By Sherry Bunting, Farmshine, March 2, 2018
BROWNSTOWN, Pa. — Every avenue of approach to a four-way crossroads comes with a temporary stop or yield and the need to know whether to turn one way or the other, double back, or drive forward. Staying put is only an option for the time it takes to know which way to go.
For dairy producers at this turning point, not one of these options can be exercised without knowing the farm’s cost of production and its equity position to decide upon a direction for what’s ahead.
Difficult discussions are being had around farm kitchen tables across the country. Seek out the help that is available to navigate, say dairy lenders and consultants interviewed recently by Farmshine.
“Don’t internalize too much or to try to do it on your own. Don’t be afraid to reach out for help,” says Dale Hershey of Univest Bank and Trust. “Don’t wait to raise your hand until after it’s too late. There are people out there, good people, who can give advice and ways to do this at little or no cost.”
Competitive cost of production is shaping the future of the dairy industry. While we hear about the multi-owner multi-site dairies with nearly 100,000 cows and a very low cost of production, size does not dictate the ability to compete.
“It is being achieved here. We have 100-cow dairies and 1000-cow dairies with very competitive cost of production,” says Mike Peachey of Acuity Advisors and CPAs.
He explains that the Northeast has historically had a higher cost of production for a variety of reasons.
“We have been saved by having higher premiums for our milk, but as those premiums erode, the competitiveness of our operations is exposed,” says Peachey. “It comes down to how well-managed a dairy operation is — regardless of size — and how competitive we can get in cost of production.”
“We used to have a milk price advantage in Pennsylvania. That is gone,” adds Mike Hosterman AgChoice Farm Credit business consultant. “We are less than 25 to 50 cents difference to New York, when it used to be $1.00.”
They both see a wide range in cost of production among dairy farms that can vary by $2 to $3/cwt.
“There is easily a variance (in profitability) from bottom to top of at least $1000 per cow, so it really is segmented by thirds,” says Peachey. “We have a top third with a very competitive cost of production, a middle third hanging in there and a bottom third making tough decisions that carry a lot of emotion.”
“So much of the difference comes back to debt, especially for younger farmers,” says Hershey. “Dairy is tough to get into, and the biggest thing is how you come in. Those beginning farms won’t survive without capital or backing from family. We will have some startups this year, but fewer than other years.”
In this business of large capital investments, Hosterman observes debt per cow creeping higher.
“If you go back 10 years, debt was just under $3000/cow. As milk prices go through these wild swings, the trendline was still slowly increasing so producers could afford that increase. Now the price is leveling out while debt per cow can be over $5000 or $6000,” he reports.
“As lenders, we’re all stepping up to help these producers, but we may not have the capacity to help them all.” He notes that refinancing options, different debt structures, and FSA loan availability are some options.
While the fundamentals of future dairy demand and proximity to consumers in the eastern U.S. would suggest a key place for small farms here, Hershey is realistic about the hand being dealt.
“To be in this for the long haul, we have to look ahead and know what we’re dealing with,” he says, wistfully reflecting upon growing when his father made a good living with 40 registered dairy cows.
“That model is pretty tough to cash flow right now. I see a return to where we were 40 years ago, where farms here had different things going on, multiple income streams, seeing more farms diversify to strengthen their positions,” says Hershey. “If producers are solely dependent on their small dairies, it will be very tough unless they have a very low cost of production.”
Key advice? “Bring a team in around you.”
“Dairy producers are managing expenses and monitoring cash flows, budgets and cost of production throughout the year. They are bouncing ideas off their advisors and consultants to be more competitive,” says Mike Firestine of Fulton Bank. He was recently recognized by American Bankers Association with the Bruning Award for dedicated leadership.
Extension educators also report they are receiving very high interest from dairy farmers wanting to do financial analysis because of varying degrees of stress already experienced over the past three years.
As for Acuity, Peachey regularly looks at clients’ positions around four key areas: cost of production, percent equity, profitability and cash flow, providing information and context for discussions about where they stand, what is their competitive position and where they think they are going to be not just now, but a year from now.
Because things change from year to year due to many variables, including weather and markets, Peachey says it’s important to be monitoring all the things that go into that “cost of production stew,” including milk quality, good internal herd growth, good milk components and feed conversion.
Armed with a team approach, and the numbers, they can uncover how well the animal husbandry is being managed, the breeding program, pregnancy rates, heifer replacement programs, milk production, especially components, and milk quality.
