Required Report - Public distribution

**Date:** 11/30/2007

**GAIN Report Number:** NZ7030

NZ7030

**New Zealand**

**Dairy and Products**

**New Zealand Dairy and Products 2007 Annual Report**

**2007**

**Approved by:**

![](media/image1.wmf)Laura G. Scandurra

U.S. Embassy

**Prepared by:**

David E.Lee-Jones

**Report Highlights:** New Zealand's dairy exports reached a record in
Marketing Year (MY) 2006/07 (June 1-May 31) on both a value and a volume
basis. Fonterra Co-operative Ltd, New Zealand's leading dairy
cooperative with a 95% share of exports and the country's largest
company, announced a milk price payout to farmers of \$6.40/kg of milk
solids (U.S.\$ 5.12/kg milk solids), a 43.5% increase over last years
payout. New Zealand is expected to see a significant production response
to the increased payout, estimated at between 4 and 6% during MY
2008/09, followed by a further estimated increase of 3-5% in MY 2009/10.

Includes PSD Changes: Yes

Includes Trade Matrix: Yes

Annual Report

Wellington \[NZ1\]

\[NZ\]

[**Section I Executive Summary 3**](#section-i.-executive-summary)

[Section II Statistical Tables 4](#section-ii-.-statistical-tables)

[Section III Narrative 10](#section-iii.-narrative)

[Production: 10](#production)

[Milk Supply Trends 2007/08 and 2008/09 years
10](#milk-supply-trends-200708-and-200809-years)

[Milk Supply Trends over the Longer Term
11](#milk-supply-trends-over-the-longer-term)

[Note on Seasonal Nature of Dairy Production in New Zealand
11](#note-on-seasonal-nature-of-dairy-production-in-new-zealand)

[Consumption: 12](#consumption)

[Stocks: 12](#stocks)

[Trade: 12](#trade)

[Whole Milk Powder Exports (WMP) 12](#whole-milk-powder-exports-wmp)

[Skim Milk Powder Exports (SMP) 13](#skim-milk-powder-exports-smp)

[Cheese Exports 13](#cheese-exports)

[Butter Exports 13](#butter-exports)

[Whey Exports 13](#whey-exports)

[Casein Exports 13](#casein-exports)

[Current Export Trends 13](#current-export-trends)

[Longer Term Export Trends/Mix of Products
15](#longer-term-export-trendsmix-of-products)

[Government Policy: 17](#government-policy)

[Dairy Industry Restructuring Act (DIRA)
17](#dairy-industry-restructuring-act-dira)

[Climate Change and Greenhouse Gas Emissions
17](#climate-change-and-greenhouse-gas-emissions)

[No Government Subsidies to Producers
17](#no-government-subsidies-to-producers)

[Other: 18](#__RefHeading___Toc182974119)

[Fonterra Capital Restructure 21](#fonterra-capital-restructure)

# Section I. Executive Summary

Spurred by a 2.6% increase in milk supply during Marketing Year (MY)
2006/07 (June 1-May 31) and a draw down of accumulated inventories, New
Zealand's dairy exports reached a record in MY 2006/07 on both a value
and a volume basis. The coming year promises to be another record
breaker on a value basis, while export volumes are expected to register
just below last year's record setting level.

New Zealand's dairy product export destinations, while fairly constant
over the past three or four years, have changed dramatically over the
past 20 years. In the past, New Zealand's primary markets were the
United States and Europe. While these markets are still important, New
Zealand is increasingly diversifying its exports markets and expanding
dairy product exports to Asia, Australia and the Middle East.

Fonterra Co-operative Ltd, New Zealand's leading dairy cooperative with
a 95% share of exports and the country's largest company, announced a
milk price payout to farmers of \$6.40/kg of milk solids (U.S.\$ 5.12/kg
milk solids), a 43.5% increase over last years payout. New Zealand will
likely have a significant production increase in response to the
increased payout, estimated between 4 and 6%, during MY 2008/09,
followed by a further 3 to 5% increase in MY 2009/10.

Over the longer term, growth in New Zealand milk production is expected
to stabilize at between 1.5% and 3% per year. There are a number of
factors tempering production including the ability of producers to
manage costs. Each time the milk payout price increases, farmers tend to
respond by increasing expenditure on inputs to achieve increased milk
output. This, combined with significant land price appreciation, has
negatively impacted on returns to capital and brings into question the
ability of New Zealand to continue its status as a low cost dairy
producer.

Additional factors impacting on growth include a shortage of staff,
limited availability of suitable land, the significant capital costs
associated with entry into dairying, and a growing public awareness of
the environmental impacts of dairy production, which has translated into
increased pressure to regulate water quality and greenhouse gas
emissions. In fact, the New Zealand Government is in the process of
implementing far reaching climate change policies that are expected to
impact on the agricultural sector in 2013 and will likely increase the
cost of production. (In New Zealand, it is commonly estimated that 49%
of green house gas emissions are attributable to agriculture.)

Fonterra Co-operative Ltd, New Zealand\'s largest company, announced on
November 15 that it wants to split into a milk-supply cooperative and an
operational subsidiary. If approved by shareholders, the subsidiary will
be listed on the stock exchange in 2010 and external investors could
purchase up to 20% of the shares, which would enable Fonterra to raise
capital through outside investors for expansion of overseas investments,
primarily in China, Asia and South America. Fifteen percent of shares
would be provided to existing farmer shareholders and the remaining 65%
would be held by the co-op. Fonterra controls nearly 40% of the global
trade in dairy exports, and its 2007 assets of NZ \$12.6 billion (US
\$10.1) and revenue of NZ \$13.9 billion (US \$11.12) mean it would
dwarf the currently largest listed company on the New Zealand Stock
Exchange - Telecom. While the investment community has responded
positively to the plan, the initial reaction of farmer shareholders is
mixed.

