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«David Alvis A 2008 Oxford Farming Conference / Nuffield Farming Scholarship Trust award Thanks and acknowledgements I would first and foremost like ...»

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Approximately 90 local Farm Credit associations and 5 System banks each have their own boards of directors and are owned cooperatively by those who borrow from them. Each bank and association manages and controls its own business activities, operations and financial performance.

This system provides access to finance for US farmers and growers enabling access to capital that might not otherwise be available, particularly due to the in-built risk management infrastructure within the FCS organisation. However the conservative nature and requisite levels of securitisation against assets required by the FCS meant that it alone would not be sufficient to fund Milksource’s ambitious growth model External Investment & Diversification Consequently external investors were brought into the business to provide growth capital, industry knowledge to help diversify their business interests. Two parallel ventures were started with mixed success. The first, a milk bottling business, was in Jims words ‘a BIG failure’ and incurred substantial losses.

When it was clear that this business had no future the 3 original investors and their new partners faced disagreement over how the company should be wound up. The external investors were looking to cut their losses and seek bankruptcy protection, leaving a number of local suppliers facing heavy losses with little likelihood of recovering any of them.

The original partners however were concerned over the potential damage this would do to their reputation and local standing and therefore decided to cut their ties with the external investors and seek to wind up the business at their cost paying back all the supplier debt in the process.

The winding up of that business was a salutary lesson in business ethics and taught the team a lot about where their expertise lay and where they should focus their efforts in future. It also illustrated the risks of engaging external investors whose objectives were not fully aligned with their own; something they would not repeat again.

The second diversification, Calfsource, a contract calf rearing enterprise was a more successful venture. Building on their collective stockmanship and understanding of the needs of local farmers, they grew Calfsource into a 7,000 head rearing facility that was generating a valuable income stream. Calfsource was sold in 2003 to Smithfield Foods, releasing a significant amount of capital that allowed the business to further expand its core dairying business.

Focusing on core strengths The business model was now a simple one; to grow their asset base focusing on their core strengths which were expertise in milk production, and in structuring finance for continued land acquisition.

In Jim’s view land ownership is a critical component of the business’s success. The long term appreciation in asset value has provided an equity cushion that has allowed them to continue to grow without recourse to external (non-bank) sources of finance. It is very much a business model that is contingent on maintaining a track record of consistent performance and minimising downside risk, but avoids the exposure to the ‘local feed mafia’ that Jim felt was a fundamental weakness of the Holsum Dairies model.

Kenn Buelow had in Jims view set a floor value for locally contract grown forage that was driving prices in the area. By keeping production in house, Milksource avoided direct competition for cropping expertise, which they have subsequently developed internally and instead concentrate on acquiring the right land at the most economic cost.

Managing Risk

On an operational level Jim’s key area of focus within the business is to manage the business’s financial risk which he has achieved by locking in a margin over cost of production that generates sufficient cash to service their debt level and to drive further expansion through acquisition.

This in turn relies on the business maintaining the requisite level of technical performance which is down to John’s (livestock) & Todd’s (operational) expertise.

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All input costs will be for crop production, feed purchase, operational and energy costs are fixed over an 18month horizon. Likewise the company’s milk price had been secured with their buyer over a similar period, at a modest discount to the historically high but relatively illiquid and thus volatile milk futures market, to secure a net margin over total cost of production of $3.5 dollar per cwt of milk sold.

After debt service that left a significant seven figure net free cash-flow* available for investment, against which further debt could be securitised to drive their continued expansion.

Financing Expansion

When I visited they had just completed the construction of phase one of a new $70million dairy facility in Rosendale, Fond du Lac county (www.rosendaledairy.com) and were about to start stocking this unit with the first of 4,000 cows. The facility was designed to house up to 8,000 cows at full capacity, in state of the art air-conditioned free-stall barns employing cross ventilation & evaporative cooling technology and milked through two 80 point rotary milking parlours. Unlike their earlier units the Rosendale facility will incorporate AD & CHP technology to process manure as part of an integrated environmental risk management process and to generate additional revenue for the business.

Rosendale Dairy milk loading dock

As of autumn 2009, stage two had subsequently been built and was in the process of being stocked. This is doubly remarkable given that the second phase of expansion has occurred during a period of marked downturn in US milk prices, yet MilkSource’s disciplined approach to risk management had enabled them to maintain their planned growth despite the ravages of the commodity cycle and the credit crunch.

As they have developed their business and established a consistent track record of operational and financial performance, so their sources of finance have evolved.

Operational assets continue to be funded via the Farm credit system, typically geared at 50%. In Jim’s words, ‘The FCS understands the industry and as such is easier to deal with than the generic banking system when it comes to financing operational assets and working capital, particularly when your track record is as consistently sound as ours is’.

The Real estate portion of their portfolio tends to financed at 30-35% equity (65-70% gearing) using generic commercial banking channels, where the more competitive nature of the market has allowed them to borrow at cheaper rates. Jim budgets on a long term weighted cost of capital of between 6½ to 7%; in 2008, prior to the credit crunch, he was able to secure borrowing at 4%.

Sustaining Growth

The operational structure of the business is also constantly evolving to support their continued growth. The business has employed an in house lawyer and a professional project manager from the construction industry to manage the legal and operational aspects of their planned expansion, which is set to grow by an ambitious 3,500 cows per year for the next ten years and achieve a target of 50,000 cows within a 2hr flight of their home base.

