Eco Investor February 2016

Pre-Profit Securities

Carbon Conscious - How Environmental and Ethical Is Its Farming Strategy?

Simon Turner
Principal
Rising Star Research

Carbon Conscious recently announced a major change in strategic direction with their move into dairy production. The company has also notified the ASX of their intention to change the company's name to Alterra at the company's AGM in February to reflect their change in business direction. Prior to this announcement the company's main business activity was the long term contract management of carbon plantation assets (reforesting the Wheat Belt) reflecting an environmental passion within the management team. Carbon Conscious will continue to generate around $1 million per annum of earnings (EBITDA) from these long term reforestation contracts which will continue for the next 20 years. The company also owns some New Zealand forestry assets worth around NZ$4 million which are likely to be sold in order to move into a net cash surplus ahead of the company's dairy expansion which will require significant investment. The company already has a strong balance sheet with only $1.3 million of debt and $1.0 million of cash and receivables. Net assets amount to $12.0 million and the current market cap is $21 million.

Under the new strategic plan the company will supply Western Australian milk into the Chinese market through Green Lake, which currently distributes Australian products to 150 minimarts in China. Carbon Conscious was attracted to the Chinese dairy market by the extremely high prices for Australian milk which retails for $8-10 per litre, 8-10 times higher than in Australia, reflecting its luxury good status. The attraction of distributing through Green Lake is no doubt the company's aggressive expansion plan; Green Lake is planning to open 300 Capel Farm branded stores, which will specialize in Australian sourced and branded produce.

Carbon Conscious will lease a dairy farm at Capel in Western Australia from Green Lake, its distribution partner in China, on a 12 month lease with an option to extend for up to 20 years. The company has initially purchased 418 cows whilst the proposed herd size is 2,500 cows. Carbon Conscious intends to farm using the System 5 dairy management method, which involves keeping the cows within barns at all times and feeding them on grains, vitamins, etc to ensure a better milk yield per cow than from traditional pasture based farming. This is the world's most intensive farming method. Carbon Conscious are aiming to produce 10,000 plus litres of milk per annum per cow, well above the 6,500 litres per annum per cow generally produced using traditional pasture farming methods.

This System 5 approach raises numerous ethical and environmental questions given the lack of free roaming for the animals and the intensive milking approach:

- The cows are given very little space to move around despite their natural inclination to roam for pasture. Abnormal behaviours such as tongue rolling and excessive licking are tell-tale signs that confinement causes distress.

- The cows are largely fed a non-grass diet designed to boost their milk production well above natural levels. However, this unnaturally high energy diet often leads to severe digestive problems like acidosis.

- The pressure caused by the unnaturally high milk production can cause cows' udders and supporting ligaments to tear, which generally leads to an early slaughter.

- The hard flooring within the intensive facility can cause hoof lesions and lameness, which can also lead to premature slaughter.

- In terms of its environmental impact, System 5 farming generally leads to heavy run-off of nutrient-rich cow excrement. In New Zealand this run-off has become a major environmental problem, severely damaging rivers and ecosystems. Carbon Conscious mention the adoption of advanced waste management strategies in their presentation but the detail is lacking at present.

- The carbon emissions will be significant. According to Dairy Australia, the average dairy farm emits 1.11 kg of CO2 for each litre of milk produced. Carbon Conscious' large scale production plan involves 2,500 cows producing 10,000 plus litres per annum which implies 25 million plus litres of milk per annum or 28,000 plus tonnes of CO2 emitted. This is a significant carbon footprint, and it is clear why management are in a hurry to change the company's name.

For a company which previously focused upon the ethical business of reducing carbon emissions, this strategy represents a startling change in ethical stance and direction. Whilst the financial data may suggest such intensive farming methods lead to higher milk and financial yields, the ethical and environmental price paid appears to be a high one. In my experience, companies which opt for unethical business practices are best avoided over the long term. I would suggest environmental and ethical focused investors look elsewhere.

In addition, from a pure financial perspective there is a long list of serious risks to be aware of with such a dramatic change in business direction:

- The profit sharing agreement with Green Lake remains unclear. Given the company's lack of dairy management experience and track record it seems likely that Green Lake will be retaining the majority of the profit.

- Carbon Conscious will be aiming to milk 2,500 cows three times a day in a 60-stand rotary. According to Daviesway (a leading rotary dairy manufacturer), "A 60 unit rotary dairy should milk 300 cows per hour with an average production of 30 litres per cow". Even in a perfect case scenario the company will struggle to achieve its milking target with these existing facilities. This implies the company will need to buy an additional rotary dairy facility. In addition, the company will need to have an industry leading team of milkers and mechanics on site to sustainably manage such an ambitious and challenging plan.

- Carbon Conscious mention in their recent presentation that management have extensive agribusiness experience based upon their forestry management experience. However, in my opinion, this experience is arguably meaningless in the dairy sector which requires very specific experience and knowledge to be successful. It is a complex industry based upon a delicate balance of people, animal, pasture and machinery management.

- Milk prices have been weaker than expected in most developed markets in recent years reflecting stronger than expected European production. Whilst Chinese prices for Australian milk are currently at an enormous premium, this premium may be eroded as surplus milk supply finds its way to China.

- The all encompassing landlord/tenant and distribution partner relationship with Green Lake could create conflicts in the future given the extent of the co-dependency between the two companies.

In my experience, it pays investors to be cautious when a company changes its stripes overnight. It takes many years to fully understand a new industry and most management teams involved in new business areas tend to be overly optimistic when they launch. The numbers suggest to me that Carbon Conscious is in this boat.

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