Communication from Fonterra Co-operative Council

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June 2021

Capital Structure review

Feedback so far
We’ve pulled together a summary of what we’re hearing, as many of you are
keen to understand what your fellow Co-op members are thinking.
Around 4,000 have already attended a consultation meeting or joined a
webinar. More meetings are scheduled throughout the regions, a lot of Co-
op members are still digesting information, and many have yet to share or
discuss their views and ideas.

Feedback so far reflects the diversity of our Co-op. There are some common themes, and there
is also some divergence of view.
Here’s our summary of key messages so far:
• Members are pleased with the genuine consultation process that has been
implemented
• Understanding is still developing
- We are in the early stages of consultation.
- Many farmers are attending meetings seeking information and have not yet formed a
view.
- Most need more time to digest the options, work through some of the complexities and
test their own beliefs.
- There is appetite for smaller discussion groups to build understanding.
• Most understand why we need to consider change
- Intergenerational succession is important.
- There’s recognition for the Board raising the issue now, which is an outcome of the
work done to set threshold limits to protect farmer ownership and control when Trading
Among Farmers (TAF) was introduced.
- But there are mixed views on whether we need to address anything immediately.
This has led to common messages and questions on:
• Share price impact and discovery
- Common questions are about:
o loss of value and uncertainty of future share value (short and long term) due to the
restricted market and potential changes to the supply / demand balance arising from
the number of non-compulsory shares at a 1:4 share standard
o the impact on dry shareholders (in particular those exiting the dairy industry), some
of whom have already committed their share capital to their next venture but have
not sold yet
o the impact on those who have recently fully shared up.

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- Shareholders want to understand more about share price discovery and transparency
under the preferred option.
• Milk supply
- It is generally well accepted and understood that milk supply is crucial to Co-op
efficiency and performance.
- Many are supportive of addressing this through flexibility.
- Some of the supply challenges are not as well understood in regions where there is no
competition or less environmental pressure.
- Members are keen to:
o see more data on forecast milk supply
o understand the impacts on milk price and earnings if milk supply declines.
• Performance
- Shareholders seek more confidence about performance and future earnings as the
delivery of earnings in a farmer only market is seen as the key driver to share value.
• 1:4 Share Standard
- Common questions are:
o Should flexibility be available to all or could a more targeted approach be beneficial
to milk supply while protecting more of the current value in shares?
o If there is too much flexibility, will shareholders trade a large number of shares
shortly after the change to a 1:4 share standard, impacting share value?
o Is it possible to predict future trading behaviours?
o Who will be the buyers of shares in a 1:4 scenario?
o Reflecting that farmers are a homogenous group of investors, in times of financial
difficulty (e.g. drought) will many seek to share down?
• Impact on loyal / shared up suppliers
- There appears to be a trade-off between protecting current value in shares and
providing flexibility to ensure a sustainable milk supply.
- But does the preferred option have the balance too tilted in favour of the enduring Co-
op and newcomers to the Co-op, not long-term or fully shared-up suppliers?
• Bank funding
- Questions are around how lenders might respond, including as a result of share price
drop, and impact on interest rate margins.
• Transition
- Effectively and fairly managing transition to any new capital structure is essential, and
having confidence in and a good understanding of this will be critical to decision
making.
• Young farmers, sharemilkers, MyMilkers, contract milkers and managers
- Many in this group seek reduced capital constraints through more flexibility in our
capital structure, and see the Board’s preferred option as providing an achievable way
of being part of the Co-op but also believe some skin in the game is important.
- Others in this group feel the share standard should stay at 1:1 as reducing it departs
from a true co-operative and may result in significant negative impacts in 20 years’
time.
- Some in this group:
o see a need to have a strong share value that will reflect the success of the Co-op
and reward the members that are loyal to it
o would be prepared to 100% share-up over time if they felt it was a good investment
based on current and future earnings.

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Topics we believe warrant further discussion with members
• Control and influence
- Good governance should control influence - is the soft influence of the Fund any worse
or different than the soft influence of a large number of holders of dry shares?
- How will the 1:4 share standard, and how could the 4x share-up limit, impact control –
including what level of control could the largest 10% of farmers attain?
- Further explanation on how selling down shares migrates voting power to fully shared-
up members.
• Voting
- Fonterra’s Co-operative Principles state that voting should be in proportion to milk
solids supplied, and under the Constitution this is limited to share-backed milk supply. If
the compulsory shareholding requirement changes to 1:4 should votes align with milk
supply, or a combination of milk supply and shareholding?
• Alignment of ownership, control and supply
- The implications of alignment / misalignment of ownership (shareholding), control
(voting) and milk supply.

