People love to be offered options in life, up to a certain point. Unfortunately, if they are faced with too many options or ones that they do not understand, the choices available to them become overwhelming. Actually, that may describe the current situation with Milk Options. There are so many options available that the choices can, indeed, be confusing. Several years ago, I wrote an article for the Western Dairy Business publication centered upon what I felt were the “Top 10” steps to take in preparation for the coming year. One of the most critical of these steps was the development of a Milk Marketing Plan.  This is an absolute must today, particularly with the increasing amount of volatility and fluctuation in milk prices. Understanding your break-even price level (check out: www.financematters.solutions today) and knowing how to position your business to achieve that price will continue to be essential to your financial future. Get involved in your own marketing plan by working with an options broker that you trust. He or she can be invaluable to your business. About the same time, I also had an opportunity to moderate a panel of Agricultural Lenders in a discussion on the availability of financing. One of the recurring themes that seemed to surface was the issue of whether or not a producer should be using milk options, also known as Puts and Calls, in the management of their dairy business. Their response was unanimous. About the same time, I was asked to describe a scenario when I felt it would be smart to make use of a Call Option. When would it be wise to make use of a Put Option? In a moment, I’ll share my response to those two questions as well. However, I feel it is important to consider what all “options” are about. Who, in fact, needs them? The key to successfully using milk options revolves around a task known as “Margin Management.” You may know this as “Risk Management.” Several of our lenders on the panel emphasized how important they felt that was for any borrower. Their explanation covered some of the aspects of how you should use milk options to almost ensure that your margin is more positive. Our lenders also discussed a term called your “Burn Rate.” This is the rate at which you will eliminate your entire Net Worth if you continue to lose money each month. For example, if you milk 2,000 cows that produce 70 pounds per cow per day, you will produce about 42,000 hundredweights in a thirty day month (2,000 X 70 X 30 / 100). If you have a Net Worth of $2,000,000 and are losing $2.00 per cwt, your Burn Rate is about 24 months ($2,000,000 / $84,000). In other words, you could potentially operate for about two years at that rate of loss until you ran out of Equity. Your lender would much prefer that you consider making reductions in your costs or somehow place a “floor” under your milk price prior to that occurring. That is what you can accomplish by using a “Put Option.” The Put places a floor under the price you receive. Puts are all priced using Class 3 Federal prices, which can create some issues in California, Idaho and possibly several other states due to the difference in basis. These states’ systems may be somewhat correlated with the Federal Pricing system. However, they do not match it. By purchasing Put Options through a broker affiliated with the Chicago Mercantile Exchange (CME), you essentially put a floor under your milk receipts/cwt on the portion of your milk you cover. If you purchase a Put Option for $15/cwt milk for June 2010 and the Federal Order Milk price at the end of June lands at $14/cwt, you will still receive the $14/cwt from your Cooperative. However, you will also receive the difference in a separate check from the CME ($1.00/cwt e.g.). If, on the other hand, the market price comes in higher than the level your Put Option is set at, it expires unused, and you only lose the cost of the premium you paid for that Put. This is an extremely simplified example of how Put Options work. You can only purchase these through licensed, qualified brokers, for good reason, but there are many great firms out there for you to access. Why would you use Puts? Let me give you four reasons: 1.) Your loan renewal is coming up, and your banker is worried about your projected profit/cwt. 2.) Your “Burn Rate” is looking rather small. 3.) You are a young producer just getting started and need to be certain that you protect your bottom line. The use of options may help. 4.) You are highly leveraged, either as a result of past losses incurred or due to a recent expansion you’ve undertaken. How about using “Call Options” in your dairy business? These allow you to “buy” milk at the CME (not literally) at a pre-set price. Primarily, I see these used when a milk buyer offers a “Fixed Price Contract” for your milk. If, for example, you agreed to a $15/cwt price with your milk buyer for the next 12 months and during that same time period the Federal Class 3 Milk Price climbed to $18/cwt, you would still only get $15 from the buyer of your milk. What can you do? If you simultaneously have Call Options in place for some level such as $15, they will allow you to buy milk at $15 when it is worth $18/cwt, allowing you to collect the difference from the CME. This information covers only the basics of what you need to know before using Milk Options. However, I think it is important to consider how they might benefit you by smoothing out the highs and lows of the dairy industry. The easy days of managing dairy prices and margins are over. It will be critical to your future that you master the art of margin management, which requires knowing your true cost of production, particularly on feed, with which you can also use options (Hint: See www.financematters.solutions). If you have developed a better system, I hope you succeed greatly with it. However, for most producers, options offer the best insurance against devastating losses. Talk to some brokers and other dairy producers who have actually used them and develop a plan. A number of my Clients used a combination of Options and Fixed Price Contracts with their milk buyers during 2009 & 2015. Several Clients averaged almost $16/cwt for their milk and netted out over $2.00/cwt before their personal draws from the business. This was excellent, but, more importantly, it happened because they’d set themselves up to have more “options!”

