Fonterra, New Zealand’s largest corporate entity, is facing its toughest test.

The co-operative must come up with a sustainable long-term capital structure to enable continued growth and it must do so during the most significant economic crisis since the 1930s.

Fonterra claims to have made several prudent moves and have a strong balance sheet, although that is disputed.

“We have $3 billion of stand-by facilities and we are comfortable at present with our financing lines,” chief executive Andrew Ferrier says.

Fonterra is also gathering $800 million through a substantially over-subscribed retail bond issue, paying no less than 7.75% interest.

That new debt alone will cost the co-operative $60 million annually, equivalent to 5c/kg milk solids on present milk production.

The company has not said what it plans to do with the $800 million raised (when only $300 million was first targeted), save a generalised need for working capital, followed by options in debt restructuring and acquisitions.

Mr Ferrier will not disclose the components of overall finance facilities, save to say it was a mix of short, medium and long-term.

“We stress test our debt structure and on every scenario we can foresee we are fine, on things such as equity outflow or bank failure,” he says.

However, the present economic crisis is the most significant since the 1930s and there may be unforeseen possibilities, Mr Ferrier said.

“We must maintain vigilance for the unpredictable,” he says.

Fonterra has a debt-to-debt-plus-equity ratio of 57%, well above the directors’ target band of 45 to 50%.

This is due to high inventory values and the need for working capital, some of which arises because dairy farmers are receiving a higher-than-normal advance milk payment ($4.05) as a proportion of the downwards revised $5.10/kg milk solids forecast for the 2008/09 season.

A sustainable capital structure is crucial, especially if any target companies are struggling.

“We need a secure level of financial flexibility to protect our core business through the downturn and generate a capital buffer to take advantage of the opportunities which will arise in today’s market,” says chairman Henry van der Heyden.

The directors took one partial privatisation solution to 11,000 farmer-shareholders about a year ago and were rebuffed.

Farmers were not comfortable with the idea of any sell-off of the giant co-operative, in which they have an equity of $4.6 billion.

However they realised the directors’ fears over redemption risk last February, taking $500 million out of the balance sheet by surrendering shares at $6.79 and buying them back a year later at $5.57.

That opportunity arose because of the falling fair value share price and was mainly caused by reduced milk production in the 2007/08 drought.

Redemption risk is also posed by farms leaving Fonterra to supply other dairy companies, although the aggregate of those defections has been outweighed by the recent conversions to dairying in Southland, Otago, Canterbury, Hawke’s Bay, Gisborne and the Central Plateau.

The company is now committed to a careful examination of the recapitalisation options with its Shareholders’ Council, which in its last annual report criticised directors for getting out of touch with shareholder opinion.

Part II: Finding solutions
Part III: Queen Street farmers and corporate accountability
Part IV: Global stagnation
Part V: Dirty Dairying