“Done well, these things add up,” says Peachey. “Small farms can counteract some of the competitive disadvantages on the cost and income sides, by having their good management in all these areas add up.”
This becomes cumulative math. For each year that one dairy is not as competitive as another on cost of production (COP), the impact compounds.
For example, a $50,000 annual difference between two similarly-sized farms adds up to half a million dollars over a 10-year period that’s either not in a bank or being reinvested in the operation to stay competitive or being used to pay down debt to put the farm in a better financial position to weather these storms – to provide the liquidity and working capital to get through it, according to Peachey.
Continual monitoring of the COP and doing annual year-ahead budgets are key, Peachey points out, because “guarding cash flow is very important right now. Producers are really scrutinizing capital expenditures with an understanding of what is a need and a want. They are focusing on investments and management decisions that reduce cost of production beyond the initial payback.”
He notes that cutting costs is tricky: “If reduced feed costs means reduced milk production, for example, it ends up contributing to a tailspin when a cost-cut reduces top line revenue.”
“Some guys may sell off some assets and use proceeds to reduce debt,” says Hosterman, citing sales of mountain ground, extra timber, and selling heifers. “Heifer numbers have increased so much on dairy farms that selling extra heifers is not a bad option to generate some cash,” he says.
In fact, some farms are opting to sell quite a few heifers. Even though prices are not the best, these sales contribute to cash flow, which is critical. Some farms are breeding to beef breeds and producing a dairy beef cross for the feeder market. Again, not a big price, but the cost of the breeding is less, and the calves generate cash flow as well as cost savings. Such strategies require careful thought so as not to jeopardize the position of the herd for the future.
Knowing the farm’s COP provides the information to make these types of decisions.
If the farm’s COP is not competitive, the question is, can it become competitive? Is the farm within striking distance of getting to a competitive COP? If the answer is ‘no’, there may be tough business and family decisions to make, according to Peachey.
He says it is also very important to evaluate the farm’s equity position, to sit down with the lender and look at the way the farm’s debt is structured.
“If the farm still has a strong equity base to restructure things to provide cash flow relief, it should be paired with an assessment of the farm’s COP and what can be done to improve it,” says Peachey. “How much runway do you have to work with? Knowing this is helpful for a restructure, but the airplane still has to get off the ground.”
In other words, equity for restructure provides the runway and working toward a competitive COP elevates the plane before it reaches the end of that runway.
It’s critical to go through the budgeting process, says Peachey, “to understand your cash burn rate for the coming year, to know if you have the working capital and liquidity to absorb this and if you have the broader equity base to recapitalize those losses. If I lose x-amount, can I put that on a 3-year note and pay it off and still be okay?”
Peachey equates the breakeven to a Class III price and looks at it from both the intermediate and long-term perspectives. For the short term, he sees the goal being a Class III breakeven of $15 to $15.50, so if the farm’s basis is $2 over Class III, that equates to a breakeven of $17 to $17.50 in other discussions or venues.
He cautions that, long term, the marketplace is going to demand a lower COP with Class III breakevens down to $13 and $14.
Hosterman concurs: “Some of our best farms are achieving a COP under $16.50 right now, so they can get by at a $14 Class III price, but the bottom third still needs a Class III price of $17, and the average producer needs a $15 or better Class III price to break even.”
“It is being achieved here,” says Peachey. “We can do it, but it gets back to all of the other little things that add up to how well the operation can be managed. When we know our COP, we know the weak spot in our model and can figure out how to compensate for that and find where the opportunities are.”
Hershey has received numerous calls from producers wanting to do these projections and breakevens to navigate the road ahead, and he cites Dr. Kohl’s four cornerstones of success — plan, strategize, implement and monitor. “We are pushing that, more than anything, that farmers who are struggling can ask for help.”
There is high praise for what the Center for Dairy Excellence and Penn State Extension offer to improve producer competitiveness to also improve the state’s competitiveness in dairy.
“The resources, educational opportunities and ways to connect folks are greater than ever,” says Peachey. “We have a strong infrastructure and a lot of good things in place.”
Other states have similar extension and organizational services. Seek them out.
Look for more in future editions of Farmshine as we continue this dairy crossroads conversation with producers, industry participants and leaders in the East… and beyond. The next installment will move into the policy realm with a look at the critically acclaimed film “Forgotten Farms,” produced in New England, and a panel discussion about our nation’s food policy centering on the burning question: why has dairy largely been left out of the local food movement? And what is being done about it.