bank
November 3, 2017

Now Might Not Be a Good Time to Invest

 |  By: Mike Opperman

Dairy producers, generally, are wired for expansion. There is a built-in need to produce more milk by improving milk production, adding more cows or both.

Improving production is normally less expensive than adding cows or building facilities. The first takes a tweak in management, the second takes a capital investment. In today’s economy, getting a loan for a capital improvement is not easy.

With margins where they are, most dairies are at or below the break-even price which makes cash flow for capital investments in short supply. That means any investment would likely carry a large amount of borrowed money. In that situation, the type of investment makes all the difference.

Investments that increase production might be hard to come by, according to Kurt Petik senior relationship manager with Rabo AgriFinance.

“There are very few reasons that a dairy should be looking at expansion right now,” he says. “Unless they have supply agreements in place, there is not capacity in the processor system for growth and expansion.”

With limited capacity, Petik says any expansion has to be done in coordination with a processor.

The second piece of investment focuses on gaining efficiencies. This could include facility improvements and parlor upgrades.

“When producers are looking at these improvements, they need to ask if the improvements will give the return on investment the dairy needs to move toward lower break even and higher profitability,” Petik says.

Most banks will be conservative toward lending for even those types of requests, Petik says.

Lending guidelines or underwriting standards require a maximum loan to value ratio, resulting in a specific level of equity. In tough times, lenders still have standards they have to meet. “All situations are assessed on a case-by-case basis to determine client needs and how that aligns with Rabo’s risk appetite” Petik says.

“It’s always better to have the producer own more of the business than the bank,” Petik says. “Hopefully ongoing maintenance and capital expenditures, like replacing a parlor, are something the producer has spoken about with their lender and established a debt-to-equity ratio to be able to do it.”

Even if that investment works out on paper, it still has to cash flow. That’s where listening to a lender’s advice is critical. Having new, shiny and better is great, but any investment must cash flow first.

How we got to this tight financial position is mostly due to $20 milk and production growth.

“One of the mistakes made was the expectation that $20 milk was going to last forever,” Petik says. “Producers expanded because there were always two or three processors looking for milk and big premiums were there.”

The problem is processors haven’t kept up with expansion, leading to the current situation of continued production growth and maxed-out processor capacity, and some premiums have gone away.

Expansion can’t happen without support of a financial partner, so producers aren’t the only party at fault in this situation. Credit was probably a little looser than it should have been.

“Coming out of 2014 there was a lot of vigor in the lending market,” Petik says. “There were investments based on growth and more milk that probably shouldn’t have been made.”

Knowing when the situation will get better depends on definition.

“We have to ask ourselves what a sunny day looks like,” Petik says. That varies from state-to-state and farm-to-farm. “If you’re at a $16 breakeven and you have a $1 margin, you’re okay. If you’re at $16 breakeven and prices are at $16, you’d probably better put a coat on because it’s not going to get warmer for some time.”

Rabobank projects another five years before there’s an upcycle in the industry, Petik says, “It will be 2021, 2022 before we see a higher leg up due to continued export demand and growth.”

That creates a chicken and egg situation, where processing capacity will be needed to meet product demand, which could then spur another growth in expansion and production and put the industry back into the same predicament.

“We can add 100,000 cows faster than we can add 8 million pounds of processing capacity,” Petik says.

Efficient dairies that can survive the ups and downs of the industry are attractive to processors and will dictate where new processing opportunities will be located, Petik says, as well as push toward more direct-supply agreements that can secure a consistent milk source. Unfortunately that might leave some of the higher-leveraged dairies on the outside looking in.