# Section II . Statistical Tables

  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ------------ ---------- -----------
  **Country**     **New                                                                                        
                  Zealand**                                                                                    

  **Commodity**   **Dairy,                                                             (1000                   
                  Milk,                                                                HEAD)(1000              
                  Fluid**                                                              MT)                     

                  2006        Revised                2007       Estimate               2008         Forecast   

  **PSD Table**   USDA\       Post\      Post\       USDA\      Post\      Post\       USDA\        Post\      Post\
                  Official    Estimate   Estimate\   Official   Estimate   Estimate\   Official     Estimate   Estimate\
                                         New                               New                                 New

  **Market Year               06/2005    06/2005                06/2006    06/2006                  06/2007    06/2007
  Begin**                                                                                                      

  Cows In         4100        4100       4100        4140       4140       4163        0            0          4200
  Milk(000's)                                                                                                  

  Cows Milk       15200       15200      15200       15600      15600      15595       0            0          15830
  Production                                                                                                   

  Other Milk      0           0          0           0          0          0           0            0          0
  Production                                                                                                   

  Total           15200       15200      15200       15600      15600      15595       0            0          15830
  Production                                                                                                   

  Other Imports   0           0          0           0          0          0           0            0          0

  Total Imports   0           0          0           0          0          0           0            0          0

  Total Supply    15200       15200      15200       15600      15600      15595       0            0          15830

  Other Exports   50          50         53          50         50         61          0            0          61

  Total Exports   50          50         53          50         50         61          0            0          61

  Fluid Use Dom.  360         360        360         360        360        360         0            0          360
  Cons                                                                                                         

  Factory Use     14745       14745      14742       15145      15145      15139       0            0          15364
  Cons.                                                                                                        

  Feed Use Dom.   45          45         45          45         45         45          0            0          45
  Cons                                                                                                         

  Total Dom. Cons 15150       15150      15147       15550      15550      15544       0            0          15769

  Total           15200       15200      15200       15600      15600      15605       0            0          15830
  Distribution                                                                                                 
  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ------------ ---------- -----------

  ---------------------- ---------- ---------- --------- --------- --------
  **Export Trade                                                   
  Matrix**                                                         

  **Country**            New                                       
                         Zealand                                   

  **Commodity**          Dairy,                                    
                         Milk,                                     
                         Fluid                                     

  Time Period: 12 months Units:                                    
                         Tons                                      

  Exports for yr end May 2003       2004       2005      2006      2007
  31                                                               

  U.S.                   0          1          2         0         0

  Philippines            20,503     24,053     29,233    22,404    21,213

  Singapore              9,061      10,315     8,288     10,345    13,499

  Fiji                   16         410        1,654     2,441     3,364

  New Caledonia          1,646      2,472      2,968     2,718     2,954

  Japan                  1,302      1,241      333       64        2,788

  Taiwan                 911        2,747      1,684     2,131     2,406

  Hong Kong              1,990      1,983      1,857     1,608     2,152

  French Polynesia       1,347      1,426      1,282     1,914     1,745

  American Samoa         108        160        623       103       1,423

  Guam                   1,504      459        682       1,652     1,158

  Total for Others       38,389     45,267     48,604    45,379    52,702

  Others not Listed      8,588      5,374      6,194     7,453     8,755

  Grand Total            46,978     50,643     54,800    52,832    61,458
  ---------------------- ---------- ---------- --------- --------- --------

  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------
  **PSD Table**   **New                                                                                      
                  Zealand**                                                                                  

  **Commodity**   **Dairy,                                                             (1000 MT)             
                  Butter**                                                                                   

                  2006        Revised                2007       Estimate               2008       Forecast   

                  USDA\       Post\      Post\       USDA\      Post\      Post\       USDA\      Post\      Post\
                  Official    Estimate   Estimate\   Official   Estimate   Estimate\   Official   Estimate   Estimate\
                                         New                               New                               New

  **Market Year               06/2005    06/2005                06/2006    06/2006                06/2007    06/2007
  Begin**                                                                                                    

  Beginning       46          46         86          46         46         85          40         40         40
  Stocks                                                                                                     

  Production      390         390        390         419        419        419         0          0          419

  Other Imports   1           1          1           1          1          1           0          0          0

  Total Imports   1           1          1           1          1          1           0          0          0

  Total Supply    437         437        477         466        466        505         40         40         459

  Other Exports   365         365        366         400        400        439         0          0          393

  Total Exports   365         365        366         400        400        439         0          0          393

  Domestic        26          26         26          26         26         26          0          0          26
  Consumption                                                                                                

  Total Use       391         391        392         426        426        465         0          0          419

  Ending Stocks   46          46         85          40         40         40          0          0          40

  Total           437         437        477         466        466        505         0          0          459
  Distribution                                                                                               

  CY Imp. from    0           0          0           0          0          0           0          0          0
  U.S.                                                                                                       

  CY. Exp. to     30          30         30          30         30         30          0          0          30
  U.S.                                                                                                       
  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------

  --------------------- ------------- ---------- --------- --------- ---------
  **Export Trade                                                     
  Matrix**                                                           

  **Country**           New Zealand                                  

  **Commodity**         Dairy, Butter                                

  Time Period: 12       Units: Tons                                  
  months                                                             

  Exports for yr end    2,003         2,004      2,005     2,006     2,007
  May31                                                              

  U.S.                  20,120        27,284     28,072    27,263    28,901

  Others                0             0          0         0         0

  EU                    90,600        106,814    73,404    98,067    67,607

  Russia                31,851        33,224     25,332    31,523    35,535

  Egypt                 29,548        21,498     15,300    19,157    30,713

  Iran                  38,186        28,759     15,798    25,310    27,805

  Mexico                21,288        18,335     12,222    11,686    21,278

  Saudi Arabia          7,782         11,170     11,033    9,350     17,271

  Azerbaijan            627           2,822      11,017    13,924    16,721

  China                 8,665         9,906      6,451     9,131     13,239

  Taiwan                10,994        9,774      12,032    9,561     12,516

  Australia             6,383         9,370      10,196    8,830     11,766

  Total for Others      245,924       251,673    192,785   236,539   254,452

  Others not Listed     106,929       98,901     76,036    86,025    127,297

  Grand Total           372,973       377,858    296,893   349,827   410,650
  --------------------- ------------- ---------- --------- --------- ---------

  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------
  **Country**     **New                                                                                      
                  Zealand**                                                                                  

  **Commodity**   **Dairy,                                                             (1000 MT)             
                  Cheese**                                                                                   

                  2006        Revised                2007       Estimate               2008       Forecast   

  **PSD Table**   USDA\       Post\      Post\       USDA\      Post\      Post\       USDA\      Post\      Post\
                  Official    Estimate   Estimate\   Official   Estimate   Estimate\   Official   Estimate   Estimate\
                                         New                               New                               New

  **Market Year               06/2005    06/2005                06/2006    06/2006                06/2007    06/2007
  Begin**                                                                                                    

  Beginning       46          46         46          46         46         46          40         40         20
  Stocks                                                                                                     

  Production      285         285        292         319        319        308         0          0          329

  Other Imports   3           3          3           3          3          3           0          0          3

  Total Imports   3           3          3           3          3          3           0          0          3

  Total Supply    334         334        341         368        368        357         40         40         352

  Other Exports   260         260        267         300        300        309         0          0          305

  Total Exports   260         260        267         300        300        309         0          0          305

  Human Dom. Cons 28          28         28          28         28         28          0          0          28

