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Cooperation versus investor returns - the future of dairy farming in Australia

Short term investment returns must be weighed against the long term interests of Australian dairy farmers.

The battle is heating up between Australia’s Murray Goulburn Co-operative, Bega Cheese Ltd and Canada’s Saputo Inc. over the acquisition of Warrnambool Cheese and Butter Factory Ltd (WCB). Much of the discussion around who will end up buying WCB has focused on share price and investor returns, but there are much deeper issues at stake. These relate to the tensions between long term collective ownership of dairy supply chains by Australian farmers and the short term gains of shareholders. How this battle unfolds may decide the future of farmer control over Australia’s dairy industry.

Australia’s dairy industry is built on a foundation of small family owned firms

According to Dairy Australia the Australian dairy industry is estimated to be worth around AUD $13 billion and directly employs approximately 43,000 people. It also generates employment and economic value through a range of related and supporting industries such as transportation, distribution and R&D.

The supply chain of the Australian diary industry starts with some 6,686 registered dairy farms, the majority (68%) of which are located in Victoria. Most of the dairy farms in Australia are family owned and operated small businesses that produce fresh milk on a daily basis. Only about 2% of dairy farms are corporates.

Australian registered dairy farms by state. IBIS World 2013

While the total national dairy herd in 2012 was around 1.63 million cows the average herd size per farm is 240 cows. The estimated combined turnover for these dairy farms in 2013 was about $4 billion. This makes dairy the nation’s third largest rural industry.

As a community of small businesses the bargaining power of dairy farmers is generally low. Key factors that impact on their farm’s profitability are the domestic price of milk at the farm gate, the demand for milk, and the price of key inputs such as electricity and animal feeds. The impact of drought can also play a significant role.

There is little the average farmer can do about rainfall, but deregulation of Australia’s milk markets over the past 30 years has exposed these small businesses to competitive market pressures. This has forced farmers to invest more in economies of scale and technology designed to enhance on-farm productivity.

Despite such investment the total number of dairy farms has fallen from a peak of 20,300 in 1982 to its current level. There also a correlation between the farm gate price of milk and the attrition rate of family-owned farms. Periods of low farm gate milk prices often increases the flow of farmers leaving the industry.

A modest growth in milk production over the next five years is forecast due to improved herd management and greater economies of scale. However, the total number of farms is expected to fall. Farm management and the application of greater science and technology to herd health, pasture production, feeding and milking systems will be critical to success.

Milk processors and manufacturers control the system

Downstream from the farmers are the milk processors and dairy product manufacturers who control both the farm gate price and the export and domestic market distribution channels. Dairy product manufacturing is capital intensive and requires large scale and scope in operations to be economically viable.

Utilisation of Australian milk 2011/2013. Dairy Australia 2013

In Australia the utilisation of milk is segmented into cheese (34%), butter (29%), whole milk (25%), whole milk powder (WMP) (11%) and other products such as yogurts and specialised whey proteins. This is consistent with international market trends.

Today the Australian milk processing and manufacturing sector is dominated by a handful of large firms. These include several foreign owned subsidiaries, Australian Stock Exchange (ASX) listed corporations, and farmer owned co-operatives.

Australia’s leading dairy companies. IBIS World 2013

In terms of foreign owned businesses there is New Zealand’s Fonterra, Italy’s Parmalat and Lion (formerly Lion Nathan), which is a wholly owned subsidiary of Japan’s Kirin Holdings.

Although Fonterra is a farmer owned co-operative in its home country, it is not so in Australia. It represents the interests of the 10,500 New Zealand dairy farmers who are its shareholders. Fonterra owns the Anlene milk, Anchor butter, Fernleaf and Anmum powered milk and Mainland and Chesdale cheese brands.

Lion Pty Ltd is a major player in the Australian dairy industry via its National Foods division that Kirin acquired in 2007. This owns the brands Pura, Dairy Farmers, Farmers Union, Moove, Dare, Big M and Masters in milk; the Coon, King Island and Heritage brands in cheese, and the Yoplait brand in yoghurt. In 2008, in conjunction with WCB, it purchased the NSW co-operative Dairy Farmers Group.

Traditionally farmer owned co-operatives dominated Australian dairy processing sector. However, today most have been converted into investor owned firms and listed on the ASX. Victorian based Murray Goulburn is the largest remaining dairy co-operative and accounts for just over 30% of Australia’s national milk production. It owns the Devondale brand in milk, butter and cheese, as well as the Liddell’s lactose free dairy brand and the Ascend brand in sports and nutrition products.

New South Wales based Norco is the other major dairy co-operative with its own company brand. It holds a small share of the milk, cheese, butter and cream market and also manufactures ice cream. However, Norco is much smaller than the Victorian based Bega Cheese. Founded in 1899 as a farmer co-operative, Bega demutualised in 2008 and listed on the ASX in 2011. It acquired a 15% stake in WCB in 2010. The following year it merged with Tatura Milk Industries Ltd

This leaves Victorian based WCB as the other major player within the Australian dairy processing sector. Established in 1888, WCB was listed in 2004 and has a strong track record in export as well as forming alliances with larger companies. For example, it formed an alliance with U.S. food giant Kraft as early as 1935. Two of the largest shareholders in WCB are Bega and Murray Goulburn who each held around 17% of the company’s share capital in August 2013.

