Murray Goulburn has shown that balancing investor and patron interests in a co-operative is not easy

When Australia’s largest dairy co-operative, the Victorian-based Murray Goulburn Co-operative Co. Ltd (MGC) announced its decision in 2015 to partially list some of its equity on the Australian Stock Exchange (ASX), it was viewed as an opportunity to show that co-operatives could find a balance between mutuality and investor rights.

However, all this optimism has been placed under a cloud with the announcement in April 2016 of a massive profit write down, lower farm-gate milk prices (FMP) for producers and the collapse of the share price for investors. It has also led to the departure of former CEO Gary Helou and Chief Financial Officer Brad Hingle. These dramatic events highlight the challenge within co-operative enterprises of trying to balance investor and patronage interests.

Over confidence at Murray Goulburn

In March 2015 Murray Goulburn was brimming with confidence. A newsletter to shareholders announced that the co-operative was committed to keeping the FMP at $6 per kilo of milk solids (kg/MS). The co-operative’s board and management had been developing their strategy for a significant expansion of the company for some time. In 2010 they had made an unsuccessful bid to take over Warrnambool Cheese and Butter (WCB), and sought to do so again in 2013 engaging in a three-cornered battle with Bega Cheese Ltd and Canada's Saputo Inc.

The following year they announced a program to invest $127 million in three capital projects designed to build their production capacity in cheese, infant milk formula, and beverages. Later in 2014 MGC announced the expenditure of a further $57 million in an integrated business platform known as “Project Evolution” that promised to reduce complexity, lower operating costs and increased FMP. 

The MGC board had identified the need to raise around $500 million to make significant investments in upgrading its manufacturing facilities to enable it to compete within the growing markets of Asia. Of particular importance was the production of customised dairy products seen as being in high demand in China. These included nutritional milk powders such as baby formula, packaged cheese and dairy beverages.

Rather than take on more debt to fund this expansion MGC made the decision to restructure the company’s share capital and raise the money through the issuing of shares to non-farmer investors. This was undertaken in 2015 with the creation of the MG Unit Trust, which listed on the ASX in July. In addition to the share capital taken up by its own members, the MGC Unit Trust attracted substantial investment from Chinese state-owned enterprises who took up these non-voting preference shares.

However, although MGC successfully raised its target capital via the ASX listing, things turned sour in April 2016 with the collapse of both the share price and the FMP. Trading in the MGC Unit Trust was suspended and the co-operative was forced to downgrade its profit forecast and ability to meet the promised FMP target. 

A combination of falling global milk prices caused from oversupply triggered by Russian sanctions against the European Union (EU), and a decision by China to temporarily ban the import of foreign powdered and UHT milk, impacted the FMP and in turn the share price of the co-operative’s Unit Trust. This has led to the departure of the MGC executives, anger from investors and farmers, plus threats of class action from legal firm Slater and Gordon.

Was this overconfidence on the part of MGC’s board and senior management?

Certainly the outlook for global dairy prices has been trending downwards for some time. For example, in December 2015 Rabobank was reporting that stronger than anticipated production from the EU was likely to delay the recovery of global dairy markets until at least the end of 2016, and by February of this year they were cautioning that no increase in FMP was likely before 2017.

Even the decision by China to restrict dairy product imports was considered by MGC in early 2016 with the company issuing an ASX announcement on 12 April stating that: "MG has been aware of this Chinese regulatory development for some time". However, it claimed that MGC had made adequate preparations and that: "Based on the information currently available to us we do not believe there will be any material impact to our business."