  Other Use,      0           0          0           0          0          0           0          0          0
  Losses                                                                                                     

  Total Dom. Cons 28          28         28          28         28         28          0          0          28

  Total Use       288         288        295         328        328        337         0          0          333

  Ending Stocks   46          46         46          40         40         20          0          0          19

  Total           334         334        341         368        368        357         0          0          352
  Distribution                                                                                               

  CY Imp. from    0           0          0           0          0          0           0          0          0
  U.S.                                                                                                       

  CY. Exp. to     30          30         23          30         30         30          0          0          30
  U.S.                                                                                                       
  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------

  --------------- ----------- ---------- --------- ----------- --------- ---------- --------- ---------- ---------- --------- ----------- --------- ---------- -- ---------- -----------
  **Export Trade                                                                                                                                                             
  Matrix**                                                                                                                                                                   

  **Country**                            New                                                                                                                                 
                                         Zealand                                                                                                                             

  **Commodity**                          Dairy,                                                                                                                              
                                         Cheese                                                                                                                              

  Time Period:                           12 mths               Units:               Tons                                                                                     

  Exports for yr                         2003                  2004                 2005                            2006                  2007                               
  end May31:                                                                                                                                                                 

  U.S.                                   45,783                39,039               32,453                          22,811                29,781                             

  Others                                                                                                                                                                     

  Japan                                  39,658                49,582               55,691                          52,793                61,865                             

  Australia                              40,789                35,847               37,207                          47,265                49,754                             

  EU                                     51,834                42,821               27,937                          29,648                36,780                             

  Egypt                                  6,065                 8,191                5,234                           7,383                 13,288                             

  Korea, South                           11,035                13,999               13,047                          12,678                12,827                             

  Mexico                                 15,133                15,563               11,535                          13,822                12,012                             

  Saudi Arabia                           10,022                9,806                9,311                           12,042                11,201                             

  Philippines                            9,856                 11,173               10,878                          7,539                 10,412                             

  Algeria                                7,680                 5,068                3,739                           2,080                 7,277                              

  Taiwan                                 5,707                 6,874                6,798                           5,861                 6,186                              

  Total for                              197,781               198,924              181,376                         191,111               221,602                            
  Others                                                                                                                                                                     

  Others not                             49,880                50,794               53,709                          53,098                57,238                             
  Listed                                                                                                                                                                     

  Grand Total                            293,444               288,757              267,538                         267,020               308,620                            

  **PSD Table**                                                                                                                                                              

  **Country**     **New                                                                                                                                                      
                  Zealand**                                                                                                                                                  

  **Commodity**   **Dairy,                                                                                                                          (1000 MT)                
                  Milk,                                                                                                                                                      
                  Nonfat                                                                                                                                                     
                  Dry**                                                                                                                                                      

                  2006        Revised                                               2007                 Estimate                                   2008          Forecast   

                  USDA\       Post\                Post\                 USDA\                Post\                           Post\                 USDA\         Post\      Post\
                  Official    Estimate             Estimate\             Official             Estimate                        Estimate\             Official      Estimate   Estimate\
                                                   New                                                                        New                                            New

  **Market Year               06/2005              06/2005                                               06/2006              06/2006                             06/2007    06/2007
  Begin**                                                                                                                                                                    

  Beginning       35          35                   47                               35                   35                   47                    25            25         20
  Stocks                                                                                                                                                                     

  Production      247         247                  247                              304                  304                  304                   0             0          317

  Other Imports   1           1                    1                                1                    1                    1                     0             0          0

  Total Imports   1           1                    1                                1                    1                    1                     0             0          0

  Total Supply    283         283                  295                              340                  340                  352                   25            25         337

  Other Exports   243         243                  243                              310                  310                  327                   0             0          312

  Total Exports   243         243                  243                              310                  310                  327                   0             0          312

  Human Dom. Cons 5           5                    5                                5                    5                    5                     0             0          5

  Other Use,      0           0                    0                                0                    0                    0                     0             0          0
  Losses                                                                                                                                                                     

  Total Dom. Cons 5           5                    5                                5                    5                    5                     0             0          5

  Total Use       248         248                  248                              315                  315                  332                   0             0          317

  Ending Stocks   35          35                   47                               25                   25                   20                    0             0          20

  Total           283         283                  295                              340                  340                  352                   0             0          337
  Distribution                                                                                                                                                               

  CY Imp. from    0           0                    0                                0                    0                    0                     0             0          0
  U.S.                                                                                                                                                                       

  CY. Exp. to     1           1                    1                                1                    1                    1                     0             0          1
  U.S.                                                                                                                                                                       
  --------------- ----------- ---------- --------- ----------- --------- ---------- --------- ---------- ---------- --------- ----------- --------- ---------- -- ---------- -----------

  ---------------------- ------------- --------- --------- --------- ---------
  **Export Trade                                                     
  Matrix**                                                           

  **Country**            **New                                       
                         Zealand**                                   

  **Commodity**          **Dairy,                                    
                         Milk, Nonfat                                
                         Dry**                                       

  Time Period            12 mths       Units:    T                   

  Exports for yr end May 2003          2004      2005      2006      2007
  31                                                                 

  U.S.                   1,135         714       528       353       227

  Others                                                              

  Philippines            37,452        46,016    47,940    36,841    47,344

  Thailand               19,999        21,692    16,876    19,276    30,373

  Indonesia              21,820        16,043    13,447    23,224    29,873

  Malaysia               22,897        32,394    20,132    17,340    25,957

  China                  22,096        25,321    22,495    29,863    25,654

  Saudi Arabia           13,641        11,908    15,666    17,574    22,940

  Singapore              13,139        11,891    12,512    12,985    18,179

  EU                     31,958        29,659    219       0         17,456

  Vietnam                12,840        8,151     4,692     7,686     12,746

  Taiwan                 12,328        10,080    8,584     10,405    11,918

  Total for Others       208,170       213,154   162,561   175,195   242,441

  Others not Listed      65,845        62,210    58,308    67,725    67,321

  Grand Total            305,974       305,023   221,089   242,920   327,218
  ---------------------- ------------- --------- --------- --------- ---------

  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------
  **PSD Table**                                                                                              

  **Country**     **New                                                                                      
                  Zealand**                                                                                  

  **Commodity**   **Dairy,                                                             (1000 MT)             
                  Dry Whole                                                                                  
                  Milk                                                                                       
                  Powder**                                                                                   

                  2006        Revised                2007       Estimate               2008       Forecast   

                  USDA\       Post\      Post\       USDA\      Post\      Post\       USDA\      Post\      Post\
                  Official    Estimate   Estimate\   Official   Estimate   Estimate\   Official   Estimate   Estimate\
                                         New                               New                               New

