FONTERRA THE EX­PER­I­MENT THAT FAILED

Hawke's Bay Today - - Business -

Tak­ing risks and in­cur­ring some fail­ures is the essence of any busi­ness. Fonterra is not the first ma­jor New Zealand com­pany to bomb in over­seas in­vest­ments. What counts is how well it learns and adapts.

So what’s gone wrong? Fonterra puts it down to poor fore­cast­ing, high but­ter prices, a high cost of raw milk and high op­er­at­ing ex­penses.

Their plan to put it right? Move an­other long-stand­ing di­rec­tor into the role of chair­man, get a new CEO, prom­ise bet­ter fore­cast­ing and stricter dis­ci­pline around costs, and re­view as­set per­for­mance.

Yet Fonterra’s lead­er­ship still says: “Fun­da­men­tally, the strat­egy doesn’t change” and “the strat­egy in a nut­shell is de­liv­ery”.

Voices at the mar­gin have again raised the idea of sep­a­rat­ing their con­sumer busi­ness into a sep­a­rate com­pany con­trolled by Fonterra but al­low­ing out­side cap­i­tal. How­ever, it is clear that the cen­tre of grav­ity of farmer opin­ion con­tin­ues to strongly favour keep­ing Fonterra to­gether as a ver­ti­cal­ly­in­te­grated farmer-only co-op­er­a­tive, a model de­scribed by their new chair­man as hav­ing “served us well for 18 years”.

The chair of Fonterra’s Share­hold­ers’ Coun­cil weighs in more strongly: “the co­op­er­a­tive has been around for 145 years in some form or an­other, which speaks vol­umes for the en­dur­ing na­ture of the co-op­er­a­tive model and the re­spon­si­bil­ity to en­sure this re­mains for fu­ture gen­er­a­tions”.

One change that Fonterra is push­ing is to end its obli­ga­tions to sup­ply raw milk to com­peti­tors and ac­cept milk from new farmer-share­hold­ers. (More on that shortly).

In sum­mary, then, Fonterra’s di­ag­no­sis is — right model, right strat­egy, poor ex­e­cu­tion. And we need to ease reg­u­la­tions that help com­pe­ti­tion. Stronger dis­ci­plines around costs and as­sets would cer­tainly make a dif­fer­ence for Fonterra. Bet­ter ex­e­cu­tion would help too. But these are only par­tial fixes.

The deeper prob­lem is that Fonterra has fun­da­men­tally failed to achieve the ob­jec­tives for which it was es­tab­lished 17 years ago. Worse, it has failed to gen­er­ate any real growth in value for its sup­pli­ers or share­hold­ers.

In any other in­dus­try, cre­at­ing a near­monopoly by spe­cial leg­is­la­tion would be re­jected out of hand as con­trary to ba­sic norms on how to grow a coun­try’s wealth and im­prove pro­duc­tiv­ity.

But Fonterra was given spe­cial treat­ment be­cause it was go­ing to achieve spe­cial things only pos­si­ble as a near­monopoly — or, as Fonterra likes to see it­self, as New Zealand’s “na­tional cham­pion” in world dairy.

Fonterra’s for­ma­tion was her­alded as a key move in the coun­try’s eco­nomic trans­for­ma­tion. “For too long New Zealand has been try­ing to sus­tain First World liv­ing stan­dards on the back of Third World ex­ports. That does not add up,” Prime Min­is­ter He­len Clark told Par­lia­ment in 2001.

In­stead of sim­ply pro­duc­ing more dairy com­modi­ties, Fonterra was to gen­er­ate a huge amount of new rev­enue from new prod­ucts in phar­ma­ceu­ti­cals, health food and spe­cialised in­gre­di­ents. These new rev­enues were to rise to dou­ble the value of tra­di­tional com­mod­ity sales in a mas­sive 10-year step-change.

Seven­teen years down the track, did the spe­cial treat­ment de­liver spe­cial re­sults? Sadly not. Mainly, Fonterra has con­tin­ued on the in­dus­try’s pre-ex­ist­ing tra­jec­tory of pro­duc­ing ever larger vol­umes of dairy com­modi­ties, es­pe­cially whole milk pow­der, which has more than dou­bled in pro­duc­tion since 2001.

In­stead of 15 per cent rev­enue growth per year, it has achieved less than 2.5 per cent per year over the last 17 years, as re­ported by TDB Ad­vi­sory, who also cal­cu­late that its nor­malised earn­ings in­creased by just 0.6 per cent year-onyear.