Saputo versus Murray Goulburn versus Bega Cheese

The current battle between Saputo and Murray Goulburn over the acquisition of WCB needs to be understood within the broader context of the abovementioned structure of Australia’s dairy sector, and the globalisation of the dairy industry. While its share of the Australian domestic market may be modest, its export success makes it an attractive acquisition for any dairy processor seeking to expand into the lucrative Asian markets.

According to Euromonitor International the global market for dairy products is worth around USD $377 billion and is segmented into whole milk (39%), cheese (29.7%), yoghurts and sour milk drinks, and other dairy foods. Australia exports around 38% of its milk production, which generated about AUD $2.76 billion in international income in 2012. This is important because dairy is one of the most rapidly growing industries, driven by demand from emerging economies such as China and India.

WCB has established strong export markets. Around 40% of its cheese production is exported to Japan, Korea, Europe, the USA and parts of South East Asia. It also exports butter to these same countries as well as the Middle East and Russia, and has a substantial overseas market for milk powder, whey protein concentrates and nutritional supplements. Last year it signed an agreement with the Mitsubishi Corporation of Japan to supply premium milk powders.

Saputo’s interest in WCB has seen the company’s share price rise sharply. The offer of $9 per share made on 16 November was quickly accepted by the company’s board. However, a similar offer by Murray Goulburn and cash and shares offer of $9.17 by Bega Cheese were rejected by the WCB Board. The WCB Board’s antipathy of towards a takeover by Murray Goulburn dates back to at least 2010 when they rejected an acquisition offer from the co-operative.

The case in favour of the Saputo bid has been couched in terms of the Canadian food processing giant’s ability to bring to Australia significant investment and global marketing capacity. It has also been described by WCB Managing Director David Lord as significantly less risky than the Murray Goulburn and Bega Cheese offers.

The argument against Murray Goulburn has been based on the co-operative’s debt to equity ratio. This has led to discussions within the co-op over the partial float of the company in order to raise sufficient capital to recalibrate their balance sheet. The Australian Competition and Consumer Commission (ACCC) have also expressed concern over whether a takeover of WCB by Murray Goulburn would lead to a decline in market competition. In the case of Bega Cheese, the rejection of their offer was in relation to questions over whether the inclusion of 1.5 Bega Cheese shares within the deal was a true value reflection of the Bega shares.

Choosing between investor returns or farmer control

While the arguments over who should take over WCB have been largely focused on investor returns, there is a broader debate taking place over the impact of foreign ownership and the impact on the nation’s dairy farmers. As discussed above the Australian dairy industry is already dominated by foreign companies. If Saputo’s bid is successful it will further increase the level of overseas ownership.

Foreign ownership of Australian dairy manufacturing and export is not inherently bad. However, for the thousands of small, family owned dairy farms, the lack of bargaining power in the market may be a cause for concern. Co-operatives such as Murray Goulburn offer farmers greater control over the future of their industry because they are the owners of such businesses.

As member owned and focused enterprises, dairy co-operatives serve the interests of the small family farm businesses. Farm gate pricing is set at a fair rate designed to maintain the economic viability of both the co-operative and the farmer. Unlike investor owned firms that need to pay substantial returns to shareholders, the purpose of a co-operative is to improve the relative competitiveness of their members.

Murray Goulburn has demonstrated its commitment to its farmer members through initiatives such as the “Next Generation” program. This offers younger producers a package including financial support for cash flow and capital acquisitions, negotiations with major investors over farm expansions, recruitment of 457 visa skilled workers and long-term credit over key inputs. The aim is to help build up a strong and viable member base of local dairy farmers.

In terms of farm gate milk pricing Murray Goulburn acts as a “pacemaker” in setting the benchmark for milk pricing. The co-operative follows a policy of taking all the milk its members wish to supply in order to help them grow their own farm businesses. By comparison the investor owned dairy processors typically take only the milk they want, and will set their price above or below that of Murray Goulburn depending on the level of demand they have.

For “pacemaker” co-operatives the risk is that their farmer members may be tempted to sell to competitors in order to secure price premiums when market demand is high. However, if too many producers choose to free ride on the co-operative’s floor price, it may weaken the business in the long term. The existence of a large co-operative such as Murray Goulburn in a dairy market generally helps to keep prices stable at the farm gate. Yet where there is no co-operative farmers are forced to be price takers.

However, as one Victorian dairy farmer and member of Murray Goulburn recently told me, she has sometimes been tempted to take a higher price today and not support the co-operative. Yet she also recognises that if the co-op did not exist there would not be the Murray Goulburn price plus a mark-up, there would just be whatever the other processor was willing to offer.

In NSW where Norco is not large enough to serve as a pacemaker, farm gate milk prices have been negatively affected by the two-tier pricing structure introduced by Lion’s National Foods. This was explained by IBIS World in the following terms:

In spring, Farmers are offered a significantly lower price for tier-two milk, which is sold once the capacity of premium (or tier-one) milk has been reached. Downward pricing pressures and possible knock-on effects from reduced supermarket prices are constraining industry growth.

The final decision over who controls WCB raises questions over how much influence Australian farmers will have in the future of their industry. Short term investment returns will need to be weighed against the longer term best interests of the Australian dairy farmer.

Note: Tim Mazzarol has received funding support from the Australian Research Council, Co-operatives WA, Co-operative Bulk Handling and Capricorn Society Ltd, but these organisations have had no direct involvement in this article. He is also President of the Small Enterprise Association of Australia and New Zealand (SEAANZ).

SEAANZ is a not-for-profit organisation founded in 1987. It is dedicated to the advancement of research, education, policy and practice in small to medium enterprises.

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