  **Market Year               06/2005    06/2005                06/2006    06/2006                06/2007    06/2007
  Begin**                                                                                                    

  Beginning       70          70         80          70         70         57          65         65         40
  Stocks                                                                                                     

  Production      634         634        611         655        655        653         0          0          685

  Other Imports   1           1          1           1          1          1           0          0          1

  Total Imports   1           1          1           1          1          1           0          0          1

  Total Supply    705         705        692         726        726        711         65         65         726

  Other Exports   634         634        634         660        660        670         0          0          685

  Total Exports   634         634        634         660        660        670         0          0          685

  Human Dom. Cons 1           1          1           1          1          1           0          0          1

  Other Use,      0           0          0           0          0          0           0          0          0
  Losses                                                                                                     

  Total Dom. Cons 1           1          1           1          1          1           0          0          1

  Total Use       635         635        635         661        661        671         0          0          686

  Ending Stocks   70          70         57          65         65         40          0          0          40

  Total           705         705        692         726        726        711         0          0          726
  Distribution                                                                                               

  CY Imp. from    0           0          0           0          0          0           0          0          0
  U.S.                                                                                                       

  CY. Exp. to     4           4          2           4          4          4           0          0          4
  U.S.                                                                                                       
  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- -----------

  ------------------------- ----------- ---------- ---------- ---------- ----------
  **Export Trade Matrix**                                                

  **Country**               **New                                        
                            Zealand**                                    

  **Commodity**             **Dairy,                                     
                            Dry Whole                                    
                            Milk                                         
                            Powder**                                     

  Time Period:              12 months   Units:      Tons                 

  Exports for year end May  **2003**    **2004**   **2005**   **2006**   **2007**
  31                                                                     

  U.S.                      3,796       4,205      3,549      1,534      3,708

  Others                                                                 

  Venezuela                 27,351      44,972     27,898     44,276     66,028

  Sri Lanka                 32,295      42,758     45,287     47,962     53,400

  China                     71,632      82,310     60,607     66,727     51,702

  Saudi Arabia              29,509      37,362     54,170     43,648     38,347

  Malaysia                  28,370      38,311     31,707     27,685     36,685

  Indonesia                 40,572      21,697     32,157     21,185     33,506

  Algeria                   17,230      22,674     24,904     37,762     32,921

  Philippines               32,780      26,449     31,752     25,804     30,988

  Mexico                    30,093      38,737     29,342     34,491     26,292

  Thailand                  23,697      20,112     20,313     18,015     25,438

  Total for Others          333,528     375,382    358,138    367,553    395,308

  Others not Listed         202,281     209,463    195,027    258,017    269,806

  Grand Total               539,605     589,050    556,715    627,104    668,822
  ------------------------- ----------- ---------- ---------- ---------- ----------

  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- ----------- -----
  **PSD Table**                                                                                                          

  **Country**     **New                                                                                                  
                  Zealand**                                                                                              

  **Commodity**   **Dairy,                                                             (1000 MT)                         
                  Dried                                                                                                  
                  Whey**                                                                                                 

                  2006        Revised                2007       Estimate               2008       Forecast               

                  USDA\       Post\      Post\       USDA\      Post\      Post\       USDA\      Post\      Post\       
                  Official    Estimate   Estimate\   Official   Estimate   Estimate\   Official   Estimate   Estimate\   
                                         New                               New                               New         

  **Market Year               01/2006    01/2006                01/2006    01/2006                01/2006    01/2006     
  Begin**                                                                                                                

  Beginning       0           0          0           0          0          0           0          0          0           
  Stocks                                                                                                                 

  Production      0           0          8           0          0          11          0          0          13          

  Other Imports   0           0          0           0          0          0           0          0          0           

  Total Imports   0           0          0           0          0          0           0          0          0           

  Total Supply    0           0          8           0          0          11          0          0          13          

  Other Exports   0           0          8           0          0          11          0          0          13          

  Total Exports   0           0          8           0          0          11          0          0          13          

  Human Dom. Cons 0           0          0           0          0          0           0          0          0           

  Other Use,      0           0          0           0          0          0           0          0          0           
  Losses                                                                                                                 

  Total Dom. Cons 0           0          0           0          0          0           0          0          0           

  Total Use       0           0          8           0          0          11          0          0          13          

  Ending Stocks   0           0          0           0          0          0           0          0          0           

  Total           0           0          8           0          0          11          0          0          13          
  Distribution                                                                                                           
  --------------- ----------- ---------- ----------- ---------- ---------- ----------- ---------- ---------- ----------- -----

  ------------------------- ----------- --------- -------- -------- --------
  **Export Trade Matrix**                                           

  **Country**               **New                                   
                            Zealand**                               

  **Commodity**             **Dairy,                                
                            Dried                                   
                            Whey**                                  

  Time Period:              12 months   Units:    Tons              

  Exports for Year end May  2003        2004      2005     2006     2007
  31                                                                

  U.S.                      198         0         282      45       0

  Others                                                             

  China                     411         72        2053     1879     3378

  Indonesia                 131         0         0        804      1902

  Japan                     1229        1200      1310     924      1520

  Malaysia                  51          63        90       765      1271

  Philippines               0           0         0        1092     1254

  Singapore                 17          11        14       513      331

  Australia                 99          63        98       275      309

  Mexico                    0           0         0        182      270

  Chile                     0           0         338      186      261

  Korea, South              144         107       376      129      184

  Total for Others          2082        1515      4279     6748     10680

  Others not Listed         655         8         340      734      105

  Grand Total               2936        1524      4900     7528     10785
  ------------------------- ----------- --------- -------- -------- --------

# Section III. Narrative

## Production: 

### Milk Supply Trends 2007/08 and 2008/09 years 

Post forecasts New Zealand milk production to expand 1.5% during MY
2007/08 but increase more sharply the following season. While production
is expanding due to high milk prices, the limited availability of cows,
combined with climatic and other factors, has tempered the supply
response in New Zealand for the current year. Throughout New Zealand,
the calving pattern was more spread out than usual, which limits average
cow lactation lengths. In addition, October was cold and windy, which
decreased the lactation peak. A forecast dry summer for the Southern
North Island and South Island will make it difficult for farmers to
significantly increase production, even with considerable supplemental
feed inputs (grass and maize silage, cereal grains, and palm kernel
extract).

Next year will be a different story. Post forecasts production to
increase by between 4% and 6% during MY 2008/09 due to the on-going
increase in the number of dairy farms and because producers will have
had time to respond to higher prices, especially in terms of bringing
more cows on line, improving farm pasture management and levels, and
securing higher quantities of supplementary feed supplies.