Dan Sullivan, founder of The Strategic Coach organization stated that “people do strange things when they have no future.” Since this is undoubtedly true, I have attempted to keep my Clients on the leading edge by providing them with a system for setting regular business objectives and keeping them as far away as possible from the dangers often encountered in their industry. The purpose of this article is to demonstrate a working model for completing this process – one that we can revisit as often as needed.   It might be best to start by answering five basic questions. Why take the time to set these goals and develop a Disaster Agenda^TM? I often hear people refer to the goals they have set for themselves. When they do, they often say that they have them all firmly planted in their head. However, my experience has taught me that this just does not work as well. It is imperative that we get them down on paper since it makes us completely focused in our thinking about what we wish to accomplish. If you try to do this “just in your head,” you will find that it is too easy to get distracted by other issues, and we are all faced with distractions every day. Thus, commit them to writing, and your goals are much more likely to be reached. Even if you write them down and put them in a desk drawer, your subconscious mind will go to work on them.   How do you get started on this process? I believe that corporate America has done a great disservice in this area. During my time in corporate America, I constantly felt inundated with demands on my time. “Do this, do that, achieve the impossible! We know we didn’t provide you with your annual goals until April and they may be high, but you should have been planning for this type of production demand…” and so on. This is crazy! Why not set aside some quiet thinking time to establish new objectives for the next 12 months.   When to complete this is the best part. While it may be a “corporate sin” to set aside work time to do such planning, you will definitely be rewarded with better results. I cherish the two days each fall that I take to get away and set new goals and objectives for my business. Take advantage of this time to move your business forward.   What should your goals center on? Challenge yourself to set goals in areas that you can reasonably expect to make progress. Please note that I did not say “easily” expect to make progress. Your goals need to be challenging and set high enough to keep you excited about reaching them. However, they also need to be achievable. Otherwise, you will get frustrated with them and give up. You do not need that outcome!   I will leave the when and where part of the process up to you. As I stated earlier, I spend two days per year off site (to minimize distractions) planning my next year. Believe me; this really has paid off for my business. I normally complete this process in November of each year. This allows me to review what happened during the prior 10 months of the current year and also look ahead to what I want to accomplish in the next calendar year. I always do this off site, simply because I want to be able to focus on my objectives without any distractions. I believe the elimination of distractions is imperative to the success of this process, but you decide for yourself.   Now, let’s go one step further. I also work with Clients to develop a Disaster Agenda^TM. What is a Disaster Agenda^TM? It is a list of the three worst things that could happen in your business and how you would respond to them. When you complete this process, you accomplish several tasks:  

• You will be better prepared if one of these crises actually does occur.

 

• You are more likely to avoid these crises, due to your increased awareness of their potentially occurring.

 

• If one of these problems, or something similar, does occur, you will have a response or action plan ready to go, yielding a quicker turnaround and saving you both time and money.

  Need some examples? Here are some that I have previously written about. They still make sense today, but think of three that fit your experience and your operation.  

