8 October 1999

Processing choice is a difficult one

By John Allen

RECENT events, including the Monopolies and Mergers Commission raw milk inquiry report, United Milks intention to enter processing and Milk Marques decision to split up means dairy farmers, their advisers and bankers face a major strategic decision – to process, or not to process.

It should not be made in haste. The past five years of deregulation illustrate how snap decisions can later be regretted.

Taking a stake in co-operative processing is a long-term strategic decision for a farm business. It should:

&#8226 Give producers an additional margin from processing.

&#8226 Empower producers when negotiating to sell their product.

&#8226 Strengthen the UK dairy industry with world class processing capacity.

&#8226 Provide a good return on capital invested, certainly at higher rates than producing milk.

&#8226 Longer term it should help insulate businesses against EU reform if quotas are lifted, when the right to produce may depend on owning a stake in the processing industry, as in New Zealand.

All the above, as well as the emotional appeal of better security and renewed confidence, provide powerful arguments for those committed to the long term in our industry.

But not all producers will be convinced that strategic investment in processing is for them, for the following reasons.

&#8226 Moving into processing will use capital that could be employed more profitably in the short to medium term within their own business.

&#8226 The commitment to processing is likely to mean either a lower milk price as monies are diverted for investment into a capital fund or for borrowing capital for investment in shares.

&#8226 Investment could yield low returns on capital especially if surplus capacity is created Most processors are getting returns on capital of 10-15% and margins on turnover of 4-6%. Monies for investment could be placed elsewhere to yield higher returns with similar or lesser risk.

&#8226 Investment in processing could prove a distraction. Many businesses increasingly want to focus on specifics, like milk production. Producing milk at lower prices puts demands on management time.

&#8226 Finally, some producers may believe that farmers have a poor track record of finding or creating markets, especially on a co-operative basis. A valid alternative would be to purchase shares in existing processors such as Unigate, Express, Wiseman and Dairy Crest.

Individual businesses must use basic business principles to make their own rational assessment before investing.

This means examining potential returns on capital and risk associated with investing available capital. Basing decisions on emotions is not a good way to operate any business.

It could be considered reasonable for an existing large-scale farmer, perhaps producing 2-3m litres of milk a year, who has a strong business and long term commitment to invest with others in processing.

However, he must be able to see a good business plan, yielding good, long-term returns on capital investment.

However, a smaller, tenanted producer with perhaps 700,000 litres of output and a weaker business may wish to strengthen the milk production side of his business before subjecting it to further risk through increased borrowing or lower, short-term prices.

He may also need to focus on short-term returns from limited capital. Better to have short-term positive cashflow than long-term, risky yields.

&#8226 John Allen is head of dairying at ADAS.