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Rebuilding equity: Are you heading down the right path?

Scott E. Plew Published on 21 September 2011

In a recent survey performed by Progressive Dairyman, 75 percent of dairymen think they will be back to pre-2009 levels of equity within five years.

When the dust settled from 2009, our firm analyzed the impact that year had on most dairy operations, and at that time we determined it would take anywhere from three to five years to get back to where we were before that destructive year.

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After seeing the results from 2010, it will likely take the better part of five years to rebuild equity. Through the third quarter of 2011, many dairy operations have been profitable and their equity has received a shot in the arm, but looking into 2012, there isn’t as much to be excited about – yet.

In this article, we will take a look at some averages from dairy producers in Idaho, as well as other states, and examine ways to rebuild equity and reshape the balance sheet.

The aftermath of 2009
During 2009, most dairy operations realized a significant reduction to the equity they had spent many of the past years building. Within a matter of a year, dairy operations lost equity that took 20 or more years to build. The dairies we work with averaged a loss of slightly more than $4 per hundredweight (cwt).

At the same time these horrible losses were occurring, the banking industry began changing lending practices and tightening up on the credit available to borrowers. Collateral values were decreased and more equity was required in order to be in compliance with loan covenants.

We can look at 2009 in the rearview mirror, but we are all still trying to deal with the aftermath.

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Are we making progress?
As I alluded to in the introduction, 2010 was a positive year for most, but only a small step along the path to financial stability. For 2010, our dairies averaged profit of approximately $.20 per cwt – less than 5 percent of 2009’s average loss.

At that rate, it will take 20 years to get back to where we were prior to 2009, assuming there are no losses during that time, which is an unrealistic expectation due to the cyclical nature of the dairy industry.

Nonetheless, it is progress in the right direction. In reviewing averages from other Western states, most states fared better than Idaho, with net income averaging between $.40 and $1.30 per cwt for 2010.

For many, 2011 to date has been very profitable. Our first quarter average was $.23 per cwt, while the second quarter has seen increased profits, and we expect third quarter to be just as profitable, if not more profitable, than the second quarter.

Fourth quarter appears to be somewhat of a toss-up based on the current milk prices on the CME for November and December.

We expect costs of production to increase in the fourth quarter and throughout 2012 when dairymen begin feeding this year’s corn silage, which is expected to cost approximately 33 percent more than 2010’s corn silage – not to mention the impact higher-priced hay has already had on a dairy’s cost of production.

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With cost of production currently expected to range between $17 and $18 per cwt in 2012, there aren’t any milk contracting opportunities with the current Class III average price for 2012 right around $17 per cwt.

In short, yes, we are making progress, but we may not be able to rely on cash flow and profits alone. In the next section, we’ll explore other ways to rebuild equity and reshape one’s balance sheet to improve a dairy’s financial viability and the way it is viewed by current and potential lenders.

Options to rebuild the balance sheet
From our perspective, and the perspective of most dairymen and dairywomen we talk to, rebuilding equity through profits and cash flow is the ideal approach. However, under this approach, a dairy operation is subject to the volatile nature of the milk and feed markets.

It does help if the dairy operation has a good risk management strategy in place and functioning to be able to smooth out the volatility and capture positive margins when they present themselves. Let’s explore some other ways of reshaping the balance sheet other than through profit.

Deleveraging is the opposite of what most dairy operations had been doing prior to 2009. When times were good and profits were being made, dairymen were leveraging their equity with additional debt to buy more cows and expand their operations.

Deleveraging is the other side of the spectrum, where the focus is to reduce debt. Of course deleveraging can be done through profits and cash flow, but typically not as quickly as it can be done by strategically selling assets.

Farmland is a hot commodity right now and more people than just dairymen and farmers are looking to buy it. Investors are looking to buy farmland, which they view as a safe investment that generates the required rate of return they are looking for.

There may be an opportunity for you to sell all or part of the farmland you own and enter into a long-term lease agreement for the use of the land so that you still have control of the feed grown and utilization of the land for your nutrient management plan. This type of transaction is often referred to as a “sale-leaseback.”

So how does selling land affect your balance sheet? Here’s an example how:

Let’s say you have farmland that is worth $1 million today. You paid $500,000 for 10 years ago, and you currently owe $400,000. Since the financial statements your CPA prepares for you to submit to the bank is on a cost basis, the land on your balance sheet only reflects the original cost of $500,000.

Once you sell the land, you recognize a gain of $500,000, pay off the mortgage of $400,000 and deposit $600,000 into your checking account. The effect to your balance sheet is a $500,000 increase to your equity due to the gain on the sale of the land.

However, from a fair market value standpoint, your overall equity hasn’t increased; it has just been reallocated from land to cash.

More important than the increase to your equity reflected on your cost-basis financial statements is the increase in your working capital. Working capital is a measure of a dairy’s liquidity or ability to withstand short periods of negative cash flow without having to borrow additional funds to pay current bills.

The above hypothetical transaction increased the dairy’s working capital by $600,000 – the amount of cash received after paying off the mortgage.

Working capital is a key target that lenders are tracking and requiring dairy operations to rebuild. Lenders are requiring a lower loan-to-value (LTV) on a dairy’s feed and herd inventory so there is equity to rely on in the case of another downturn in the industry.

Another way of accessing the equity a dairy operation has in its real estate is through refinancing and borrowing more against the real estate. This option may be more appealing to you versus selling your real estate outright, but unlike selling your real estate, you’ll only be able to access a certain percentage of the equity since lenders typically don’t want to lend much more than between 65 and 75 percent of the value of the real estate.

In the above example, if the dairyman decided to refinance the real estate and the lender was willing to loan up to 65 percent LTV, the increase to working capital would have been $250,000 ($650,000 less the existing mortgage of $400,000).

The above are a few of the ways you can rebuild your balance sheet and equity. We recommend you consult with your “dairy team” of financial advisers to identify other strategies and determine which strategy is the best fit for your operation.

Looking forward
We all appreciate the fact that it isn’t going to be an easy journey toward rebuilding equity and reshaping balance sheets, but the fact of the matter is that you can’t just sit back and wait for it to happen. You need to be proactive in bringing ideas to your lender so you can work together to attain financial security again for your dairy operation. PD

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Scott E. Plew
CPA
Cooper Norman

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