Next week, MG will host meetings for farmer supplier-shareholders to discuss its recently announced FY16 results. It’s the first set of annual financial results since the co-op’s partial listing and the accounts have seen some change, so Milk Maid Marian asked financial whiz, Michael Stapleton, to help make sense of the figures. This is not a light blog post but well worth reading right through to the end.

Michael is a Melbourne based Virtual CFO who helps business owners understand the drivers of their cash flow and make financially informed decisions. He is a founding member of the Association of Virtual CFOs and an occasional contributor of financial articles to Smart Company.

Murray Goulburn (MG) released its unaudited FY16 report last week, reporting an increased profit. At face value this didn’t sound like a business that had to claw back $183.3m of payments already made to its supplier members.

So, I thought I’d take a look at their information to see what is going on behind the headline numbers.

Here is a snapshot of MG’s reported earnings:

MG produced an unchanged sales/litre return but a higher Gross Profit, Gross Margin and Net Profit in FY16.  To do this, it paid a lower FMP of $4.80/kgms in FY16.

The FMP is derived through a pool payment system.  Under a pool payment system, supplier members of a co-op receive what is left over once the cost of production and cost to run the business has been deducted from the revenue of the business.

MG’s magic profit

Do you see the trick?  The final pool payment figure (and final profit figure) is worked out in reverse.  In practice, a conservative pool price is set at the start of each year and adjusted as the year progresses.  Supplier member expectations are managed by delivery of a final realised price usually somewhat better than the initial pool price.

MG’s Distributable Milk Pool for FY16 was $1.157bn.  Of this amount, $1.1bn has been paid as Milk Payments, which are included in the Cost of Goods Sold as the Cost of Raw Materials.  The other component of their Cost of Goods Sold is the Cost of Production – drying milk into powder, turning it into cheese, pasteurising and homogenising for drinking milk etc.

Incorporating this detail into MG’s earnings looks like this:

This additional layer of detail exposes an increase in the Cost of Production.  At 45.7% of Sales, it is a big increase from FY15.

If this was my business, I would like to know what is happening to the operational efficiency of my factories.

Let’s see what MG’s earnings look like if they had not taken the $183.3m of payments to the supplier members out of their Cost of Raw Materials (they did this by capitalising the payment on their balance sheet as an asset – essentially as a prepayment of future FMPs):

The FY16 Adjusted column shows that retaining the $183.3m as a payment to suppliers increases the Cost of Raw Materials to $1,282m and lowers the Gross Profit to $228m.

A final Pre-Tax loss of $126m is realised. Quite a different position to that announced, and more in line with the issues faced by the business.

What hybridisation means for MG’s finances

FY16 is the first year MG has operated under a hybrid structure. Its results for FY16 are a child of the hybridisation process and I think some observations about the practical effects of hybridisation are relevant.

First of all, hybridisation has strengthened the financial position of the business. But, it has come at the cost of reduced flexibility, higher payments to the ATO than in the past and the difficulty of balancing competing interests.

The Profit Sharing Mechanism means MG has limited flexibility when deciding the split of the Distributable Milk Pool between FMP and Net Profit.  Except in abnormal circumstances, MG must now record a Net Profit after Tax of between 3.5% and 7.5% of the Distributable Milk Pool.  

In practical terms, as MG has elected to move from a Co-operative tax status to a Corporate tax status, the Profit Sharing Mechanism means MG must record a Pre Tax Profit of between 5% and 10.7% of the Distributable Milk Pool (this is the grossed up level of NPAT required to meet the 30% Company Income Tax obligation and achieve the 3.5% – 7.5% after tax profit outcome).

The pre-tax profit is shared between the ATO (first) and then suppliers and external investors.  The ATO and the external investors receive 56% of the higher Net Profit before Tax, whilst the remaining 44% flows to supplier members.

In the four years prior to hybridisation, MG’s declared Net Profit before Tax averaged 1.9% of the Distributable Milk Pool (well below the 5 – 7.5% range now required).  The tax paid averaged 0.05% of pre-tax profit, well below the 30% now required to be paid.

The trade-off for a stronger balance sheet has been a reduction in the Distributable Milk Pool flowing to supplier members in favour of the ATO and external investors.

Prior to hybridisation, MG’s purpose was clear – all its activities were for the benefit of their supplier members.

Since hybridisation, MG has to consider both the interests of the supplier member and those of the external investor. These interests will not always align and I think FY16 is a clear example of competing, not aligned interests.

I think the alignment of supplier member and external investor interests is vitally dependent upon the success of the value-add strategy.

Thank you very much to Michael Stapleton for this analysis of MG’s FY16 results and the impact of the new structure.