Keith Woodford describes how Fonterra entrapped itself into factory farming in China

Keith Woodford describes how Fonterra entrapped itself into factory farming in China

By Keith Woodford*

This is the first of a two-part series putting Fonterra’s China Farms under scrutiny. In this first part, the focus is on the origins of how Fonterra managed to entrap itself in its loss-making China Farms project.

Fonterra’s new leadership team of Chair John Monaghan, CEO Miles Hurrell and CFO Marc Rivers has made it clear in recent farmer meetings that debt reduction is a priority.  All options are supposedly on the table. However, the only way to achieve rapid debt reduction is by selling non-strategic assets. In that context, Fonterra’s China Farms must surely be lined up in the cross wires.

Fonterra’s China Farms have been loss-making for at least four years. Accumulated losses over that period, using market prices rather than internal transfer prices, total NZD $179 million EBIT.  These losses are before any contribution to Fonterra’s unallocated overheads of nearly $500 million per annum or paying interest on the borrowed capital. More detail on that in Part 2 of this series.

Given the ongoing losses, hard questions have to be asked about the strategic importance of these farms. Was it ever important for Fonterra to be producing milk in China? Even if that was the case, is it still important?

Fonterra’s China Farms go back to decisions made around 2006, with the first cattle shipped there in 2007 to the Hangu Farm. This was part of the joint venture with San Lu, and the only part of that venture to survive the 2008 melamine disaster.  Soon thereafter, Fonterra embarked on further farm development at what is now known as the Yutian Hub.

To find out why Fonterra wanted to build farms in China. it is helpful to study a report by the Commercial Steering Group of the NZ-China Dairy Project, written in 2007, at a time when the first cows were on the water. The project report was never formally published, despite having a nice glossy cover, and written for a general audience. It was overtaken by events. I was part of that NZ-China Dairy Project.

There were nine organisations represented in the project, with Fonterra chairing, and NZ Trade and Enterprise (NZTE) playing a key role from in the wings. Various agricultural technology companies were the other major participants, plus two university academics of which I was one. But the overall drive for the project was Fonterra and the then Labour Government who were working together with a vision of “NZ Dairy Inc”.

The starting point was a belief that “playing a key role in China’s ‘dairy revolution’ presents exciting opportunities for New Zealand”. An early assumption was that “liquid dairy product, including fresh milk, UHT milk and yoghurt, will continue to be the largest growth segment”. There was also a belief that “Export opportunities to China for dairy commodities may stagnate. The question for Fonterra is how to capture the opportunities in China without growth in traditional exports.”

From there, it was easy for Fonterra and the Government to reach a conclusion that Fonterra needed to be a strong “Number Three”, (presumably behind Yili and Mengniu) in milk production in China.

As stated in the report, “Fonterra must access between 4% and 6% of the total milk production in the Chinese market by 2015”. This statement, supposedly written by the group, was in fact guided from the highest levels in Fonterra and the Government.

From elsewhere in the industry, there were some cautionary thoughts. For example, one quote in relation to ancillary businesses, credited to an anonymous “Managing Director of a Livestock Business”, was that “China is not an easy market…. If we can avoid going there we will”.

In fact, that comment was from Craig Norgate, former Fonterra CEO but at that time Managing Director of PGG Wrightson, who for whatever reasons wanted nothing to do with the project. There is indeed an irony there, given the subsequent journey of PGG Wrightson.

Given the dominant ‘gung ho’ perspective within the group, it was an easy step to think that New Zealand had lots of expertise, and that there was a “dairy knowledge base in New Zealand that is second to none”. Also, working on a collaborative basis, “policy experts from within the Ministry of Foreign Affairs and Trade (MFAT), the Ministry of Agriculture and Forestry (MAF) and the Ministry of Economic Development (MED) are well placed to share their experiences with their Chinese counterparts”.

My own involvement with the project started mid-way through the work, with a call from NZTE asking me to join the team. When I asked what my role was to be, NZTE said that they did not actually know, but that Fonterra had asked for me. We agreed that clarification would be sought.

It turned out that the project was, amongst other things, identifying opportunities in China for New Zealand-style grassland farming systems. China-based consulting teams were developing some glossy reports indicating that “the south-central provinces contain areas that would be very suitable for traditional New Zealand grass-based dairy systems”. Indeed, that part of the project was referred to as ‘The Waikato Project’ based on the notion we could recreate the Waikato in China. My task would be to critique those proposals. 