Although hindsight is a wonderful thing, these comments from the most senior levels of MGC suggest that there were clearly some red flags showing on the horizon. It suggests that the level of confidence the management and board was demonstrating in their ability to keep the FMP at $6 per kg/MS was at best overly optimistic. As Joe Aston commented in the Australian Financial Review on 20 April:

"In its Prospectus, Murray Goulburn committed 89 per cent of the $500 million in IPO proceeds (or $446.2 million) to 'repayment of existing borrowings'. So why in its recent interim results did the company report a reduction in net debt of just $242.4 million compared to six months ago ($347.1 million against December 31, 2014)? Because, right now, MG's operational business model is an uddered Morgana, relying entirely on the balance sheet for debt or new equity, with net negative cashflow for the first-half of FY16 of a whopping $198.2 million. At this unsustainable rate, Gary the Great will have burned through the $500 million of newly-issued capital before Christmas, while having surrendered ownership of 40 per cent of the company (a good chunk of it offshore). Milk me, Morgana!" 

The challenge of being a "pacemaker" co-operative

Part of the dilemma facing MGC is its role as what Claire LeVay, in her excellent 1983 review of the theory of agricultural co-operatives, described as being a "pacemaker". Once a co-operative becomes successful and engages actively in open market competition as a major player, it is placed under pressure by its members to take on a "pacemaker" role. In this situation the co-operative is obligated to keep prices to members higher than what might be available to non-members. If the co-operative is unable to maintain superior prices, particularly when it once did so, its members will become disenchanted and withdraw their support and patronage. 

This results in the loss of member cohesion and loyalty to the co-operative, along with a sense of proprietary interest by members. If not checked, this can result in the members becoming focused on short term gains and the long-term sustainability of the co-operative can be placed at risk. What might keep the co-operative going is recognition by the members that its loss would leave the market open to competitive pressures likely to result in further falls in price. Here the desire to achieve self-interest through mutual ownership may override any individual self-interest that can be satisfied through independent action.

MGC has played the role of a "pacemaker" co-operative for much of its history. In a study of MGC as a "pacemaker" co-operative, undertaken by this author in concert with my colleagues Dr Elena Mamouni Limnios and Professor Geoff Soutar at the University of Western Australia, we traced the history of MGC and examined its behaviour over time. From its establishment in 1950 to the present, MGC has been a growth focused enterprise. For example, it was already one of the largest dairy co-operatives in northern Victoria only five years after foundation and had its eyes on growth. 

Throughout the 1960s and into the early 1970s MGC undertook a range of mergers and acquisitions doubling in size and making it Australia's largest dairy company by 1973. However, the aggressive growth strategy it had followed in the previous decade resulted in MGC facing serious problems by the 1970s. Many of the smaller dairies it had acquired were operating outdated and inefficient production facilities. Debt levels were high and the company board was comprised of 50 directors. The decision by Britain to join the European Community's "Common Market" also impacted the co-operative's export trade. 

MGC was forced to substantially restructure and by the early 1980s had recovered financially. Nevertheless, the next three decades from the 1980s to the mid-2000s was marked by significant change within the Australian dairy industry. With full deregulation in 2000 MGC positioned itself as a "pacemaker" using its size and market power to effectively set the benchmark FMP for the Victorian and much of the south east Australian milk market. Highly innovative, MGC built strong domestic retail brands for milk, milk powder, butter, cheese and milk drinks. It also expanded into international markets, in particular Japan and China. 

A key feature of MGC that is often overlooked is the corporate structure of the co-operative. Unlike most co-operative enterprises in Australia, which are registered with their state or territory Co-operative Acts, MGC is a corporation registered under the Corporations Act (2001). Its co-operative mutuality has been enshrined in its constitution, but its corporate legal status has enabled it to do things that many more conventional co-operatives cannot. This includes having various classes of shareholder. Active "wet" farmers who supply to the co-operative were able to secure ordinary "A" class shares that conferred voting rights. Retired "dry" farmers were permitted to convert their ordinary shares to "B" class preference shares that did not have voting rights. Employees also had the opportunity to own preference shares without voting rights. Preference shares generally paid a slightly reduced dividend.

For a "pacemaker" co-operative such as MGC to succeed it must maintain high volumes of patronage from its suppliers. When times are good and the co-operative can pay farmers a premium FMP this is relatively easy. However, when drought hits or supply is reduced due to competitive forces, the co-operative must focus on cost-efficiency. It can also focus on moving forward into the marketing channel, building retail brands and using innovation in product development and marketing to secure price premiums. This is a pattern that MGC has followed in past decades. More recently MGC's investment in state-of-art dairy processing facilities can be seen as part of this drive to keep production costs down, while also seeking to develop national and global markets.