Only four years ago, Fonterra fore­cast ad­di­tional earn­ings of $15 bil­lion within three years from its $750m in­vest­ment in Be­ingMate. How­ever, as First NZ Cap­i­tal re­ports, there has been no growth in cash­flows or earn­ings since 2012.

In­stead of grow­ing share­hold­ers’ eq­uity by $20b in its first 10 years, Fonterra added just $3b over 17 years, and most of that came from farm­ers buy­ing more Fonterra shares so they could sup­ply more milk.

Since 2012, share­hold­ers’ eq­uity has barely in­creased. In the same pe­riod, net debt has in­creased 63 per cent.

In short, de­spite large in­vest­ments by Fonterra, the only mean­ing­ful growth has been in­creased vol­umes of milk. The dom­i­nant force driv­ing Fonterra has not been a strat­egy of trans­for­ma­tion, but rather a seis­mic shift in land use.

Since 1990, nearly a mil­lion hectares of sheep and beef land has been con­verted to dairy­ing, bring­ing with it nearly 2.5 mil­lion ad­di­tional cows, with 20 per cent more cows per hectare, and each cow now pro­duc­ing nearly 50 per cent more milk on av­er­age.

The re­sult has been a ti­dal wave of ex­tra milk, nearly all of which has to be ex­ported.

De­spite decades of strat­egy hype about “mov­ing up the value chain”, the re­al­ity is that Fonterra has been driven not by what con­sumers de­mand but rather by what its sup­pli­ers push.

Fonterra’s crux role as a pro­ducer co­op­er­a­tive is to serve its sup­pli­er­share­hold­ers. This im­per­a­tive, which dwarfs the rest, re­quires Fonterra to pour large sums of scarce cap­i­tal into new fac­to­ries to process that white ti­dal wave. By de­fault, most of the milk is turned into com­modi­ties, es­pe­cially whole milk pow­der.

While Fonterra likes to think of it­self as also be­ing a multi­na­tional mar­ket­ing com­pany and in­ter­na­tional cap­i­tal in­vestor, at its core, it is an ex­ten­sion of its mem­bers’ farms — a club in which farm­ers jointly own plant to pro­vide shared ser­vices that they can’t af­ford in­di­vid­u­ally.

So how has the av­er­age Fonterra dairy farmer fared? The av­er­age price re­ceived for his or her milk has barely in­creased in real terms since Fonterra was formed 17 years ago. Their shares in Fonterra are worth only 28 per cent more than in 2001, while over the same pe­riod the NZX50 in­dex (and pre­de­ces­sors) has in­creased by more than 400 per cent.

Over the last 10 years, while pro­duc­tion on the av­er­age farm in­creased by 40 per cent, term bor­row­ings have nearly dou­bled. An­nual re­turn on as­sets has av­er­aged just 5.7 per cent (this in­cludes changes in cap­i­tal value, which av­er­aged 1.4 per cent per year). Over the same 10-year pe­riod, av­er­age re­turn on eq­uity for the av­er­age farmer was just 5.6 per cent (which in­cludes changes in cap­i­tal value).

Put sim­ply, the re­turn de­liv­ered by Fonterra on the spe­cial treat­ment it re­ceived from Par­lia­ment has been less than or­di­nary.

For the en­vi­ron­ment, the costs have yet to be fully counted or com­pen­sated. The crux of the prob­lem re­mains the same as when Fonterra was formed 17 years ago — namely, the se­ri­ous mis­match be­tween Fonterra’s as­pi­ra­tions and strat­egy (on the one hand) and its ca­pa­bil­ity, re­sources and share­hold­ers’ struc­tural re­quire­ments (on the other).

It as­pires to be an in­no­va­tive, ag­ile, con­sumer-driven busi­ness with ac­cess to large amounts of cap­i­tal to fund higher mar­gin prod­ucts and brands in higher value mar­kets around the world, and to in­vest in com­ple­men­tary busi­nesses.

But it can only do this from a pro­duc­er­driven, cap­i­tal con­strained, rel­a­tively in­flex­i­ble plat­form bounded by deeply en­trenched re­quire­ments from farm­ers in re­la­tion to struc­ture — namely, a farmeronly co-op­er­a­tive, with no out­side share cap­i­tal, pay­ing out most of its earn­ings, pro­cess­ing all mem­bers’ milk, with a sin­gle na­tional milk price set at the end of the sea­son, with na­tion­ally av­er­aged col­lec­tion costs, op­er­at­ing as a near­monopoly within New Zealand.

In short, it’s an oxy­moron — a tan­gled knot of con­tra­dic­tions and wish­ful think­ing. Like a weightlifter pre­tend­ing that he or she can be a great pole-vaulter.

