Arla Foods amba - the business case

Arla Foods amba - the business case This report considers the business case for potential investment in, and part ownership of, Arla amba via the Roadmap offer ( the offer ) made by the Milk Partnership Ltd to Arla Foods Milk Partnership suppliers and direct suppliers on 30th August 2013. It briefly evaluates the balance sheet of Arla amba, and appraises the investment case for making the commitment to invest according to various business scenarios. This report is only intended as a guide. It is not investment advice and it cannot take account of your own particular circumstances. You should not, therefore, take investment decisions without first taking the appropriate professional legal and financial advice. Investment rationale The investment rationale behind the offer is to buy into and become a part owner, along with around 12,000 other farmers, of the world s sixth-largest global dairy company (and the third largest co-operative), with global brands, and where all of the profits are returned to the owners. The company s mission is To secure the highest value for our farmers milk while creating opportunities for growth. Balance sheet The Arla Annual Report 2012 has all the financial details set out from page 58 onwards. This can be found at http://goo.gl/r2mulu. The key conclusion that can be drawn from reading this document is that Arla has a low level of bank debt, with the majority of capital reserves held in farmers names. They also have a stated aspiration to achieve investment grade balance sheet security, which underlines their commitment to building a secure, sustainable business. Based on this, there does not appear to be any area for concern in relation to Arla s balance sheet strength. Business model, trading performance and milk price determination The latest trading performance for the business can be viewed on the Media section of the Arla Foods UK website (www.arlafoods. co.uk). Understanding the business model, and therefore how the milk price is determined, is a good starting point for understanding the fundamentals of the investment and the ownership model. As a producer owned co-operative, Arla amba s business model is based on the premise that the organisation will purchase and process all of the milk from its members. What this means in practice is that if volumes increase then the business must be able to adapt accordingly something that can result in challenges, particularly given the volatility of supply we ve seen in recent years. This approach is why Arla is constantly seeking growth opportunities, to enable it to accommodate increased milk volumes and deliver a viable return from them. The pricing mechanism that the business uses is as follows: At the start of the year the Farmer Board of Arla amba agrees a percentage of turnover (currently 3%) that will be considered profit. Producers are then paid in the following way: 1. The on account price. This is the monthly milk cheque price paid out to producers based on the collective price across the international business. This is varied monthly. 2. The performance price. This is the gross milk price paid, i.e. the on account price plus the profit element. This profit element is split between: i. A 13th payment an annual bonus paid on profits ii. An individual consolidation this is a capital account where money is invested in the co-operative in the farmer s 1

name up to a maximum of 5ppl. This money can only be withdrawn from the co-operative if a producer leaves or retires from milk production. iii. The common consolidation this is a capital account where the money from all producers is held. Individual producers cannot access this money but it is used to support future investment and growth for the overall business, in turn strengthening the business and increasing its opportunity to deliver improved returns in the future. Of the above elements the on account price and the 13th payments are obviously key when making any investment/ownership decision. The investment and return on capital The total investment required to be a full member of Arla amba is 7.5ppl. Of this, two pence per litre will come from farmers existing investment in Milk Partnership Ltd, of which one pence per litre will convert into individual consolidation. A further three pence per litre will come from a bank loan repaid over five years and held as individual consolidation. This is paid back via a monthly levy in years 1 & 2 and a deduction from the 13th payment in years 3-5. A further one pence per litre will come from ongoing individual consolidation in years 1 and 2 (part of the profit element described above). This leaves a remaining 1.5 pence per litre, which will come from the thirteenth payments in years 1 and 2 (also part of the profit element described above). What this all means is that for every 1 million litres of milk output, a producer will need to invest 75,000 to get full membership of Arla amba. However, 40,000 (4ppl) of this is held as individual consolidation (3ppl from the loan and 1ppl from existing MPL investment) and would be repaid if the farmer was to subsequently leave the co-operative after year two. The other part of the investment is retained within Arla as common consolidation and used for reinvestment to benefit the whole business. In order to establish what a realistic return on the capital invested may be, we have reviewed the historic performance of the cooperative to see what milk prices would have been, compared to those paid to Arla non-aligned suppliers and Arla Tesco suppliers since 2007. This period has been chosen because it covers the period when international and UK prices increased by 20 per cent and when the Tesco aligned pool was created. All the monthly prices reported here have been provided by Arla (including balancing costs) and they take account of currency effects during the period. A summary is set out below: Summary of what average milk prices paid from July 2007 to August 2013 would have been for 1 million litres, 4.00% butterfat, 3.3% protein Contract price Pence per litre Arla on account price monthly price paid 26.18 Arla performance price inc. 13th payment 27.64 AFMP net price 25.98 Tesco TSDG price 28.17 Note: the Tesco price going forward for Arla amba members will have 0.7ppl added for those producers providing costings and complying with the TSDG scheme, i.e. the price would have been 27.64ppl plus 0.7ppl if this had operated over the past 7 years, so the Arla Performance price plus Tesco payments would have been 28.34ppl in the above table. 2