Cow numbers are expected to be up by approximately 100,000 head in MY
2008/09, a 2.4% increase. The increase in cow numbers alone would result
in a 2.5% to 3% increase in milk supply. Farmers are also investing in
extra feed for their cows to improve their condition, which will pay off
during the 2008/09 season and help maximize production. The increased
use of supplements this season will allow farmers adequate time to set
up their dairy farm pastures for the spring of 2008 and secure
supplemental feed supplies as part of an overall effort to expand
production to take advantage of the high payout prices for milk.

The on-going surge in conversions to dairy farms will increase milk
production during MY 2008/09. During the 2007/08 season, 70 farms were
converted to dairy production, down from 85 the previous year. Because
the conversion process takes about 12 months, and the sharply increased
price signals didn't start filtering through to farmers until April or
May of 2007, the wave of new conversions isn't expected to come on
stream until 2008 and 2009. Sources estimate that up to 150 or even 200
farms are beginning the conversion process. However, the scarcity of
cows, the lack of contractors to build dairy sheds, the limited
availability of labor, and other factors will likely limit conversions
to between 100 and 130 actually coming on line in the next 12 months. An
additional 100 to 120 farms are expected to commence production in 2009.
On the flip side, New Zealand loses approximately 150 to 200 small dairy
farms each year due to retirement or other factors.

During MY 2009/10, post expects milk supply to increase between 3% and
5%. Record high world dairy prices and the relatively poor profitability
of other livestock sectors in New Zealand will help drive this expected
growth. Because of the high degree of reliance on exports and lack of
domestic subsidies, the New Zealand dairy industry is heavily exposed to
global market conditions. Even if dairy prices mediate, an expected
downturn in the value of the New Zealand dollar, which reached record
highs in 2007, would likely sustain high milk prices for New Zealand
dairy farmers.

###  

### Milk Supply Trends over the Longer Term 

Over the long term, post expects New Zealand dairy industry to sustain
annual milk production increases of between 1.5% and 3%. Over the last
nine years, milk supply has expanded, on average, 4% per year. (Source:
LIC Ltd) However, in recent years, the average growth rate has fallen
below 2%.

The on-going surge in dairy conversions has helped New Zealand producers
achieve economies of scale and the attendant technological advances and
management efficiencies bode well for future productivity. Dairy
producers will also continue to benefit from Fonterra's continued
expenditures on research and development and a recent industry refocus
of its science funding and extension work. (Dairy Insight, an industry
commodity organization that raises funds through producer levies and
funds research, has merged with Dexcel, the primary research and
extension provider for dairy farmers.)

Factors tempering growth over the long term include the ability of
producers to manage costs. In New Zealand, each time milk prices
increase, farmers tend to respond by increasing expenditure on inputs to
achieve increased milk output. This, combined with significant land
price appreciation, has negatively impacted on returns to capital and
brings into question the ability of New Zealand to continue its status
as a low cost dairy producer.

Additional factors impacting on growth include a shortage of staff,
limited availability of suitable land, the significant capital costs
associated with entry into dairying, which discourages new entrants, and
a growing public awareness of the environmental impacts of dairy
production, which has translated into increased pressure to regulate
water quality and greenhouse gas emissions. (In New Zealand, it is
commonly estimated that 49% of green house gas emissions are
attributable to agriculture.)

New Zealand has one of the most comprehensive and restrictive
biotechnology regulatory regimes in the world and many recent newspaper
articles have questioned whether or not this is disadvantaging the New
Zealand agricultural sector because of the inability of the sector to
avail itself to the benefit of biotechnology, including GM technology.

### Note on Seasonal Nature of Dairy Production in New Zealand

Dairy cows in New Zealand are fed principally on pasture. Typically,
most cows spend their entire lives outdoors without access to covered
housing. They walk to and from their paddocks to the farm dairy once or
twice a day to be milked. Pasture growth rates follow a seasonal pattern
with a spring/early summer peak and a winter trough. In order to
maximize the conversion of pasture to milk, farmers mostly calve their
entire herd in as short as possible time span in the spring so their
cows' lactation peaks occur when pasture growth rates are peaking. As
winter approaches the cows are generally dried off and are not milked
during the winter. Supplementary feed (maize silage, cereal grain,
vegetable by-products etc) is generally only fed to top up pasture
deficits.

## 

## 

## 

##  

## Consumption:

Domestic consumption is forecast to remain stable through 2007/08 and
2008/09.

Under its marketing and production strategy, Fonterra is treating
Australia and New Zealand as one domestic market. Fonterra is working to
establish a strong domestic presence in this reasonably homogeneous
market of approximately 22 million people (4 million New Zealanders and
18 million Australians), partly as a platform to launch its global
marketing effort. To this end, Fonterra has purchased outright control
of Bonlac, a significant Australian milk processor and marketer, and is
working to achieve control of a significant proportion of milk
processing in Australia.

Under the New Zealand Government's Dairy Industry Restructuring Act,
which made way for the formation of Fonterra, Fonterra is obligated to
supply up to 400 million liters of milk (potentially increasing to 500
million liters over the next twelve months) to other milk processors in
order to prevent anti-competitive practices within New Zealand. There
will be a review of the act over the next twelve months. Fonterra
contends that the pricing mechanism and the actual milk supply mechanism
severely disadvantages it and provides an inexpensive means for
competing smaller processors to keep processing plants running
efficiently for virtually twelve months out of the year.

## Stocks:

While there are several dairy product exporters in New Zealand, Fonterra
processes approximately 95% of the country's milk supply, which means
that Fonterra's inventories are representative for the whole of New
Zealand. The Fonterra board reportedly made a conscious decision
approximately two years ago to build inventories up. However, once world
prices started moving up, Fonterra brought down its inventories. As of
October 2007, virtually no stocks are being carried forward.

## 

## Trade:

### Whole Milk Powder Exports (WMP)

Whole milk powder production is the most feasible way for a large
processing company like Fonterra to handle the seasonal nature of milk
production from New Zealand's dairy farmers who mostly calve their cows
in spring and milk them through until early Autumn, after which, they
are typically dried off during the winter. This enables processors to
take advantage of the seasonal nature of pasture production, which peaks
in late spring/early summer and drops to a minimum in winter. However,
this also means processors must cope with massive inflows of milk for
two months of the year and then milk flow easing and virtually ceasing
for six to eight weeks in the winter.

Whole milk powder exports from New Zealand have expanded at an average
annual rate of 7.3% since 1992. (Milk production has grown at an average
annual rate of 4% over the last nine years.) The growth in whole milk
powder reflects increased world demand for dairy proteins. From 2003 to
2005, stocks of whole milk powder were built up in New Zealand but were
sold down in 2006 and 2007 to a point where they are now virtually
depleted.

