Merging co-ops may be the way to go, after all
Over the past couple of months two high profile dairy companies in the US – Dean Foods and Borden – have filed for Chapter 11 bankruptcy.
Their demise is a salutary lesson for those invested in the dairy sector and a reminder of how important it is to keep a tight rein on debt.
Borden is a 150-year old business which used to be revered by many in the Irish dairy industry.
Indeed, during the 1960s Ballyclough Co-op, now part of Dairygold, formed a joint venture to secure dairy supplies from a plant in Mallow.
Borden has collapsed partly because of a long-term decline in dairy consumption in America, but it was also spancilled by excessive amounts of debt.
Dean Foods, the largest supplier of fresh milk in the US, had a similar problem.
Too much borrowing was loaded onto its balance sheet. When business conditions got tough, and cashflow was squeezed, the company suffocated under its debt.
The demise of these two companies should be carefully analysed by all involved in the Irish dairy industry.
Academics in financial markets often define a business with low levels of debt as having an “inefficient” balance sheet.
The argument goes that if a business has cashflows that can sustain high levels of debt then those borrowings should be taken on to help drive equity value.
This thesis primarily applies to private companies but it brings with it an elevated level of risk. If business conditions deteriorate for any reason then a company with relatively high levels of debt can find itself in deep trouble.
A period of weakening milk sales in the US, caused by growing demand for alternatives such as almond milk, doomed Dean Foods for this reason.
In Ireland we have a dairy sector dominated by co-operatives and these have a different purpose in financial terms.
Instead of focusing largely on equity value creation their chief purpose is to process members’ output - namely, milk - and sell them inputs such as feed and fertiliser.
Management are encouraged to do business in this context that makes a profit sufficient to finance necessary capital expenditure and other investments that can help the core business stay strong.
This is a long way from the efficiency theory that presides over third level education about finance and banking currently.
Instead of using debt as a means to achieve equity value it should, in a co-op, be utilised primarily to support the business without incurring excessive risk.
In the stock market we often talk about companies having a conservative debt-to-Ebitda ratio of about two times debt to earnings.
I suggest in the co-op world that ratio has to be dialled back for a couple of reasons; firstly, stockmarket companies can tap equity markets for funding if they encounter tough trading whereas co-ops do not have that luxury, and, secondly, co-ops tend to work with lean margins so their capacity to manage large amounts of debt are limited.
As we continue to gorge on a wave of milk production in Ireland, and capital expenditure bills mount to pay for more stainless steel, it would be worthwhile noting the sad state of affairs in Dean Foods and Borden.
The Irish dairy industry must devise ways of achieving its growth ambitions without incurring too much debt on the journey.
I’ve long been an advocate of consolidation among co-ops in Ireland.
It’s a sensitive subject, especially at local community level.
However, if we are to build an industry fit for long-term healthy growth, we need to do so without burdening farmer shareholders with too much debt.
Merging processing entities around the country, without losing local co-op identity, would be a way to progress. Its been done in west Cork, and should happen elsewhere too.