Critiquing the proposals was easy in a technical sense. In fact, the proposals were nonsense. But from a group dynamics perspective, I did have to be a little careful.  After all, the beautiful graphs and diagrams had been prepared by a world leading international management consultancy company, which both before and since has made many millions at the expense of Fonterra.  Other data came from NZTE folk who knew a lot about trade but nothing about geography and farming systems.

There was another part of the project where I was totally unsuccessful in changing the dominant perspective. That related to the notion of producing UHT milk in New Zealand and shipping it across to China.

The dominant perspective was that exporting UHT milk was a crazy idea. The conventional thinking was that transporting long-life milk would be killed by the transport charges. I saw things differently, with good premiums possible. Ten years later, the wheel has turned and Fonterra does indeed have a significant business exporting UHT milk from the Waikato to China.

Given the impracticality of creating a new pastoral Waikato in China, and the perceived impracticality of shipping UHT milk to China, the logical outcome for Fonterra was to focus on intensive factory farming in China to get the quality milk they wanted. And this is what happened.

China’s first farm at Hangu, in association with San Lu, had some fundamental design flaws. However, drawing both from this experience, and from the ashes of the melamine disaster, Fonterra decided that it still wanted a Chinese source of milk. That meant having farms where Fonterra had total control over milk quality.

Someone at Fonterra had the wisdom to recognise that American technology and expertise rather than New Zealand technology and expertise was the way ahead, and that technology was bought in. For some time, the results from the Yutian hub looked promising, but then everything turned to custard, at least in a financial sense. That story is Part 2 of this series.


*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. He can be contacted at kbwoodford@gmail.com

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39 Comments

A wonderful lesson in how to undermine your domestic market whilst loading yourself with debt that makes your domestic market less competitive.

[ Unnecessary OTT bit removed. Please keep commenting sensible. Ed ]

One needs to also take a close hard look at large American consulting groups track records over time.

Not always as one would expect given the many many millions of dollars charged.

JB,
What I see time and time again is that the international management consulting companies rely on their 'brand' to sell their services. Corporate managers and directors like the comfort of being able to say they 'took the advice' of these so-called experts - it is a key survival strategy. Also, the management consultants are quick to figure out the answers which the company managers actually want, and tailor their advice accordingly. That way they are in a strong position to get the next job. As a consequence, so-called independent advice is not really independent at all; it is all a very incestuous business.
KeithW.

GFC and the credit analysts show just how poor such consultant groups are, and thats why there are no more in existence having all died out naturally.
Are these farms even worth anything, they are a long way from profitable having leeched off Fonterra Brands ? to get remotely close.

Sorry to disagree with another grumpy old farmer but the consultancy business is alive and well. it is reputed McKinseys took around $100 MILLION per year off Fonterra in consultancy fees and performance bonuses over the last couple of years while involved in the Velocity strategy.

You hear this "$100 mln/year" number flung around a lot. I have gone looking into their accounts for a few years, looking for where it might be. I have come to the conclusion, it is a made-up myth. For example, in their latest accounts, the expenses of Selling, Distribution, Admin and "Other" costs = $2.5 mln. So you might think it is hidden in there somewhere (that is, hiding $0.1 bln). But then you understand that $2.1 bln is payroll, so that only leaves $380 mln. I doubt $100 mln is 'hidden' in the non-payroll operating costs of $380 mln. Given Fonterra's scale, $380 mln for all non-payroll expenses (which doesn't include milk or manufacturing costs of course), is actually pretty small, ie less than 1.9% of revenue. I am pretty certain the "McKinsey $100 mln" is just myth, perpetuated by people looking for a smoking gun/magic bullet.

David,
To the extent it is true I think it may be somewhere in the unallocated expenses which get somewhere approaching $500 million. I am fairly sure there would have been big McKinsey bonuses, but I have no information as to the quantification thereof.
KeithW

David. How about working the numbers back the other way. John Wilson's statement- velocity strategy had reduced costs for 2017 by 8%. OPEX including finance costs around $3B -8% around $240 million in accepted cost savings on top of a similar amount claimed the year before. Fonterra statement - Management team velocity strategy bonuses long and short term around 50% of total remuneration. Theo bonus $4m and assuming management team on $1m plus each, 6 x $.5m equals $7m plus drop down bonuses to lower management another $3m. Fonterra claims 3600 initiatives and 4000 staff involved. Management alone were on around $10m per year bonuses confirmed as good value by McKinsey's who in turn were remunerated by that same management team. A lovely cosy circle. The $100m is not my claim but it is a feasible number when you look at the other incentives paid.