Next steps for Council
• Attending the regional consultation meetings, and continuing to talk to members, to hear
your feedback.
• Seeking independent advice on the possible liquidity and restricted market discounts arising
from the preferred option.
• Reviewing other co-ops to inform discussion around the divergence of ownership, control
and supply.
• Understanding the milk supply scenarios and testing the assumptions they are based on:
- Scenarios have been presented – how realistic are they?
- What are the wider NZ dairy industry milk supply forecasts? How do carbon and
essential freshwater etc play into these and how might they drive milk flows down even
lower?
- What is the optimal milk volume for Fonterra?
• Better understanding:
- how the preferred option would function (in terms of transition and as a permanent
state) in reducing, stable and increasing milk supply scenarios
- possible tensions in the future between the Co-op not wanting more milk (nationally or
in certain areas) but members wanting more farmers in the Co-op who need to buy
shares
- taxation implications
- possible DIRA implications, and the extent of DIRA change required, process and
timeframes.
• Reporting back to you. Keep a look out for our further updates and emails.

Have your say
• Review the Capital Structure Consultation booklet online
• Read the Frequently Asked Questions
• Provide feedback here or email CS_Feedback@Fonterra.com

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Our view on the Q3 Business Update

• There has been continued improvement in performance, with Q3
results in line with expectations.
• Our Co-op’s scale, and ability to move milk to high value products and
markets, continues to enable it to respond to ongoing global pandemic
challenges.
• It is pleasing to see additional transparency, with EPS now being
reported at Q3 for the first time.


• The Board has taken a measured approach when approving the 2021/22 season Advance
Rate. The opening advance is 60% (rather than 65% as set out in the Advance Rate Board
Guideline) of the midpoint ($8) of the forecast milk price range ($7.25 - $8.75 per kgMS).
The Board advised it felt this was the prudent and responsible thing to do. It’s relevant to
note that the Advance Rate does not mean Fonterra is holding onto unpaid milk payments
for free, as there is a charge in the Milk Price Manual calculation to compensate for this.
• Famers will notice greater simplicity in the Advance Rate schedule for next season with the
removal of the capacity adjustment payment.

Questions put to Management
When Management presented the Q3 business update to Council our key areas of questioning
were:
• The basis for narrowing this season’s forecast milk price range resulting in a mid-point that
is 5 cents lower.
• The seasonal profile of the milk supply curve relative to manufacturing costs.
• What’s expected to impact earnings in the last quarter given NPAT at Q3 represents
normalised earnings per share of 34 cents and full year normalised earnings are forecast to
be towards the mid-point of the 25-35 cents range.
• Business performance and return on capital for key individual business units, including
Australia and Chile.
• The final financial outcome of the Beingmate investment, given the sale of the remaining
shares.
We have also requested medium term earnings expectations.

Independent analysis
Our independent financial analyst Northington Partners has summarised Q3 performance as
follows:

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Questions put to the Board

Below are three questions that we formally put to the Board this month, and
its responses. We deliberately asked similar questions to those we put to
the Board in Q1 and Q2:

Q: What key achievements were made during Q3 that demonstrate the implementation of
Fonterra’s strategy?
A: Q3 continues the story of the first half of the year. Fonterra has stayed on strategy and
focused on what’s in its control and this has come through in performance outcomes for the nine
months ending 30 April 2021.
Operationally, we’re continuing to experience some shipping delays but relative to global
competitors they remain minor and product has continued to get to market, thanks to the
partnership with Kotahi.
A few notable examples of implementation of strategy are:
• By shifting milk into higher value products, Greater China have improved their gross margin
from 14.6% to 16.2% for the nine months ending 30 April. While gross margins improved
across all three channels (Ingredients, Foodservice and Consumer) in Greater China, they
were particularly strong in Foodservice at 28.6% year to date, up from 21.5%.
• Following a stable third quarter and with a focus on improving sales pricing (driving value of
NZ milk), Asia Pacific’s Consumer EBIT is up 29% to $156 million. AMENA’s Consumer
EBIT is up 58% to $82 million.
• Having worked on the transition to renewable energy for some time, it’s been announced that
Fonterra will get out of coal by 2037.
• Debt reduction over the last couple of years and lower interest rates have reduced the
interest bill by $69 million for the nine months ending 30 April 2021.
• The sale of the shareholding in Beingmate has been completed, marking a full exit of
investment in the company. Fonterra’s sale of the two wholly owned China farming hubs in
Ying and Yutian has also been completed. These divestments are allowing prioritisation of
more resources around the Co-op’s New Zealand milk which is key to the strategy.

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Q: How well is Fonterra ‘on-track’ for meeting its current strategic objectives?
A: Under the three goals of Healthy People, Healthy Environment and Healthy Business, there
are a series of targets to measure progress against the strategy. For a detailed summary of
progress against these targets for this year please refer to the below table.
In relation to earnings, it is important to recognise that while year-to-date normalised earnings
per share are 34 cents, it’s expected earnings in the fourth quarter will come under further
pressure due to high milk prices. Guidance is being provided that full year earnings are expected
to be more towards the mid-point of the previously announced range of 25-35 cents per share.

