The difference between Australian and New Zealand dairy

Farm investment advisor Bryony Fitzgerald argues Australia's dairy industry is a complex one and tells investors which metrics they should consider before putting down capital.

Bryony Fitzgerald is the founder of CGM Advisory, an Australian business which focuses on farm investment due diligence and strategy, management oversight and financial reporting.

Here, in a response to our editor’s letter, ‘Don’t overlook New Zealand‘, she argues the country’s dairy industry is a complex one and tells investors which metrics they should consider before putting down capital.

The ‘Don’t overlook New Zealand’ article which appeared on 3 March took too simplistic a view of the Australian dairy industry, and while it made the good point that agri investment should be long term, investors should also consider volatility, liquidity and the balance between cash surpluses and capital gains to make a successful decision.

There is no such thing as an “Australian dairy industry” – it is a fragmented collection of industries with very different product mixes, markets, climates and production systems. Overly simplistic industry comparisons or metrics frequently lead to poor investment decisions. Even Tasmania, while ostensibly a higher-rainfall, grass-based seasonal dairy industry, has some clear differences from New Zealand which farmers and investors need to be aware of.

Volatility

The last two to three years suggest volatility is not confined to the Australian dairy industry, and not just related to the country’s variable climate. New Zealand’s heavy reliance on commodity products and export markets appears to be resulting in price-driven volatility, from which Australia is somewhat protected due to a higher local consumption.

While Australian prices lagged behind New Zealand’s in 2013-14, they have not plunged as far in response to the severe global dairy commodity price drop. Milk price volatility can disrupt farm incomes and creates as many, if not more, management headaches as dry seasons and water shortages.

Figure 1

Sources: Dairybase NZ, Victorian Dairy Farm Monitoring Project annual reports, Murray Goulburn and Fonterra 2015-16 media releases

While operating costs on Australian dairy farms are higher than in New Zealand, recently production costs in New Zealand have been increasing at a faster rate. New Zealand farmers would typically react to lower milk prices by reducing input costs, but with commentators suggesting that the break-even cost of production in 2015-16 is NZ$5.20/kg MS, it seems some of the major costs are proving difficult to reduce or eliminate.

Figure 2

Sources: Dairybase NZ, Victorian Dairy Farm Monitoring Project annual reports

Operating returns on capital versus capital gains

Looking at income and costs per unit of production is one of the most misleading metrics in farm analysis, particularly from an investment viewpoint, and probably one of the greatest causes of poor forecasting.

Pasture-based dairy farms are somewhat unusual – as the output of milk increases, the cost per unit of production often rises instead of falling. As production and stocking rates intensify beyond a self-contained pasture-based system, a farm’s reliance upon high-priced inputs increases, there is usually more infrastructure and machinery involved as well as labour, and the cost structure alters – as does the risk profile.

It is also critical to remember the greatest concentration of capital relates to the hectare of land. Therefore it makes sense to consider returns per hectare and operating returns on capital.

Let’s examine comparative per hectare EBIT returns for Victoria and New Zealand, based on industry averages.

Figure 3

Sources: Dairybase NZ, Victorian Dairy Farm Monitoring Project annual reports

Earnings per hectare (converted to A$) were generally considerably higher on New Zealand dairy farms throughout the period, driven by higher cow stocking rates, milk output and gross income per hectare, while incurring similar per hectare costs.

Although earnings tended to follow a similar pattern, seasonal variations are more apparent in the Victorian graph. For example 2012-13 saw a very dry season with higher input costs, resulting in lower profits despite a reasonable milk price.

A more complete picture will appear when 2014-15 and 2015-16 data is available; Dairy NZ estimates up to 85 percent of New Zealand farms will be in negative return territory in 2015-16.

However, for the eight-year period from 2006-7 to 2013-14, New Zealand dairy farms enjoyed higher earnings, averaging AUD$1755 per hectare versus AUD$841 per hectare. This period does not take into account cost inflation in New Zealand in the last two years, nor the dramatic milk price drop in 2015-16, but over time there has been a historic earnings advantage for New Zealand dairying operations. How does this translate to operating returns on capital?

Figure 4

Sources: Dairybase NZ, Victorian Dairy Farm Monitoring Project annual reports

There is plenty of variation on both sides of the Tasman here – the averages over the period were 5.02 percent in New Zealand (range: 1.6-7.3 percent), and 4.54 percent in Victoria (range: 0.1-8.5 percent). Again, the 2014-15 and 2015-16 results may balance this out a little. Despite higher earnings per hectare, New Zealand’s higher land prices have resulted in operating returns on capital which were not dissimilar from the Victorian average.

This raises the big question of capital requirements and prospective capital gains. It’s no secret land values have soared in New Zealand, with the 2013-14 DairyBase report calculating a staggering 71 percent of the equity growth experienced by participants between 2009 and 2014 was driven by increased value of land, buildings and investments, primarily dairy company shares.

The flipside is that only 29 percent of this wealth creation was created from operating profits. Investors looking at buying farms in New Zealand may be facing an investment in excess of NZ$50,000 per hectare by the time cows, replacements, co-op shares and plant and equipment are included – at which point achieving competitive operating returns on capital is challenging.

One of my clients, who has farming operations in Victoria and New Zealand, recently commented the combination of fluctuating milk price and capital requirement in New Zealand substantially increases its investment risk versus Australia, despite Victoria’s inbuilt variations.

Many external investors have been so far been happy to accept the value uplifts at the expense of cashflow. But with a growing level of indebtedness among larger farm operations which is making the major agricultural lenders uneasy, can New Zealand land prices continue to defy gravity, especially when coupled with negative earnings in the current downturn? It’s a question investors need to consider carefully, taking into account individual project risks, timeframes and the cash generative ability of prospective farms.

Liquidity

Liquity is an important point – but frequently overlooked – when investing in farmland in Australia.

Buying farms is relatively straightforward, managing them can be challenging, and selling them can be harder still.

While there are some periods of frenzied market activity, in general dairy farms take longer to sell in the main dairy areas of Australia compared with New Zealand. Investors looking at the long-term picture with flexible exit timeframes should not be perturbed, but those seeking greater liquidity and shorter turnarounds, this should be kept in mind.

Conclusion

Both the New Zealand and Australian dairy industries possess some great attributes in terms of market opportunities, established infrastructure, stable land ownership, and some top operators. Individual farm situations vary within the wider industry, and regional variations are huge. It’s not a simple case of one industry being better than the other; each has different characteristics which may meet the needs and preferences of different types of investor.

Investors looking seriously at farms need to:

  • Avoid simplistic financial analyses, and any financial projection which relies strongly upon farm capital uplift linked to increasing milk output. This relationship simply doesn’t apply in Australia, and will be severely challenged in the next 12-18 months in New Zealand
  • Consider risk tolerances and timeframes – this will affect the choice of farm, operating system, location, financing structure and extent of outlay
  • Research and verify – the industry in both countries is fortunate to have a wealth of financial information at its disposal, and an objective opinion is worth obtaining
  • Due diligence – in my experience, the majority of failed or struggling farm investments are down to poor quality due diligence, usually carried out by non-locals with a strong vested interest in the deal going through. Research, verify, get a local opinion and when in doubt – do more!

Bryony Fitzgerald started her career in the dairy industry in Tasmania in 1993, working in a research and advisory role. She ran a farm business advisory service in Europe before moving back to Australia in 2012. Fitzgerald then developed and actively managed a farm asset portfolio on behalf of various local and offshore investors, eventually forming CGM Advisory to focus upon farm investment due diligence and strategy, management oversight and financial reporting.