Post predicts that New Zealand's exports of whole milk powder in 2007/08
will expand by 2.2% over the previous year in response to strong world
demand.

### Skim Milk Powder Exports (SMP)

Exports of skim milk powder have grown at the average annual rate of
7.0% since 1992.

In view of the stock drawn down, combined with production constraints,
post predicts exports to fall slightly this year but forecasts
production to continue upward in line with long-term trends.

### Cheese Exports

Over the past 15 years, New Zealand cheese exports have grown at an
average annual rate of 6.6%. While post forecasts New Zealand cheese
production to increase 6.8% in 2007/08, exports are forecast to fall by
1.3%. This is in contrast to a 16% increase in exports the previous
year. The forecast decline is primarily attributable to limited stock
levels. While stocks were trending upward and reached 20,000 tons above
historical levels in 2005/06, they have been drawn down significantly
since then.

### Butter Exports

Butter exports, over the past eleven years, have been growing at an
average annual rate of 2.2%. In MY 2006/07, exports jumped 19% over the
previous year, due primarily to increased production, which grew an
estimated 7.4% over the previous year, combined with a draw down of
stocks held over from the previous year. Post expects production in MY
2007/08 to stabilize into line with long term trends. Limited stocks
suggest exports will likely drop by approximately 10% in MY 2007/08. Fat
taken out of Protein type products but not used in butter production can
be broken down into its constituents and sold as ingredients (such as
lipids)

### Whey Exports

Whey, which is basically a by-product of cheese production, encompasses
very valuable proteins that are ingredients in many products. Post
estimates that exports will increase in 2007/08 by 3,000 tons, or 18% -
the same as the previous year.

### Casein Exports

The volume of casein exported in MY 2006/07 was actually lower than in
MY 2001/02. Casein manufacture requires dedicated processing facilities
and these have not been expanded in the last few years. Casein prices
have improved over the last few months so, as milk volumes grow, casein
manufacture could potentially expand.

### Current Export Trends

New Zealand dairy exports reached a record in MY 2006/07, on both a
volume and value basis. Post forecasts total dairy exports for MY
2007/08 on the order of 2.02 to 2.05 million tons (this estimate
includes products not in the PS&D), just down from the record set in MY
2006/07, largely due to lower stock levels.

Major New Zealand dairy exports include milk powder, cheese, butter and
casein. Of these four, on a volume basis, milk powder is growing the
fastest reaching nearly 998,000 tons in 2007 (June 1-May 31 year) - a
growth trend of 4% per year over the last six years. On a volume basis,
cheese exports were up a meager 0.5% per year during the same period.
However, on a value basis, cheese exports have been growing at an
average of 8% per year reflecting an increase in world cheese prices.

![](media/image2.wmf)

Butter has held its own with export volumes increasing at an average
rate of 1.8% per year between MY 2001/02 and MY 2006/07 (about the same
as the rate of increase of milk

supply). However, on a value basis, butter exports have increased an
average annual rate of 9.7% over the past six years. While casein
exports have dropped off considerably in recent years, they recovered
somewhat in MY 2006/07. Casein prices have risen dramatically over the
last few months so it is likely exports will recover.

Among the more minor export categories, there are some big movers in
volume terms with whey and other products now rivaling casein in terms
of both volume and value. All the minor export product categories - whey
& other, yogurt products, liquid milk, and lactose products - recorded
double digit rates of export growth (over the last six years) on a value
basis. Other Products include milk protein concentrates. Of the 106,559
tonnes exported in My2007 (up from 57,683T MY 2005) approx 53,000T went
to USA and 94% of this is milk protein concentrate.

  --------------------- ---------- -------- -------- -------- -------- --------
  **New Zealand Dairy                                                  
  Exports by Category**                                                

  Description           2002       2003     2004     2005     2006     2007

                        Thousand                                       
                        Tons                                           

  Milk Powder           706.1      921.7    976.1    808.0    877.8    997.8

  Cheese                277.1      293.4    288.8    267.5    267.0    308.6

  Butter                331.4      373.0    377.9    296.9    349.8    410.7

  Casein                109.5      141.2    118.7    84.2     68.5     91.6

  Whey & Other Products 9.7        8.0      8.9      62.6     79.7     117.3

  Yogurt Products       44.9       44.4     39.8     38.5     41.4     46.0

  Liquid Milk           56.3       59.4     63.1     70.2     63.6     76.1

  Lactose Products      24.4       22.4     24.7     46.3     52.3     33.1

  TOTAL EXPORT          1559.4     1863.6   1898.0   1674.2   1800.1   2081.2
  QUANTITIES                                                           
  --------------------- ---------- -------- -------- -------- -------- --------

  -------------------- --------- -------- -------- -------- -------- --------
  **New Zealand Dairy                                                
  Export Returns by                                                  
  Category**                                                         

  Description          2002      2003     2004     2005     2006     2007

                       U.S.\$                                        
                       million                                       

  Milk Powder          1336.6    1356.8   1731.0   1737.2   1929.9   2293.9

  Cheese               608.7     545.4    627.7    731.4    756.5    831.6

  Butter               467.6     485.8    654.6    600.3    696.2    733.0

  Casein               502.2     516.5    481.7    463.7    434.0    562.9

  Whey & Other         22.1      15.6     24.6     228.4    290.5    408.7
  Products                                                           

  Yogurt Products      61.0      44.7     58.2     72.5     80.4     105.2

  Liquid Milk          33.2      40.7     47.2     56.4     53.1     57.7

  Lactose Products     16.9      17.6     18.7     28.2     34.1     53.3

  TOTAL EXPORT RETURNS 3048.3    3023.1   3643.7   3918.1   4274.8   5046.3
  -------------------- --------- -------- -------- -------- -------- --------

![](media/image3.wmf){width="5.251388888888889in"
height="3.4229166666666666in"}

### Longer Term Export Trends/Mix of Products

Over the past several years, the volume of protein product exports has
increased slightly faster than butter and cheese. The primary reasons
for this are the price advantage for protein products and the
suitability of whole milk powder as a product as it is the most feasible
way of dealing with the seasonal peaks in milk supply experienced in New
Zealand.

The mix of each of the New Zealand dairy product exports, as a
proportion of total exports, tend to fluctuate within a fairy narrow
band. This trend is expected to continue.