• Environmental Pressure – This is an area that is worthy of some serious review. How will you respond if your dairy business is sued for potential damage to the environment, whether the claim is legitimate or not?  These types of lawsuits are not going away anytime soon!  Litigation is a costly process, particularly when you consider the legal costs and the expenses associated with capital projects “held hostage” in an unfinished state that does not lead to your intended increase in cash flows.  One solution might be to pursue the training that is available from various agencies.  This is time well spent.
• Losing Financial Control – As the number of dairy operations in the US continues to decrease (76,630 in 2001) and average herd size keeps increasing, it is more critical than ever to maintain control over your operation’s finances. Regardless of industry, businesses often run into trouble when they expand in a rapid, uncontrolled manner.  The primary reason is they run out of cash.  One of the best preventative measures against this problem, as covered in prior columns, is to work within the guidelines of an ongoing strategic plan with detailed financial projections.  Another helpful item is to know your costs/hundredweight on a historical basis and for future projections.  Increasing the size of your dairy is no excuse to lose control over costs/cwt.  Visit us at financematters.solutions.
• Inability to locate financing – This has been the case for many producers across the US as they attempt to expand their operations. This trend toward tighter lending standards actually began in late 2000.  In an effort to avoid a credit crunch, some borrowers have accepted excessive short-term financing when they should have focused on additional long-term financing.  Unfortunately, having the wrong loan structure always seems to “rear its ugly head” at the most inopportune times, e.g. during a period of low milk prices.  A potential solution: Grow your business with better financial records to help you maintain a loan structure that yields Debt Service Coverage of at least 1.25 times the level required to make your loan payments.  Having good financial information can go a long way toward avoiding unnecessary challenges in finding financing.
• Loss of your Milk Market – I was visiting with a dairyman who had suffered the loss of his milk market due to a sudden change among the players in his area. It literally cost him in excess of $30,000 monthly for six months before he was able to get the situation under control.  What would you do?  Eventually, he was able to negotiate a better contract with a new buyer of his milk.  However, his losses in the short term were enormous and help remind us of the vulnerability we face as a “price taker.”  This could also occur if your herd was suddenly faced with a major health problem.  These potential cash flow shortfalls further reinforce the need for cash or available credit at all times.
• Sudden Loss of Key Personnel – Whenever a key worker departs, particularly on short notice, it is essential to have a plan in place to cover for them, at least in the short term. These departures clearly illustrate the need for team development and the cross training of personnel at each key position. Attractive benefits, retirement plans, insurance and competitive pay help to avoid this type of crisis.  However, it still pays to have a backup plan in place.

  This list of potential crises is far from exhaustive, but hopefully it will stimulate your thinking as you develop your own “Disaster Agenda^TM.” As Author Jim Taylor stated, “Plan for the future or you will have no future.” It can be crucial to your success levels!

Consider using the following questions in the financial analysis of your business. The first question, “What is our current performance?” In the area of finance, we would naturally consider measures such as profitability, cash flow and debt service coverage. Many of us study expense items when our revenue is lower, as in 2006, 2009 or 2015. I would challenge you to review these line items in the good times as well. It is easy to let costs slip upward when there is less downward pressure on milk prices and cash flows. Question number two, “Are we getting better or worse?” “…and WHY?” It is important that we ask why we are improving or regressing. If we are spending money on capital expenditures designed to improve our labor efficiency, are we actually seeing a reduction in direct labor costs? If not, will we at some point in the future? Are we projecting improved cash flows as a result of these expenditures? Monitoring monthly expenses can help you keep them closer to your annual budget. Your banker will be looking at each of the line items throughout the year. Shouldn’t you also? For assistance with this ongoing process, check out our new program (coming out soon) at www.financematters.solutions. The third question, “If your operation is broken, what needs to be fixed?” Many times we resist change because it can take us out of our “comfort zone!” We all need to stretch ourselves. In this case it is by closely examining each expense item and making those tough decisions no one enjoys, but which will assist you to take your operation to a new level of financial performance. The final question, “Are there patterns to which we can apply resources?” Are you seeing some measurable trends that can be improved upon with additional capital expenditures (CAPEX)? The best way to approach this task is to review current trends in profitability, cash flow or other measurements, and then project what you expect to occur with the implementation of your possible changes. Of course, as with all operational decisions, only hindsight provides 20-20 vision, so you have to use your best business judgment to select from all available options. Make what you feel is your best choice and give it a chance to work for you. If you complete the process of reviewing your current performance, checking whether it is getting better or worse, fixing items that seem to be broken, and using patterns or trends to determine where to best allocate your resources, these steps can pay huge dividends and substantially improve your business!!

