The dairy industry, as with virtually all other agricultural commodity industries, can and will have volatile price cycles over time. These price cycles provide both challenges and opportunities in making financial decisions. We will examine these decisions from two broad producer perspectives: 1. The steady and growing dairy operation and 2. The liquidating dairy operation.
Steady and growing dairy operations
Some of the decisions the steady and growing dairy operation must make to move forward successfully include these key considerations.
• The pricing of feed commodities .
Dairy operations always need feed for animals. Whether an operation raises its own feed, buys feed or does both, there are strategies to hedge against price volatility. As a banker, I would encourage producers to at least evaluate whether forward contracting or hedging feed commodities or crop inputs makes good financial logic. Normally this type of price management could be used in harmony with milk pricing, as described below.
• Procurement and purchase of replacement animals .
Generally, as milk prices increase, so does the cost of purchasing replacement animals. It is important for a dairy operation to evaluate its replacement needs, whether for expansion or general replacement purposes. A number of factors will influence a producer’s decision on replacements, including feed cost, feed availability, price of cows, price of open heifers and price of bred heifers. For example, if feed costs are known to be very low and replacements are needed 12 to 18 months into the future, it may make financial logic to purchase young heifers. However, if feed costs are high and replacements are needed very soon, procuring bred heifers or milking cows may be the correct choice.
• Planning and construction of new facilities .
Decisions concerning expansion and/or upgrade of facilities are long-term by nature and therefore should be planned in advance and in view of the operation’s long-term goals. However, once the construction decision is made, there may be opportunities to contract the project and secure competitive pricing on the various elements that will constitute its completion. There are numerous websites dedicated to volume purchasing of many commodity materials that are necessary for new construction. Vendors and contractors will also have access to options as well. The pricing power available will also be dependent upon the timing of construction.
• Milk pricing .
Most milk marketing cooperatives provide options for forward contracting/hedging of milk production. Several questions need to be asked and answered in order to evaluate this as an effective tool in managing volatility. Having a good understanding of an operation’s cost of production is the primary information needed to explore this option. An operation needs to understand what feed variables will most notably impact the cost of production and consider forward contracting these variables along with milk. Generally speaking, contracting 30 percent to 70 percent of a farm’s production would be considered prudent. Operators should very carefully consider this area of pricing and actively manage it once they have implemented such contracts.
• Interest rate cost .
Interest rates can fluctuate and exhibit volatility, like commodities; but in recent years, interest rates have trended downward. This is likely to change in the very near future. Financial markets are recovering from the Great Recession, which saw Federal Reserve policy reduce the federal funds rate to near 0 percent. (This is the overnight rate that allows banks to borrow from each other.) As the economy improves, rates will likely begin to edge upward. Now is a good time to refinance and consolidate term debt and obtain a fixed rate on that structure. Operating loans and revolving loans typically are variable in nature, because they are short-term. Look carefully at your operating needs and projected cash flow to insure you have the right financing in place moving forward.
This is not meant to be an exhaustive list, and some of these may not be important to every operation. However, these are the decisions that seem to come to mind first when thinking about the volatility of dairy prices and what can be actively managed to minimize risk to bottom line results.
Liquidating dairy operations
Dairy operations that have made the decision to get out of business have a different set of financial decisions to make during volatile times, although their short-term concerns may require some of the same financial decisions discussed earlier.
Generally speaking, the primary financial objective of a liquidating operation is to maximize its equity position while disposing of assets. For a dairy, these assets would include feed, dairy livestock, equipment and facilities. Operations that choose to stop milking have several broad options available to them in liquidating their dairy assets.
• Selling various assets over time .
Generally speaking, when milk prices are elevated, dairy assets will be worth more. Conversely, when milk prices are low, so is the value of those assets. Selling the most liquid assets first, such as livestock and feed, may make good financial logic if milk prices are higher and the market for those assets is strong. This may provide some liquidity while equipment and facilities are marketed. One advantage to this option is that the tax liability could be spread over multiple years if the actual disposition of these assets were made over several tax years. This also provides for an orderly liquidation, which should aid in obtaining the highest price for the assets.
• Selling the operation as an operating farm .
There is some appeal to selling the operation in its entirety as an operating farm where the owner(s) agrees to a selling price and the buyer pays the price and takes over the farm with all assets in place. This option might also be prompted by a lease agreement for a period of time, to transition day-to-day operations from the owner to the prospective buyer. This option can in some ways simplify the selling of assets, in that everything is sold together and remains in operation, which is often appealing to potential buyers.
Both of these methods can be effective in liquidating the operation and maximizing the equity position of the farm. There may also be other ways to liquidate dairy assets not discussed here. Sellers would be wise to discuss all options with tax and legal counsel to determine the proper course of action.
Market volatility is a real challenge in the dairy business, but it can also be viewed as an opportunity. There are tools available to manage and minimize the effects of volatility if your operation can plan accordingly. PD
- Vice President
- KeyBank Food and Agribusiness Team
- Email Larry Davis