  ------------------------------ ---------- ---------- ---------- ----------
  **New Zealand Exports: Product                                  
  Mix from 2004-2007**                                            

  Product group                                        Percent of 
                                                       total      
                                                       exports    

                                            Lowest %              Highest %

  Whole Milk Powder                         31                    36

  Skim Milk Powder                          13                    16

  Butter                                    19                    21

  Cheese                                    15                    17

  Casein                                    4                     8

  Other Products                            11                    13
  ------------------------------ ---------- ---------- ---------- ----------

Source: Rabobank

Fonterra predicts world-wide demand for dairy products to increase
between 2.5% to 2.7% per annum with the bulk of the demand growth in
liquid milk products. To leverage this demand, Fonterra is setting up
joint ventures in target countries, including China. China is already
New Zealand's fourth largest export destination for dairy products on
both a value and volume basis. Fonterra has a 43% share in San Lu, a
domestic milk processor and marketer. The joint venture is developing a
demonstration farm using New Zealand production methods. More
importantly, the joint venture will be used to market Fonterra's premium
branded products into China. Currently, the New Zealand Government is in
the process of negotiating a free trade agreement with China, which will
likely improve Fonterra's access to the Chinese market.

New Zealand's dairy product export destinations, while fairly constant
over the past three or four years, have changed dramatically over the
past 20 years. In the past, New Zealand's primary markets were the
United States and Europe. While these markets are still important,
increasingly, New Zealand is diversifying its exports markets and
expanding dairy product exports to Asia, Australia and the Middle East.
The "other" category in the table below now includes approximately 180
countries.

## 

## Government Policy:

### Dairy Industry Restructuring Act (DIRA)

DIRA was enacted in 2001 when Fonterra was formed. It addressed both
external factors impacting on the New Zealand dairy industry, such as
export country quota management, as well as domestic issues such as the
potential for anti-competitive practices. (See the 2006 New Zealand
Dairy and Products GAIN6020 report for additional information including
export quotas managed under the act and the timetable by which
Fonterra's sole licenses to these quotas will expire.)

The license to the EU butter (77,000 tons) and cheese quota (11,000
tons) expires at the rate of 25% of the total volume per year beginning
Dec 31, 2007. An amendment bill to the act, which is currently before
the New Zealand Parliament, will re-allocate the license to processors
based on the proportion of total milk supply a processor collects from
farmers. The licenses will be re-allocated on a periodic basis. On this
basis Fonterra will have 95% of the quota, Westland 3%, and Tatua
approximately 1%.

It is likely that other export quotas will be handled in the same way
except where the Ministry of Agriculture (MAF) decides that it would
beneficial to deregulate the quota management entirely, which may happen
for parts of the U.S. cheese quota. Fonterra's sole rights to these
quotas expire in December 2008 and December 2009.

### Climate Change and Greenhouse Gas Emissions

The New Zealand Government announced a suite of measures in September
2007 aimed at halting the increase and ultimately lowering New Zealand's
greenhouse gas emissions. The basis of the program is a nationwide, all
sector emissions trading scheme (ETS). Under the scheme, there will be
limits set on the level of greenhouse gases that each sector can emit.
Agriculture will have its emissions monitored as of 2012, and will be
fully brought into the ETS in 2013.

Agriculture contributes approximately 49% of New Zealand's total
greenhouse gas emissions. This is a growing area of concern, especially
for the New Zealand dairy sector. According to AgResearch, a crown
research institute, the on-going intensification of the New Zealand
dairy sector has resulted in a decline in energy and greenhouse gas
efficiency. It is estimated that 70-85% of the carbon footprint of dairy
production in New Zealand is directly attributable to the on-farm stage
of production while only 2-3% comes from transportation.

### No Government Subsidies to Producers

The Government does not provide subsidies for milk to farmers in New
Zealand. However, the Government does fund research and other activities
in all sectors, but at a level lower than virtually all other OECD
countries. The Government also funds trade access initiatives to open
markets overseas.

### Other:

### 

### Fonterra Capital Restructure

On November 15, 2007, Fonterra, the largest company in New Zealand and
the world's fifth largest dairy company by revenue, presented six
options for a fundamental capital restructuring for shareholders to
consider, including a preferred option that would retain the cooperative
structure while offering shares on the stock market.

Two years of consultations and two rounds of shareholder voting will be
required in order to implement the initial public offering (IPO). In May
of 2008, Fonterra's 11,000 shareholders will vote on whether to allow
Fonterra to change to the two entity structure and to adopt a more
transparent milk pricing system. The milk price system will be used to
determine the price by which the co-op transfers milk produced by
shareholders to the new subsidiary. The second vote, which will probably
be around May 2010, will determine whether to let Fonterra list on the
stock exchange and introduce external capital. In both ballots, 75% of
shareholders must vote to approve the measures.

Reason for IPO

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Fonterra wants to change its capital profile to address three sets of
pressures on its current structure -- the need to provide a secure and
expanding capital base to implement its growth strategy, redemption
risk, and more flexible investment choices for farmers. Of the six
options presented to shareholders by the Fonterra Board, the preferred
option was the only one that would achieve all three goals. The start of
the consultation process comes two months after Fonterra announced a
record payout to suppliers of NZ \$6.40 (US \$5.12) per kilogram of milk
solids. "While NZ \$6.40 (US \$5.12) is good for farmers, it doesn't
give the Co-operative the capital to implement our strategy," said van
der Heyden. "It may lessen the redemption risk for a while, but that is
debatable because our shareholders can choose to redeem their shares
regardless of the level of payout.  And NZ \$6.40 (US \$5.12) does
nothing to address shareholder investment choice."

Pre-Conditions Required Before a Fonterra Listing on the Stock Market

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

The following conditions must be met before the IPO can be launched:

\- 75 per cent farmer shareholder approval to create parent co-op and
operating subsidiary and a transparent milk pricing system (to be voted
on by 11,000 Fonterra farmer shareholders in May 2008).

\- A competitive milk pricing mechanism.

\- Superior business performance across Fonterra.

\- Acceptable share market conditions.

\- Acceptable listing value for current shareholders.

\- Acceptable legislation to support necessary changes.

\- 75 per cent farmer shareholder approval in second vote (expected
around 2010) of listing and raising external capital.

Floating Fonterra - The Process, The Structure, The Safeguards

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

The process calls for two years of consultations and two shareholder
votes. The first vote is scheduled for May 2008. Fonterra farmer
shareholders will vote on: splitting Fonterra into two entities -- a
parent co-op and an operational subsidiary with manufacturing and
marketing responsibility; and a milk pricing system that sets the price
for transferring milk from the co-op, which will collect the milk from
farmers, to the operational subsidiary, which will produce and market
the milk products. The second and final vote is expected around May
2010. Shareholders will vote on listing on the stock market and raising
external capital. In both votes, 75 per cent approval of shareholders is
required for the measures to pass. The two year consultation process
will provide farmers with a chance to assess how the milk pricing system
is working before voting on the listing option.

