Fonterra's 'asset beta' may be too low, propping up farmgate milk price, ComCom report finds
By Jonathan Underhill
April 11 (BusinessDesk) - Advisory firms that looked into the 'asset beta' Fonterra Cooperative Group uses to determine
the farmgate milk price say it may be too low, meaning its farmer-shareholders are receiving a bigger payout than
warranted under the company's enabling law.
The Commerce Commission hired Cambridge Economic Policy Associates (CEPA) and Freshagenda to establish whether
Fonterra’s proposed approach to estimating the asset beta for a "notional processor" - as set out in the Dairy Industry
Restructuring Act 2001 (Dira) - is appropriate. The Act sets out an approach to calculating the farmgate milk price paid
by Fonterra, to ensure New Zealand's dairy markets are efficient and contestable in the face of Fonterra's market
dominance.
A lower asset beta allows a higher milk price to be calculated. Last month Fonterra lifted its forecast farmgate milk
price to $6.55 per kilogram of milk solids from the $6.40/kgMS it projected in December, reflecting the improvement in
global dairy prices since then.
Under Dira, the commission conducts an annual review of the milk price 'manual' that Fonterra uses to calculate its base
milk price each season. The regime was put in place when Fonterra was created because there wasn't a competitive market
for the purchase of farmers’ milk. In the past two years, the regulator has concluded that the manual is largely
consistent with its statutory purpose under the Act but has been unable to reach a conclusion on whether the asset beta
is consistent with the Act.
Beta is a measure of the volatility, or systemic risk, of a security or a portfolio in comparison to the market as a
whole, according to Investopedia. A beta of less than 1 suggests the security is theoretically less volatile than the
market. Utility stocks typically have a beta of less than 1, which is important for Fonterra because the beta it
advocates, of 0.38, is based on a sample of electricity lines businesses.
Its adviser, Auckland UniServices, argues that the systemic risk for the notional processor is lower than for companies
in the same broad sector as "as the cash flows, and therefore asset beta, of the business are more similar to that of a
price capped/revenue capped business such as an electricity lines business," the report says. Fonterra makes a large
downward adjustment to the commission's asset beta estimate on the basis that the notional processor has lower exposure
to systemic risk because it can pass on commodity price risk to its farmers, paying them from the residue of revenue
after its notional and actual costs are taken out, including its weighted average cost of capital (WACC).
"The estimate of the asset beta is a crucial determinant of the WACC, and thus the farmgate milk price," the report from
CEPA and Freshagenda says. Its analysis indicates other dairy companies "are a reasonable proxy for asset beta in the
dairy industry in general, and the notional processor in particular," and indicates an asset beta range of 0.45 to 0.58.
"We have not seen sufficient empirical support for an asset beta below the bottom end of this range," the report says.
It does acknowledge that the risks faced by the notional processor are limited given that the Dira price risk is passed
on to farmers via the farmgate milk price.
"This might suggest that the business is very low risk compared to comparator companies that may face commodity price
risk," the report says. "However, our analysis indicates that dairy price variation is not correlated with general stock
market movements, and so may not be systematic."
The report says the argument that a sample of electricity utilities is the best proxy for the notional processor "is
unconvincing." It says in a mature economy such as New Zealand, drivers of electricity lines business revenue is
somewhat decoupled from economic growth and is more influenced by factors such as changing patterns of electricity
demand and supply.
The commission monitors the milk price manual but has no powers of enforcement. For 2017-18, the regulator's "primary
focus of our calculation review for this year will be the estimate of the asset beta and estimated cost of capital used
in the calculation," it has said.
“While our recent reviews have found the way Fonterra sets its milk prices is largely consistent with the Dira, we
continue to be concerned that Fonterra has not provided sufficient evidence to support using an asset beta lower than
that of comparable processors,” commission deputy chair Sue Begg said in a statement released today with the report.
The commission is seeking feedback on the report by 5pm on May 9 and will then confirm the next steps for its review of
this year's milk price calculation, it said.
The government has put on hold an amendment to Dira that had been prepared by the previous National-led administration
and in February, Primary Industries Minister Damien O'Connor said the move would allow a broader review of New Zealand's
dairy sector and whether it is adding enough value to the nation's biggest export commodity. The legislative amendment
followed a Commerce Commission review triggered by Fonterra's share of South Island milk falling below a Dira threshold
which concluded Fonterra's market dominance still warranted regulation.
Units in the Fonterra Shareholders' Fund, which are entitled to dividends from Fonterra's ordinary shares, last traded
at $5.73 and have fallen 5.5 percent in the past 12 months while the S/NZX 50 Index rose 17 percent.
(BusinessDesk)
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