Value.able: Roger Montgomery

Times are tough, and investors need to be careful where they tread

Australia’s first dairy cows arrived in 1788 with the First Fleet. Understandably, poor grazing country, a lack of refrigeration and the overriding need for meat saw cows eaten and the nascent dairy industry put on hold. Towards the end of the following century, as refrigeration become more advanced and milk and its by-products could be stored and transported, co-operatives were established to process and market produce.

The industry was originally regulated to organise the export of Australia’s dairy products. In the 1980s and 90s, state governments controlled pricing for fresh milk and state dairy corporations were established to regulate quality and production. The result was that farmers who sold their milk into the domestic market received better prices than those who exported it.

With prices needing to fall, the deregulation of the industry occurred in 2000. In the 17 years since then, the co-ops were gradually incorporated (Bega Cheese) or sold (Dairy Farmers).

In Australia 6102 dairy farms manage 1,663,000 dairy cows and employ just under 40,000 people. The average dairy farm therefore holds 273 cows, each producing 5669 litres of milk a year. That’s 9.5 billion litres of raw milk production, and 321,900 tonnes of milk powders, 344,300 tonnes of cheese and 118,600 tonnes of butter, according to Dairy Australia.

Behind the wheat and beef industries, the dairy industry, which is heavily reliant on water (many operators contend dairies are simply “grass conversion” factories), ranks third largest with a gross value of $4 billion. And with 66% of production the dairy industry is concentrated in Victoria. But Victorian production is seasonal and tends to supply the export market. Year-round domestic supply is typically serviced by New South Wales.

Australia is only a small producer, manufacturing just 2% of global dairy produc- tion. However, 34% of our milk production is exported, earning $3 billion and making Australia the third largest exporter.

In 2001 the industry was deregulated and, unsurprisingly, a rationalisation (a euphemism for the financial hardship of thousands of people despite $1.73 billion being paid to farmers for restructuring) has occurred, leaving a core of more efficient producers that are trying to compete against heavily subsidised international competitors.

Australian milk prices are based on milk fat and protein content and prices received by farmers vary by manufacturer, by state and by farmer, who must negotiate a range of incentives and penalties implemented by processors and related to quality, productivity and ability to supply out of season.

Last season was described by many as “tough” for dairy farmers, with the impact of low international prices being compounded by a step-down in farm-gate prices. “Tough”, however, understates the situation, with many operators going to the wall. Margins for farmers are typically low and even negative. More recently, modest growth in milk production, generally favourable seasonal conditions and contained input costs all pointed to the industry entering a “recovery phase”, according to the latest Situation and Outlook report from Dairy Australia.

In the longer term the growing global population, along with increasing per capita annual consumption (from 101kg per person a year in 2005 to 111kg in 2015) should bode well for Australia’s high-quality products. Moreover, while annual cheese consumption in Japan is between 2kg and 4kg per capita, and close to 2kg in Korea and Taiwan, it is currently less than 100 grams in China.

The only limitation is that world dairy trade represents just 8% of total global production; Australia is responsible for just 6% of this global traded dairy, and therefore there are many competitors. But it is also worth noting that Victorian farmers are some of the lowest-cost producers globally, and Australia’s competitive position is enhanced to some extent by a lower dollar.

Investors in the sector should also be aware of Murray Goulburn’s impact on the supply chain. In early 2016 Murray Goulburn implemented a raw milk pricing mechanism that was designed to provide unitholders, along with farmers, exposure to increases in the realised profit per unit of milk solids. The structure, however, inadequately rewarded the unitholders for capital investments they made that were necessary to grow the company’s branded product capacity. The milk price and NPAT (net profit after tax) formula largely rewarded farmers, through high raw milk prices, for the returns generated by capital investment made by the company and its unitholders.

While dairy farmers became accustomed to processors announcing a season-opening price along with a forecast closing price, with regular “step-ups” through the season, Murray Goulburn and Fonterra, on realising the flaw in the model, cut the prices towards the end of the season, causing financial hardship and triggering legal action by the Australian Competition & Consumer Commission for alleged unconscionable conduct.

With the argument that there is money to be made in farming, but not by farmers, local operators have no choice but to become more efficient or leave. To that end, some operators claim that the sale or break-up of operator Murray Goulburn is the catalyst required to encourage further consolidation.