What does this mean? Assuming 7.5ppl had been invested in 2007 and the above prices paid, then the return on capital invested would have averaged 1.66ppl or 22.13 per cent. This would have represented a very good return, especially in light of the low risk profile of investing in a co-operative and compared to other investment options elsewhere. (Eg ISA rates at 2 3%). Risks going forward Ownership of Arla amba does not come without risks, however, and - as with all investments - historic performance is not always a guide to future performance. The key risks are: 1. Cashflow. The entry to Arla amba is, as far as the investment goes, cash flow neutral, because if the roadmap hadn t been developed then AFMP farmers would still be contributing 0.5ppl to MPL for two years. However, other dairy companies do not ask for this 0.5ppl, so there is an immediate cash implication here. The main cashflow risk relates to volatility, however (see point 4, below). 2. Currency risk. The milk price paid will be affected by currency. If the weakens against the Danish Krone then the returns will increase, and, conversely, if it strengthens versus the Krone then returns will reduce. This is almost impossible to predict! 3. UK market increases to match Arla performance price. There is no doubt that the emergence of the new EU pricing mechanism that UK ownership of Arla amba will bring will have an impact on UK markets, and possibly put upward pressure on UK prices. But it will also increase volatility see point 4, below. However, matching the thirteenth payment could prove hard for other processors. This has been worth an average of 1.46ppl over the past six years, so it has a significant impact. At this level it provides a return on investment of 19.2%. 4. Volatility. This is the biggest factor suppliers will need to take into account. The graph below illustrates this well: Price volatility of Arla prices versus UK prices (2007-13) Although the Arla amba Performance Price (red) betters the net AFMP price (green), and is similar to the Tesco TSDG price (blue), there are periods when it is significantly lower, e.g. May-Sept 2009 and September 2012, as well as periods when it is significantly higher, e.g. May 2008 and May-Sept 2011. This graph illustrates how the UK market has been partially insulated from international volatility, a point often contested in the industry. The key take-home message for producers thinking of making this investment is that they need to be prepared for the volatility and ensure that their businesses are competitive so that they can weather the storms and profit in the good times. They will get higher highs, and lower lows. Farmers thus need to question how volatility vulnerable their businesses are. 3