Under the preferred option, the operational subsidiary will own the
assets, liabilities and operations of the existing co-op. The co-op will
retain a 65 per cent stake, 15 per cent will go to farmers, and an
additional 20 per cent will be issued to external shareholders. Farmers
will have the option of selling their shares on the stock market or
keeping them.

The preferred option includes contractual, constitutional and
legislative safeguards to help ensure New Zealand farmer majority
ownership and New Zealand control. These include:

\- The operational subsidiary will contract with the co-op to pick up
all milk produced by shareholders, maintain adequate processing
facilities, and adhere to a milk pricing agreement.

\- Only the co-op will be allowed to own more than 10 percent of shares.

\- 50.1 per cent of shares must be held exclusively by New Zealanders.

\- The co-op will not be able to own less than 50.1 per cent without a
75 per cent approval vote.

\- The minimum co-op stake will be 35 per cent.

\- The co-op will have a board comprised of eight farmer directors and
two independent directors.

\- The co-op board will have the power to appoint the board of the new
subsidiary, which will consist of six farmer and four independent
directors.

\- The two boards will share the same chairman and four farmer
directors.

\- Fonterra headquarters will remain in New Zealand.

\- Only New Zealand dairy farmers will be able to be shareholders of the
co-op.

Rationale

\-\-\-\-\-\-\-\-\--

Of all of the options considered, the preferred option reportedly best
ensures that Fonterra would be able to raise capital at a competitive
cost. It is estimated that NZ \$2 to 3 billion (US \$1.8 to 2.4) could
be raised through the share offering, which would enable Fonterra to
pursue its growth strategy of expanding in the fastest growing markets
around the world, including South America, China and other countries in
Asia. In these markets, there is strong demand for fresh milk and
Fonterra's strategy is to supply this demand by building profitable
businesses using locally-produced milk. In New Zealand, this strategy is
commonly referred to as a "behind the borders" approach.

The preferred option also enables Fonterra to address redemption risk,
which is significant. Producers that supply Fonterra must purchase fair
value shares proportional to the amount of milk supplied. These shares
are fully redeemable if producers decide to cease supplying Fonterra.
Because of the way the Fonterra cooperative was initially set up with a
fair value shares system, Fonterra has virtually no permanent capital.
The total value of all fair value shares represents the entire equity
capital of Fonterra. By issuing non-redeemable, tradable shares that can
be listed on the stock market, Fonterra would be able to minimize
redemption risk.

Wall St. Reaction

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Following the news of the planned restructure, Fitch Ratings announced
it retained a negative outlook for the dairy giant and assigned its AA-
(minus) credit rating.. Standard & Poor\'s has reassessed Fonterra\'s
rating and downgraded the outlook to negative, continuing the rating
agencies\' declining assessment of Fonterra begun a year ago. Fonterra
wants to maintain highest positive ratings, but the rating agencies said
the co-operative\'s business and financial risk profiles have weakened.
Fonterra\'s debt is ranked so its shareholder farmer-suppliers are last
in any potential line of creditors. The annual milk payments are
Fonterra\'s single biggest business cost. A revised capital restructure
would enable Fonterra to raise capital to fund growth, rather than rely
on debt, and would reduce redemption risk if the amount of milk supplied
decreased significantly. A Fitch analyst warned that while the capital
restructure has credit-enhancing features, it also requires a
restructuring of the milk supply arrangements - potentially leading to a
significant diminution in Fonterra\'s financial flexibility.

According to newspaper reports, a listed Fonterra would be worth between
NZ \$8.6 (US \$6.9) and NZ \$10 billion (US \$8 billion), making it the
largest company on the New Zealand stock market. (The next largest
company is Telecom valued at NZ \$7.7 billion (US\$ 6.15).) Many in the
industry expect the fair value share of Fonterra stocks owned by current
shareholders to go down by approximately 35 per cent because the
cooperative's equity will be distributed -- 15 per cent to farmers and
20 per cent to new investors.

Initial Reaction by Dairy Farmers

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Despite the safeguards in the proposal and reassurances from Finance
Minister Michael Cullen that Fonterra's plan would be in New Zealand\'s
best interests, the initial reaction from farmers is mixed with most
indicating that they need more information before they can make a
decision. How the milk transfer price between the co-op and the
operational subsidiary will be determined is a key factor as this will
determine how much of the operational subsidiary's revenue, after costs,
will be passed on to producers in the form of higher milk prices and how
much will be passed on to investors in the form of higher profits. The
new board will be in the unenviable position of trying to balance the
desires of farmers, who will want the highest possible milk price, and
external investors, who will want the highest possible dividend. Under
the current system, virtually all of Fonterra's revenue is passed on to
dairy producers in the form of higher milk prices.

A team in Fonterra is working on a system to calculate the milk transfer
price and aims to put a proposal in front of farmers in the next couple
of months. Because there's no market price for milk in New Zealand,
coming up with a suitable mechanism that is transparent, competitive and
fair will be tricky. According to Fonterra, the new system will build on
the approach used by Duff & Phelps, the company that calculates the fair
value of Fonterra shares. Farmers will need to be convinced that this
system protects their interests before they vote to approve the listing
plan.

Another concern among Fonterra shareholders is the issue of non-farmer
dominance and encroaching foreign direct investment. While the preferred
option put forward to stakeholders has contractual, constitutional and
legislative safeguards to protect farmer control and New Zealand farmer
majority ownership, many farmers are questioning whether these
safeguards are adequate. While the proposed governance structure is
intended to ensure farmer concerns are addressed, many see an inherent
conflict of interest in the way boards are set up. Others have expressed
concern that the co-op will still be exposed to significant redemption
risk and capital management issues, which, in the minds of some could
lead to a sell off of shares and increased external investment,
especially if there is a drop in the milk pay out price. (If the milk
pay out price drops and there is a loss of supply, the co-op would
potentially be forced to sell shares to fund the farmers exiting the
system.) Another frequently heard complaint is that the Fonterra
announcement was "big on spin" but "short on hard facts".

### New Entrants into the Processing Sector 

Over the last year, two more new entrants have entered the industry. A
\$100 million plant, built in South Canterbury by New Zealand Dairies
Ltd, is now processing milk. In addition, Dairy Trust, an offshoot of
the meat coy AFFCO and the Talley family interests, has taken over Open
Country Cheese and plans to build up to four processing plants near the
sites of existing AFFCO meat processing plants. Both these processors
will source milk from contract suppliers and from Fonterra.