This is not, and never has been, an anti-co-op­er­a­tive stance. Dairy co­op­er­a­tives are well adapted to cer­tain pur­poses. With their fo­cus on shift­ing large vol­umes of milk for sup­pli­er­share­hold­ers, they tend to dom­i­nate milk col­lec­tion and dairy com­mod­ity mar­kets around the world. How­ever, when prod­ucts be­come highly dif­fer­en­ti­ated and per­for­mance cen­tres on cap­i­tal rather than mem­bers’ milk, dairy co­op­er­a­tives are less well adapted.

Their dif­fi­cul­ties in re­tain­ing funds (pay­ing out too much to mem­bers), and in find­ing a struc­ture that al­lows in­no­va­tion and ac­cess to out­side cap­i­tal, have been well known among ex­perts for many years. Back in 1999, Bengt Holm­strom, cowin­ner of the 2016 No­bel Prize in eco­nom­ics, ob­served that co-op­er­a­tives are “dis­ad­van­taged in the in­no­va­tion race”. The sim­ple an­swer is for Fonterra to ad­just its as­pi­ra­tions and strat­egy to prop­erly re­flect its ca­pa­bil­ity, struc­ture and re­sources, or vice-versa, or both.

Com­mon to all op­tions is the need for Fonterra and its sup­pli­ers to be driven by prof­itabil­ity, not vol­ume, with a higher stan­dard of dis­clo­sure and per­for­mance mon­i­tor­ing.

The key op­tions in­clude:

1) Bet­ter ex­e­cu­tion of cur­rent strat­egy. Con­tinue with the cur­rent struc­ture and scope of busi­ness, but put in place in­ter­nal mea­sures to make fore­cast­ing more ac­cu­rate, dis­card or rec­tify poorly per­form­ing in­vest­ments, im­prove dis­ci­plines around de­ci­sion-mak­ing and mon­i­tor­ing, and some­how do bet­ter at ex­e­cut­ing the cur­rent strat­egy.

2) Trim to the core and sim­plify. Keep the things Fonterra is good at and trim the rest. The re­sult­ing core must then be­come a very ef­fi­cient low over­head ma­chine, sim­pli­fied around com­modi­ties and cer­tain in­gre­di­ents made from New Zealand milk, with a fo­cus on de­liv­er­ing proper re­turns on in­vest­ment.

Large vol­umes are not es­sen­tial to do com­modi­ties well. TDB Ad­vi­sory anal­y­sis in­di­cates that Open Coun­try Dairy, a mainly com­mod­ity pro­ces­sor with just 7 per cent of the mar­ket, is well ahead of Fonterra in cost ef­fi­ciency. Aus­tralia’s Pro­duc­tiv­ity Com­mis­sion has high­lighted that the ben­e­fits of size and scale are not nec­es­sar­ily greater than its costs.

Other im­prove­ments un­der this op­tion in­clude much bet­ter milk price sig­nals, a va­ri­ety of risk man­age­ment op­tions for sup­pli­ers, sep­a­rat­ing re­turns on pro­cess­ing from the milk price, more flex­i­bil­ity for farm­ers on how many shares they have to hold rel­a­tive to milk vol­ume sup­plied, strength­en­ing Fonterra’s bal­ance sheet and cre­at­ing a proper whole­sale milk mar­ket.

3) Sep­a­rate com­pany for non-core busi­ness. Par­cel up the non-core parts of Fonterra (which in­cludes the higher risk, cap­i­tal-thirsty con­sumer busi­ness) into a sep­a­rate com­pany con­trolled by Fonterra with ac­cess to non-farmer eq­uity. Farm­ers could choose whether to hold shares or in­stead put their cap­i­tal into other as­sets.

At present, farm­ers have no choice on whether their Fonterra cap­i­tal is in­vested out­side the core, which makes it rel­a­tively “soft” money for Fonterra. This struc­ture was pro­posed 20 years ago by in­dus­try lead­ers who were, in ef­fect, over­thrown.

4) Split into two or more co-op­er­a­tives. Given farm­ers’ aver­sion to out­siders, an al­ter­na­tive would be to split Fonterra into two or more sep­a­rate co-op­er­a­tives owned by New Zealand dairy farm­ers. Most of the spe­cial rules and reg­u­la­tions now in place to guard against Fonterra’s highly dom­i­nant po­si­tion in New Zealand would cease. A proper whole­sale milk mar­ket among com­peti­tors could be fos­tered.