However, the trap that must be avoided is falling volumes of patronage and high-costs of production. Under these conditions the "pacemaker" co-operative finds itself entering a negative reinforcing loop or "vicious cycle" whereby reducing supply volumes trigger rising overhead and production costs and weaker prices that can be offered to member suppliers. To avoid the worst aspects of this "vicious cycle" the "pacemaker" co-operative can respond with a variety of options. The first is to employ flexible infrastructure that can enable overhead costs to be linked to variations in supply. The second is to diversify risk though moving away from a declining market into new product/market opportunities. Finally, the co-operative can attempt to strengthen the loyalty of its members offering both financial and non-financial incentives to retain their patronage.

The consequences of Murray Goulburn's financial crisis on Australia's co-operative sector

Only time will determine the full impact of the financial crisis that MGC has created on both the co-operative itself and the wider co-operatives sector in Australia. At time of writing the FMP offered by MGC had fallen from $5.60 kg/MS to $5.47 kg/MS, with the lower price only possible as a result of the co-operative having borrowed money to prop up its members' prices. The average MGC supplier was forecast to lose around $127,000 over three years. Further, major competitor New Zealand's Fonterra had cut their FMP from $5.60 kg/MS to $5 kg/MS for the rest of 2016. 

This reduction in the FMP is likely to hit farmers across the dairy sector of Victoria, Tasmania and other states very hard. One of the reasons for this is the sheer size of the co-operative within the Australian dairy sector. MGC has around 2,500 members across four states and controls approximately 31.3% of the national market for milk and cream processing. Of the 6,061 registered dairy farms in Australia 67.3% are located in Victoria. MGC therefore has a significant influence over the Australian dairy sector and any severe down turn in FMP and the co-operative's fortunes will impact substantially.

Concerns are already being expressed within the media over dairy producers losing their farms, with serious consequences for many regional towns. As reported by the ABC's Landline on 6 May, a lot of dairy farmers were already carrying substantial debts before the collapse of the MG Unit Trust and the FMP. The average debt owed by each farmer in the aftermath of the MGC share price collapse was estimated to be between $100,000 and $120,000, which has to be repaid over the next three years. This has raised concerns over whether some farmers might be forced into liquidation. There are also concerns over the mental health of many dairy farmers and suggestions that many will leave MGC for alternative milk processors.

Any significant exodus of members from MGC will risk placing the company into the "vicious cycle" that can beset a "pacemaker" co-operative. Forced to borrow money to keep its FMP at a level above the market rate, and with an erosion of trust between it and its members, the current situation facing MGC is not a good one. Not only have farmers experienced the collapse of the FMP, but many have also lost on the shares they purchased in the MGC Unit Trust. The Chairman of MGC Philip Tracy has been busy travelling around rural communities apologising for the situation and seeking to retain the trust and loyalty of members. However, trust is hard won and easily lost. There will need to be much more than apologies from MGC's senior leadership to regain the trust of many farmers.

As a "pacemaker" co-operative with such a dominant market position MGC has essentially set the benchmark FMP within the Australian dairy industry since the removal of government regulation in the dairy industry 15 years ago. If anything were to happen to MGC as a co-operative it is likely that Australian dairy farmers would see even lower FMP levels than they are currently experiencing. There would also be the potential for greater market volatility over FMP within the sector.

It is worth remembering that outside MGC the dominant market share of the milk and cream processing industry in Australia is controlled by investor owned firms such as Lion Pty Ltd, with 25.8% and Parmalat Australia Pty Ltd with 22.8%. Both these firms are foreign owned. Lion is owned by Japan's Kirin Holdings Co. Ltd, and Parmalat by European Parmalat Belgium SA. Only the NSW based Norco Co-operative Ltd has any significant market presence with around 4% market share. The demutualisation or collapse of MGC would have a profoundly negative impact on most Australian dairy farmers.