Sorry should have put up the sarcasm alert flag.

it is a key survival strategy.

Not sure survival is the word - I think you mean that those that employ them think they will survive (politically) because the big names are seen as an ass-covering, safe pairs of hands - when in reality they are well known brand names that provide the most expensive, (often) least independent and (more often than not the) poorest quality advice around;

https://www.stuff.co.nz/national/105880518/Auckland-Councils-multi-milli...

Thank goodness the media are on their case.

Kate,
I meant that it is a survival strategy for the managers and governors, not for the company itself.
KeithW

Surely anyone who has read or watched the TV series House of Lies knows that these "international management consulting companies" are rotten to the core, make decisions that are in the best interests of their own future fee generating ability and not the client company, and who are woefully inexperienced in the operations of the actual industries they are consulting in. If you havent read/watched House of Lies, you really should - its a memoir of a management consultant.

Why would anyone buy an asset that only loses money?

Wilco,
I will have something to say about the value of the assets in the next part of this story.
The cows are valued at about $280 million and those values will probably be realistic. As for the other assets (some of which are good quality), there will probably be someone who thinks they can use them more profitably than Fonterra.
KeithW

Keith I guess my question was more along the lines of - if someone else can fix it why can't Fonterra with their scale and resources. Will there be any political fallout or loss of trade relationship if another country picked up the farms and made them successful?

Hi Keith

But if anyone were to be interested in buying these 'assets' in China then the acquirer would have to take into account the issues that Fonterra has faced, the position that Fonterra is in with respect to debt levels and the risks that anyone doing business in China may face. What is a likely acquisition price? Who's buying? I would have thought that the value to an acquirer is likely to be someway short of the value that Fonterra has it booked at.

And why did Fonterra management, proud of our 'clean green' image, that is a part of their brand image go down the factory farming route?

Wilco
There is plenty of evidence that the 'clean green' image in China is only important to the extent that it is a subset of food safety. The key issue for Chinese is whether or not the product has been produced within a Western-world QA certified system.
KeithW

Keith, why were the south-central China provinces technically incapable of replicating our grass-fed (i.e., e.g., per Waikato) farming systems? Was it principally rainfall and/or soil quality and/or some other kind of technical difference(s)?

Kate,
It was a combination of climate and soils.
There are some part of Yunnan that have a sub-tropical climate with a suitable temperature range for perennial grasses, but unreliable rainfall is a huge issue ( monsoon climate), and the karst soils also have their challenges.
Other parts of China such as Gansu are too dry. And almost all other regions of China have too great a difference between summer and winter temperatures for perennial grasses to grow.
Kiwis don't understand how lucky they are when it comes to the resources for grassland dairying.
KeithW

Thought it would be something as simple/obvious as that - which does make me wonder how the Chinese glossy reports tried to characterise these areas as in any way similar.

I do wonder to what degree there were some behind-the-scenes stand-over type trade tactics going on.

Kate,
In situations where one has to choose between a conspiracy and a stuff-up, then the odds are on a stuff-up caused by ignorance. The reports were all written by expatriate Westerners and some Government officials back here in NZ. They would have known the answers that were wanted, and may have organised information accordingly, but that is a function more of organisational culture and a little spin rather than any explicit conspiracy. Those who understand the game know intuitively which side the bread is buttered on, without themselves even recognising that they are contributing to the game.

The reason that I was brought in was because someone recognised there could be some hidden dangers associated with the way the game tends to be played. And someone in Fonterra did not want to be caught stranded if the tide did turn. Smart folk recognise that in those situations there is almost always going to be a fall guy .
I always try to go where the evidence takes me, and at my stage of life that seems to work OK - when one door slams shut another usually seems to open. But for someone with much of their career in front of them, it would be a very high-risk strategy.
KeithW

They would have known the answers that were wanted

But don't you think that is the essence of the conspiracy? - i.e., that those answers "were wanted" in the first place. Wanted by whom? And why?