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Q: What new and/or emerging challenges is Fonterra facing, in relation to its strategic
objectives, and how is it responding?
A: For the last quarter of FY21, the immediate challenge for the business relates to further
pressure on margins. While overall, stronger gross margins have been seen so far this year,
they’ve narrowed in the third quarter as the increasing raw milk prices have flowed through to
input costs and, in addition, the impact of pricing lags on sales contracts with major customers
has delayed the ability to pass through the increase in input costs.
As a result, increased pressure on margins is forecast in the fourth quarter. This is
compounded by the normal seasonal profile of the business, where we have ongoing fixed
costs but lower volumes of milk are being processed and sold. All of this means the fourth
quarter will be challenging from an earnings perspective and we expect the margin pressure to
continue into the first quarter of the 2022 financial year. Fonterra is responding through
activities to generate further demand for its products. It is also managing costs carefully,
through the financial discipline embedded in the business.
As mentioned above, we’re experiencing some shipping delays due to the congestion across
the global supply chain and we are continuing to work with Kotahi to get our product to market
and minimise the impact of increased shipping costs.
For the Co-op’s 2021/22 forecast Farmgate Milk Price, there are number of risks. These are
also relevant to the Co-op more generally and include:
• COVID 19, which is far from over;
• Impacts of governments winding back their economic stimulus packages;
• Foreign exchange volatility;
• Changes in the supply and demand patterns that can enter dairy markets when prices are
high; and
• Potential impacts of any geopolitical issues around the world.
These broader challenges are being responded to by staying on strategy and focusing on what’s
within our control. This includes being close to customers and understanding in advance their
consumption trends and local operating environments, as well as minimising risk by continuing
to sell milk into a diversified portfolio of consumption categories, in multiple regions/markets
around the world.



Reporting to the Board

In our May report to the Board we advised the following sentiment and
feedback from Co-op members:
• Sentiment about the direction and performance of the Co-op continues
to be largely positive, and there is general optimism about the dairy
industry.

• Research conducted in April on Council’s behalf by UMR Research showed that of the 1000
Co-op members surveyed:
- most are confident about their Co-operative and the New Zealand dairy industry;
- over half are likely to invest in their business over the next few years;
- four out of five members were more comfortable with Fonterra’s overall direction
compared to two - three years ago;
- around half say they understand Fonterra’s current strategy; and
- in terms of support for the strategy, over two-thirds believe that Fonterra has the
balance right between consolidation and growth.

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• The topic most frequently raised with Councillors (excluding the capital structure review)
over the last quarter has been Co-operative Difference. Many members are positive, or at
least understand why the framework has been introduced, but farmers are still developing
their understanding of how it works.
We have asked the Board to provide more information to members on:
• medium term earnings expectations (noting the 3 and 5-year guidance given with the FY19
results);
• how Management will measure the premium that’s created for our New Zealand milk;
• the return on capital being derived from key business units such as Fonterra Brands NZ,
Australia and Chile;
• global supply and demand outlooks; and
• milk price trends in terms of prices received by NZ farmers compared to farmers in key
overseas markets.


Key activities

Since our last update we have:
• Represented your views to the Board at its May meeting.
(See above.)

• Been briefed on the Capital Structure proposal by management and the Board, attended all
the Director led consultation meetings, and analysed and discussed the feedback we have
heard so far. (See above.)
• Met with Miles Hurrell (CEO) and Marc Rivers (CFO) to receive and discuss the Q3
business update, and discussed that update with our independent financial analyst
Northington Partners. (See above.)
• Made a submission on the Climate Change Commission’s draft recommendations. You can
read our submission here.
• Held farmer meetings in most Wards. The purpose of these meetings is to create regular
opportunities to connect with members and to capture your views and feedback.
• Worked with members of the Board to review the 2016 Governance and Representation
changes, as modified following the review of the Director election process in 2018 and the
review of Council in 2020. The conclusions and recommendations from this year’s review
will be shared with you shortly, for your feedback.
• Completed research to better understand members’ views and expectations, and started
drafting the first Letter of Members’ Expectations to be delivered to the Board. We expect to
share a draft of that Letter with you shortly, for your feedback.

The full Council met in May while in Auckland for the MyConnect conference. Key agenda items
were:
• The Board’s capital structure options, including presentations from two external advisers to
the Board on the expected outcomes of farmer-only trading (in terms of the restricted
market discount and risks of ownership concentration and voting), and the benefits of
retaining supply.
• The results of the research undertaken to inform the Letter of Members’ Expectations to the
Board.
• A presentation from Management on the 2021 Director election skills matrix

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Other Council activities
• Council Chairman James Barron has spoken regularly with Fonterra Chairman Peter
McBride. James conveys farmer feedback and Peter and James inform each other on the
progress of Council and Board workstreams.
• In April, around 75 Co-op members attended the Understanding Your Co-operative
Programme (UYCP), hosted by four Councillors. The June programme is full, with over 110
registered to attend, but there are still places available for the November/December event.
• Four Councillors represented farmer views and perspectives on matters relating to New
Zealand milk supply at the May meeting of the Board’s Co-operative Relations Committee.



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The information and opinions expressed in this report are those of the Fonterra Co-operative Council and
not of Fonterra Co-operative Group Limited (‘Fonterra Co-operative’). The Fonterra Co-operative Council
forms its opinions independently of Fonterra Co-operative. Fonterra Co-operative has not provided any input
into the content of this report and provides no warranty or assurance as to the accuracy, adequacy or
completeness of the information in it. Fonterra Co-operative does not accept or assume any duty,
responsibility or liability to any party (including, without limitation, in negligence) in connection with this
report.