On a broader level the financial woes currently impacting MGC may have consequences for other co-operatives in Australia. A major challenge facing the directors of co-operative enterprises is the need to balance the often conflicting interests of members as patrons who demand better prices, and members as shareholders who seek more attractive investment returns. Satisfying both interests while simultaneously keeping the business profitable can be difficult. 

In traditional co-operatives the principle of "one-member-one-vote" democracy remains a sacrosanct foundation of their mutuality. It has even been written into the Co-operatives legislation at the state level in Australia. However, not all co-operatives adhere to this level of democracy. For many years MGC has used a system of proportional voting rights based on patronage, but with limits on the total amount of shares that can be held by a single member. This has rewarded patronage without serious loss of democracy within the co-operative. Unfortunately the outcome of this ASX listing by MGC may be to undermine the loyalty of its members. It will also focus the company's board on the difficult challenge of satisfying the interests of both its members as patron suppliers, with those of investors holding stock via the ASX listed MGC Unit Trust.

The financial restructuring undertaken by MGC in relation to their ASX partial listing was an opportunity to see whether the co-operative business model could be designed to allow for mutuality and members' interests as patrons, to be successfully aligned with the interests of share market investors. It was a potential role model for other co-operatives seeking to raise equity on the open market. So far the experience has not been a positive one. It has already had an impact on grower-owned companies such as SunRice, which had been moving towards a similar capital restructuring and partial ASX listing.

Over in Western Australia the large co-operative grain bulk handling company CBH Group Ltd, Australia's largest co-operative in 2015 by annual turnover, has been facing down pressure to demutualise by a splinter group of former directors known at the Australian Grains Champion (AGC) backed up by GrainCorp. While the majority of its grower members have dismissed the initial bid by AGC/GrainCorp they have also overwhelmingly called for a review of the co-operative's financial structure and business model. CBH is a "non-distributing" (not-for-profit) fairly conventional co-operative that rewards its members through the maintenance of cost-efficient grains handling. Its share capital is non-tradeable and non-redeemable and dividends are not paid from profits. 

The co-operative business model structure of CBH has been challenged in 2000 when a push for demutualisation failed. A constant theme heard from the financial press and investor-owned corporate sector is that co-operative business models like that of CBH are "archaic" and have little place in the future of a modern economy. Such views conveniently ignore the fact that many of the world's most successful agribusinesses are co-operatives. They also focus purely on the financial returns that a member producer can obtain from the carving up of the balance sheet. 

This type of thinking is rather myopic and forgets the purpose for which the co-operative was established. The existence of co-operative and mutual enterprises (CMEs) is typically driven by market failure. It occurs where small farmers, small business owners, or the individual consumer cannot secure services or access to infrastructure at a price they can sustain. Their collective self-interest and willingness to cooperative to solve this market failure help to launch these CMEs.

As a result the CME has a dual-purpose that is somewhat unique. It must be both a successful, efficient and sustainable business able to generate economic value, and a member-focused social enterprise that exists not for third-party shareholders, but for the long-term benefit of its members. In fact its purpose is not just to support the existing membership base at a given point in time, but the future generations of members who share the common "community of purpose" that formed it.

The recent experience of MGC is likely to shake up both the dairy industry and the wider CME sector. Co-operatives, in particular agricultural producer firms, have attracted significant interest from government. The federal government's announcement in April 2016 of a $13.8 million Farm Co-operatives and Collaboration Project to be run by Southern Cross University is evidence of this. However, those who seek to promote or challenge the co-operative business model must first understand it. CMEs are not a panacea to every social or economic problem, and they are not a perfect business model. However, they play a significant role within the wider economic business ecosystem and if well-managed, with the trust and loyalty of their members, and a clear sense of their purpose, they can generate substantial economic and social value to their communities.


Tim Mazzarol is a Winthrop Professor at the University of Western Australia where he is the Director of the Co-operative Enterprise Research Unit (CERU). However, the opinions expressed in this article are entirely his own.


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