We’ve talked previously about setting goals! There are benefits to being prepared for crises that can occur in your business. We need to have a plan in place for these types of challenges. Futurists Jim Taylor and Watts Wacker, in their book The 500 Year Delta, stated that every business should develop a “Disaster Agenda”. While all of us are faced with negative challenges and nobody wants to dwell on them, we would be well served if we have given these situations some forethought. This is true for a crisis that might occur in any part of your operation: herd health, nutrition, facilities, management, or finances. A Disaster Agenda is a list of the three worst things that could happen to your business, along with what your planned response would be. How do you accomplish this task? By seeing the world as it is; not by trying to wish the bad away, but by acknowledging some things will happen to you and your business. They might even be events we consider to be unreasonable today. Step “out of the box” on this job. Need some examples? What if your dairy was hit with a serious disease and you lost 1/3 of your herd? What if your milk co-op runs into financial trouble and is forced into bankruptcy? What if one of their largest customers files Chapter 11 and is unable to pay them? Unlikely? Perhaps; Is it possible? Absolutely! This is what completing a Disaster Agenda can do for you. It will help you to be better prepared. When you follow this process to completion, you will accomplish several tasks: *    You will be better prepared if one of these crises does occur. *    You are more likely to avoid these crises, due to increased awareness. *    If something similar does occur, you will have a response or action plan set to go, yielding quicker turnaround and saving you time and money. My client was planning to expand from 400 cows to 800 cows since he had a son who was soon returning from college. We began hearing rumors about how his bank was a candidate for merging with another lending institution. What if his bank gets bought and new ownership wants to reduce their dairy lending? Having a positive, long-term history with his lender, we decided to consider other potential sources of funds for the expansion project and, using financial tools at www.success-strategies.com to outline our proposal, received offers from two other lenders with loan structures suitable to his needs. As it turned out, his former bank did sell, and the new ownership did decide to reduce their Ag lending portfolio. What could have happened if we had not planned ahead…Jerry could have lost a lot of time and money in revising his plans at the last minute! Developing a similar contingency plan in your operation is definitely in your best interest. It’s a great example of Next Level Thinking™!

Where do you really want to be in five years? In ten years? How can you get there? What will it take to succeed in reaching those goals?

1. Who will take over your business when you are gone? Do you have a plan already in place? If not, why not develop one? Several years ago, I witnessed a sad but true situation where one person controlled all aspects of his business operation and, frankly, made all the decisions. One day, at the ripe old age of 42, this person was killed in an unfortunate auto accident. The result was absolute chaos around his business. No one else was trained to make effective decisions, and there was no succession plan in place. It was a financial nightmare for his family. It all could have been avoided with a minimal amount of planning.

 

2. Have you implemented a “milk marketing plan” yet? If no, why not? Are you using put options to establish a floor under your milk price? Likewise, are you working closely with your nutritionist and others to lock in the best prices on feed at all times? Do you truly know your breakeven points on milk price and feed cost? You need to know these! For help with this task, visit www.financematters.solutions.

 

3. Have a plan on everything you do. Follow the latest industry reports. Can we be assured of always making the correct decisions? Of course not. However, your odds of success will be greatly improved if you think about and develop your own plan for your business, particularly in comparison to letting the industry or others decide for you. Former Notre Dame Football coach Charlie Weis, upon being hired to lead a team that had win-loss records of 5-7 and 6-6 the past two seasons and hearing the players complain about the school’s administration, replied as follows: “Quit blaming everyone but yourselves for the reason there was a coaching change. There was a coaching change because you’re 6-6 and last year you were 5-7. There was a coaching change because you guys didn’t live up to the expectations around Notre Dame…Why don’t you just look in the mirror? Maybe the reason why you were 5-7 and 6-6 is that you’ve played crummy. Just maybe.” He certainly got their full attention. He claimed that you could have heard a pin drop. His message had come through loud and clear: “No excuses!”

 

4. Keep this in mind as you move forward. Realize that, as an industry and as individual participants, we have not always played by the best laid game plan. Reset your course today and join me in accepting “No Excuses!”

 

5. Let’s follow a better plan, starting today! If I can assist you, please contact me at: john@success-strategies.com.