Managing the key risk areas of the business is fundamental to achieving this target.

Continually improving operational performance underpins the financial risk management strategy and this is down to attracting, motivating and retaining the right people and ensuring that the business stays at least one jump ahead of ever tightening environmental legislation.

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However the rewards for success are clear and Jim is comfortable that his approach is sustainable. ‘A pollution Tsar would insist on dairying being done this way as we have to demonstrate a far greater degree of environmental compliance than the smaller guys’ He sees the trend towards larger scale as inevitable stating ‘what we offer is a viable exit route for smaller producers either through contract farming arrangements or sale of land based on a purchase price that is many times greater than its written down value’.

Jim cites examples of other successful dairy entrepreneurs across the US such as Louis Bettencourt (70,000 cows in Idaho) Gary Fehr (40,000 in Minnesota) and the McCloskey / den Dulk partnership based at Fair Oaks, Indiana, all of whom are rapidly expanding their operations based on leveraging their core competences in commercially and environmentally sustainable dairying.

As has happened in the pig and poultry industry, Jim foresees an exit opportunity in the longer term for dairy entrepreneurs via a ‘rolling up of the better large dairy operations’ by corporate investors in what he predicts will be the next wave of industry rationalisation.

These opportunities however will only be available to well invested businesses operating at optimum commercial scale with established risk management systems in place.

Jim Ostrom has a clear view of the future and is building a business that is able to adapt to meet the challenges and opportunities of an ever evolving industry. By creating a clear corporate structure, brand identity, and robust operating model, Milksource group will be well placed to exploit those opportunities as they arise.

Fair Oaks Farms & Bos Dairies, Fair Oaks, Indiana The art of dairy is what we do. We are so passionate about our extraordinary dairy, we invite you to visit us any day and every day. - Fair Oaks Farms Straddling interstate I65, midway between Chicago and Indianapolis in the heart of the Indiana cornbelt, is one of the largest dairy farms in the United States, home to 30,000 milking cows and some of the most innovative approaches to large scale milk production anywhere in the world.

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The dry climate in the region and allowed them to build large low cost ‘dry-lot’ dairies fed by abundant borehole water for less than $1,000 per cow. The milk was sold through co-ops in Eastern Texas to the growing market in the south east and for a number of years they enjoyed a period of high rapid growth and high returns, accumulating considerable net worth in the process.

Low cost infrastructure and competitive freight rates enabled many of the dairies to pay for themselves in under 3 years, but by the end of the 80’s, with the reorganisation of the East Texas coops and others to form Dairy Farmers of America and subsequent changes in the freight rules applied to West Texas & New Mexico producers, profitability started to fall dramatically.

So McCloskey went looking for a new market for his milk and soon identified a regional grocery chain that was looking to source its milk more effectively. Their requirement at the time was for the equivalent of 30,000 cows, so McCloskey subsequently set up Select Milk Producers in 1994, a co-op made up initially of 16 large-scale producers who were able focus on the consistent supply of quality liquid milk for the retail market. Today Select Milk is the 5th largest milk co-op n the United States supplying over 3.3 billion lbs of milk per year, from less than 50 members.

In the mid to late 1990s McCloskey started looking domestically and abroad for new opportunities to expand his successful dairy model and identified the Mid West as offering the best combination of productive land, water, good transport infrastructure and a strong and secure local market for milk.

At the same time the Prudential insurance company were looking to offload a sizeable block of land that they had acquired, about an hour’s drive south of Chicago as a speculative site for a new airport to service the city. When it became apparent that the project would never materialise, the insurance they started looking for someone to take the 15,000 acre block of irrigated land off their hands in a hurry.

Additionally the Indiana state government was, at the time, keen to attract agricultural investment into the state to relieve its flagging rural economy and was prepared to offer fairly keen tax incentives to anyone prepared to relocate to Indiana, as well as looking favourably on the granting of development permits for large scale livestock operations that would provide a local market for the states key crops of corn and soybeans.

These three factors made for a once in a lifetime investment opportunity and McCloskey and his partner Tim den Dulk were quick to capitalise on it, mobilising a syndicate of South West Dairy producers backed by a Californian real estate fund that acquired the land at Fair Oaks for a ‘fire sale’ price of $2,200 an acre and set about building what is now one of the most successful dairy operations in the United states.

Aerial photograph of Bos Dairies No.1&2, Fair Oaks, Indiana.

The land base now extends to 25,000 acres and is home 30,000 cows on 9 dairies; 4 on the west side of the interstate run by McCloskey & den Dulk as Fair Oaks Farms and 5 on the East side operated by the Bos family, who relocated from Texas, as Bos Dairies.

Financing & Operations

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“Essentially the business was funded by the principle partners own equity with external capital from a Southern Californian real estate fund.

Partners’ equity was provided by the sale or lease of their former dairy operations in the South West & Texas. US Banks have traditionally kept away from ‘Big Dairy’ due to the volatility of the milk market, perceived environmental risk and public perception issues.” The Fair Oaks business is divided into a number of separate profit centres for legal and operational reasons. These were broadly defined as Real Estate, Operations, Energy generation, Education, on farm processing & Retail.

Whilst Fair Oaks Farms (FOF) and Bos Dairies are essentially separate businesses they operate as one outward facing entity, with regards to cropping, input purchasing, environmental management and essentially milk marketing.

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