Conclusion Overall, though, the business case for investing looks good for those with the opportunity to invest. It will almost certainly be the best deal UK farmers are offered, as it is unlikely that Arla amba will make similar offers in the future to those who have the chance to join now, but who decline. The investment may not appeal to producers who are not planning to be in the industry long-term. But for those with a long-term commitment, who want to invest in a financially strong co-operative, then our view is that the opportunity, in general, represents a very sound investment for the right business. What is clear, however, is that the specifics of the offer will have different impact on different businesses, and so we have outlined a number of scenarios below to qualify our position. Scenarios for Arla amba investment decisions: Non-aligned AFMP members 1. Businesses with no succession and likely to exit in less than 5yrs For businesses with no succession and who are planning to quit milk production within five years then our view is that they should probably not consider joining Arla amba as the payback will not be realised. However Arla states that if a producer is staying in milk for as little as three years then it could still make financial sense to join as during that period they will accrue consolidation money. Thus, if any farmer is in this scenario then our advice is to assess your case with Arla and take other professional advice as you see fit well before the 15th November deadline. 2. Weak businesses where volatility could be an issue If milk markets were to see a decline in 2014-2016 then, given the historic record of the Arla price having a lower trough than the UK market price, there could be cash flow implications for weaker businesses. What s more, in the first two years there will be no cash profit share to support incomes. If cashflow is likely to be a major issue for the farming business then joining Arla amba could be seen as a higher risk strategy because of the potential volatility. Having said that, if a producer can get through the next two years, until thirteenth payments start to deliver a cash benefit, then joining a strong co-operative is likely to strengthen the farm s position in the longer term. In this instance a producer should take advice from their bank manager before making an investment decision. 3. Tenants or businesses with recent large investments and high debt As in scenario one, any decline in milk markets is likely to be more marked in the Arla amba price than the UK one. This means businesses with very little flexibility with bank support, or tenants with limited capital, should appraise the offer very carefully to see if they could withstand the short-term cashflow implications of volatility even if they believe their business has a long-term future. 4. Strong family businesses with long-term outlook Businesses with strong balance sheets, which are profitable, competitive and have a long-term outlook (that can withstand the short-term cashflow effects of any market downturn) should be very positive about the investment opportunity presented by joining Arla amba. The returns over a 7-10 year period could be very good and improve the world-class competitiveness of their businesses. 4

Aligned AFMP Members (Tesco and Asda ) Asda Farmers in scenarios 2-4 All Asda related activities will remain in place, in or out of the co-operative. Asda farmers should appraise the financial viability of the investment on the same criteria as non-aligned AFMP farmers. Tesco Farmers in scenarios 2-3 Aligned farmers in these pools who fit in the scenario 2 or 3 need to appraise the options very carefully, especially the cashflow effects on a weak business and the more volatile prices compared to the aligned cost of production contracts. Tesco Farmers in Scenario 4 For strong businesses on the aligned contracts then the Arla amba membership proposal offers good returns over the long-term, and should therefore be viewed positively. This is especially the case for producers who want to be in a farmer-owned business or who wish to be on market-related rather than cost of production contracts. The key question to assess, though, relates to the longevity of aligned retail pools. Will they be around in five or ten years time, for example? It is not a question that can be easily answered. Notice periods In all scenarios farmers must also bear in mind that if they become Arla amba owners, although their milk contract will be fully Voluntary Code compliant, the notice period terms will not be three months in the event of a price movement, as the farmers will be classed as co-operative members. The notice period will, therefore, be 12 months, although Arla states that there will be provision for shorter notice periods on payment of compensation. If the ability to move milk buyers quickly is an important criteria in a milk contract then the Roadmap offer is not an option, and switching to an Arla Direct contract would be more suitable. This is fully Code compliant with a three-month notice period. Prepared by Milk Marketing Network Kite Consulting LLP September 2013 If you have any questions about the content of this report then please contact Kite Consulting on 01902 851007. About Kite Consulting Kite Consulting is a modern consultancy company focused on delivering excellence to customers in farming and the allied industries. We operate a team approach, and our partnership of national specialists and leading business and technical consultants provides high calibre consultancy across the UK and internationally. What makes Kite unique is the quality of our people. Our consultants have talent, enthusiasm and motivation, which means the quality of consultancy we offer is second to none. And we are determined to provide practical and imaginative business advice through close working relationships with our customers. Because ultimately our success depends on your success. www.kiteconsulting.com 5