Scenario 2 represents the same environmental changes, land use changes, prepared for a future of flat or potentially and changes in productivity, but assumes that market share continues to declining milk volumes. change at the same rate as it has over the past five seasons. This scenario could result in a decline in milksolids collected to around 1,200 million kgMS in the It is important to remember that under relevant period. our current capital structure, when milk supply declines, the number of wet shares » The scenarios start from the 2019/20 season’s actual milk collections of decreases and the number of dry shares 1,517m kgMS. MILK SUPPLY SCENARIOS (KGMS MILLIONS) increases by a corresponding amount. 1,800 We have tested our current structure 1,600 against potential declining milk supply 1,400 scenarios based on variations of the 1,200 kgMS (millions) average net loss of milk we’ve seen over 1,000 the past five seasons and the expected 800 losses from factors such as climate change, new regulations and alternative 600 land uses after allowing for potential 400 productivity gains. 200 0 2001/02 2003/04 2005/06 2007/08 2009/10 2011/12 2013/14 2015/16 2017/18 2019/20 2021/22 2023/24 2025/26 2027/28 2029/30 Fonterra Milk Collections Scenario 1 Scenario 2 22
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