Af­ter an ex­tended tran­si­tional pe­riod of shar­ing brands and var­i­ous ser­vices, each co-op­er­a­tive would be­come in­de­pen­dent of the other — free to pur­sue sep­a­rate strate­gies and growth struc­tures. As econ­o­mist Tim Har­ford high­lights, adapt­ing to a com­plex change­able world is best achieved by a mul­ti­plic­ity of ex­per­i­ments from many dif­fer­ent play­ers. 5) List on the stock ex­change. If the pref­er­ence is to not sep­a­rate Fonterra’s core from its non-core busi­nesses, but to still bring in more cap­i­tal, flex­i­bil­ity and ex­ter­nal mon­i­tor­ing, an­other al­ter­na­tive would be to turn Fonterra into a pub­lic com­pany where the con­trol­ling stake is held by dairy farm­ers (through a co­op­er­a­tive) with the bal­ance of shares sold to the pub­lic. This con­cept was pro­posed by Fonterra’s board in 2007 but re­jected by dairy farm­ers.

Kerry PLC in Ire­land is of­ten cited as a model. On list­ing in 1986, the dairy co­op­er­a­tive’s 51 per cent stake was worth

40m. To­day, its hold­ing (now around 14 per cent) is worth around 2300m ($4.09b) — and the co-op­er­a­tive is still the largest share­holder by far. (In listed com­pa­nies with widely held shares, ef­fec­tive con­trol is achieved well be­low 51 per cent).

Kerry is now a di­ver­si­fied multi­na­tional food busi­ness. Its change in tra­jec­tory from tra­di­tional dairy co­op­er­a­tive was trig­gered by a bovine dis­ease cri­sis and a ma­jor philo­soph­i­cal re-think.

No such re-think­ing on planet Fonterra. De­spite its fun­da­men­tal non­per­for­mance, Fonterra’s pre­ferred op­tion is still largely the cur­rent struc­ture and strat­egy “with bet­ter ex­e­cu­tion” (the first op­tion above), plus a re­lax­ation of gov­ern­ment rules de­signed to counter Fonterra’s high mar­ket dom­i­nance in New Zealand.

Since it be­gan, Fonterra’s share of the na­tional raw milk mar­ket has fallen by 14 per cent, even though to­tal milk pro­duc­tion in New Zealand has in­creased by 61 per cent in the same pe­riod.

In­deed, Fonterra has had no ma­te­rial growth in milk sup­ply from New Zealand over the last six years, yet it still as­pires to sig­nif­i­cantly grow its vol­ume, even though New Zealand pro­duc­tion has flat­tened.

As our “na­tional cham­pion” in world dairy mar­kets, Fonterra ex­pects to re­main highly dom­i­nant in New Zealand, so it wants the Gov­ern­ment to change the rules to make it harder for farm­ers to switch and harder for com­peti­tors to grow. That would be a mis­take. The right re­sponse would be for Fonterra to de­liver bet­ter per­for­mance so that farm­ers pre­fer to sup­ply Fonterra over its com­peti­tors. There are two de­ci­sion-mak­ers. How Fonterra runs its busi­ness is for its 10,000 farmer-share­hold­ers to de­cide.

How­ever, the reg­u­la­tory con­straints within which Fonterra op­er­ates are for the Gov­ern­ment to de­cide. Not sur­pris­ingly, the in­ter­face be­tween the two is blurred in pol­i­tics.

Fonterra is poorly adapted to its pur­pose. It is time for its mem­bers and Gov­ern­ment to shed deeply in­grained be­liefs and look at things with a more open mind.

Fonterra did not achieve “crit­i­cal mass” to take on the big play­ers in higher value mar­kets. Over­seas prices would not be lower with com­pet­ing ex­porters from New Zealand. In­vestor-owned dairy com­pa­nies have not (now or in New Zealand’s his­tory) ex­ploited dairy farm­ers (quite the op­po­site, in fact). Ef­fec­tive con­trol does not re­quire 100 per cent own­er­ship.

Based on 17 years of ev­i­dence, it is ob­jec­tively fair to say that, in its cur­rent form, the Fonterra ex­per­i­ment has failed.

The grad­ual emer­gence of a few rel­a­tively small com­peti­tors is a pos­i­tive, but Fonterra’s leg­is­lated dom­i­nance con­tin­ues more than 100 years of sup­press­ing di­ver­sity and ex­per­i­men­ta­tion in how to best cap­ture value beyond the farm gate, to the sig­nif­i­cant cost of the New Zealand econ­omy.

If keep­ing co-op­er­a­tives is key, op­tion 4 should be con­sid­ered with an open mind.

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