Career risk is a much more persuasive factor that any other, all bureaucracies, corporate or otherwise, favour those who say what is expected and cover their backsides in case anything goes wrong.

Why don't Fonterra go Organic? stop using Nitrogen Fertiliser and make more money from products?

Why don't NZ Steel go to Wood Processing? stop using Coal and make more money from wooden products?
Why don't Kiwirail go to electric choo-choos everywhere? stop using Dirty Diesel, lay them sparkly new Wooden Rails from NZ ex-Steel, and make more money from Green Freight?
Why don't Air New Zealand go to domestic-only services? stop using Jet A1 and make more money from all-electric wooden planes?
Why don't ......

Well they should use less nitrogen.

But they would make less money.

I had the pleasure of ABing a good bunch of the heifers that went to China. Pleased to know I had a working holiday on Fonterra. It was a good gig. Travelling the bottom of the north island, heading into the backblocks grazing properties. I heard a figure of around 5k per heifer by the time she was shipped off in calf. Mostly heifer calves on board their mums as we used sexed semen. Hmm. Some good autumns in good company. Thanks Fonterra!

Finally - someone happy with Fonterra.

What? Who?

Just as what happened with PGG Wrightson saw an enormous legacy of bloodstock and seed research fall into foreign hands so to have the shiploads of cows now in another country. What it is? It is a technology transfer.

The_4th_ estate,
The only common feature of note between the Fonterra happenings and the PGG Wrightson happenings re China was to over-estimate the value of NZ agri technology when applied outside NZ. The Chinese buyers of PGG Wrightson themselves over-estimated the value of that technology. I know something about that as the organisation that employed me at the time wanted me to roll up my sleeves and get involved. I declined as I knew it was going to end in grief.
KeithW

Miles was in charge of Fonterras Asian strategy prior to CEO Role at Fonterra, enough said. Farmers are being farmed by Fonterra. Tit pulling all round. Pray for grass season to be good.

The Overlord,
I can find no evidence that Miles Hurrell had responsibility for Asian strategy prior to his current CEO appointment
KeithW

Stories like this just confirm a belief Ive had for many years that most New Zealand big and/or public companies are managed by a very incompetent lot. There are very few bright stars among these companies (OK - Fonterra is a co-op but its this countries biggest export enterprise). AirNZ has been a consistent good performer and there are few others - Mainfreight.
Simply from a strategic viewpoint teaching the Chinese how to run a dairy industry is just so stupid - let alone the cost of being conned.
I had a correspondence with the RBNZ a few years ago when they were having a hard lot of jaw-boning about house investment and I had dug out the history of the top 20 and over the previous10 years (it may have been 20, but at the time companies were changing their names and listings regularly) and the gain in share price over those years was 1% FOR THE WHOLE PERIOD - and I asked why any sane person would buy those shares rather than property. They had no answer really.
Fletchers share price today is 31c less than it was 10 years ago.

Keith, Im a little tired of you and other so called experts coming along after the fact and then heavily critiquing Fonterra. You were part if the team, why did you not help fix it. If you loved your country and wanted what was best that is what you would do. Instead you seem to enjoy throwing cheap pot shots at the only company of any significance in NZ; is that what you get paid for??

tamaki drive... come on... I value what Kieth says... How the fuck do u expect us to learn from our mistakes... if we don't even articulate them
Keith is not a -ve trash troll.... It is easy enuf to smell those..driven by ideology, dogma and agenda.
Surely u can see Keith is offering intelligent and considered point of views.
AND>>> Fonterra really does deserve scrutiny... just like the All Black would if they lost 20 games in a row...

Totally unfair Tamakidrive. Many people both experts and not so expert have exspressed a variety of opinions over a number of years critiquing many aspects of Fonterra before the benefit of hind sight. Id add only a very tiny minority are happy to be proven right.

Surely...common sense would point one to exploring the idea of shipping fresh milk to China..???
https://patents.google.com/patent/WO2016204614A1/en
http://www.ausfoodnews.com.au/2015/04/27/revolutionary-refrigerated-logi...
If Alibaba can sell 2L of NZ milk for $16 ...there is strong potential for Fonterra to MAXIMISE the price that NZ farmers get for THEIR milk... ie... Fonterra is a co-operative..
https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=119...
I'm guessing that there is premium value in simply milk being produced in NZ ..."green and clean"....