David Hargreaves argues the Government needs to concede that the creation of Fonterra was the wrong thing to do and start again

By David Hargreaves

The Government needs to urgently consider widening the scope of its Dairy Industry Restructuring Act review in an attempt to more directly handle the economy's problem-child Fonterra dairy co-operative.

The true magnitude of the disastrous decision to create Fonterra in 2001 is now becoming all too clear.

I think Fonterra needs breaking up into a domestic processing company controlled by farmers, while the value added and export business is put into a separate vehicle not controlled by farmers, but with a commercial mandate and a brief to make money for shareholders.

As I read the terms of reference for the upcoming review of the DIRA, there's not much there that will directly tackle the Fonterra problem. And it is a problem.  

While some might have seen as positive the announcement on Wednesday that Fonterra was putting on hold its search for a new chief executive, while it reviewed its business, I did not.

I would certainly feel a lot more comfortable with the situation if the leadership at Fonterra comes out very soon with a clear timetable of what sort of restructure it's looking at and when it will move to appoint a full-time CEO.

And I think we would need to be talking some weeks or at the very worst not many months for these issues to be clearly signposted. But I'm not holding my breath. I think this situation is going to be allowed to drift. And that's a bad thing. A week is a long time in business such as that Fonterra is in.

My concern is that what we are seeing with Fonterra at the moment is a concerted move by farmers to take absolute control of the company and absolutely run it 'their way'. 

Yeah, but, okay, they own the company, why shouldn't they control it absolutely?

Well, for the simple reason that the farmers' raison d'etre is to get top dollar for their milk. Ask a farmer what they would prefer - a good dividend from Fonterra?, or no dividend and absolute top dollar for the milk? Well, I think you know what the answer is.

It's a frankly bizarre conflict that no 'normal' business would contemplate.  

The role of the shareholder

The whole point of having shareholders in a business is that they supply the money through which the company then makes products or produces services, makes a profit and then reinvests the profit and pays some of that to the shareholders as dividends. It's not about those shareholders directly flogging things to the company to make as much money as they can from the company that way.

So, a normal commercial company gets money from shareholders, sells goods and services, and makes a profit. Then and only then does it pay out to shareholders as a dividend.

In Fonterra's case you've got shareholders who are also all suppliers (and that's the first priority) who are all demanding that the company pays them top price for the raw materials they supply. That's before there's any consideration of whether the business can make money. In effect Fonterra's paying dividends to its shareholders before it has even made and sold its products and worked out whether or not it can make a profit.

The shareholders in this instance don't have as a driving force the desire to see the company make a profit. They want to maximise what they get from the company by selling to it. It is a total conflict of interest, which means they cannot have the best interests of the company at heart.

I wish I could find some literature I read from many years ago that stuck with me. You will have to trust my recollection of it. I think it was when the whole issue was live about Fonterra maybe being opened up to outside shareholders. This literature talked about the need to guard against paying 'excessive' dividends, while ensuring 'appropriate' returns for farmers.

Yes, that's right, dividends are 'excessive'. The returns on the milk are 'appropriate'. It's a complete conflict of interest.

It's no way to run a business

Imagine any other business you can think of in a hypothetical sense operating the same way. What about a company that say makes leather jackets? And all its shareholders are leather suppliers and they all sell to the company and they demand maximum price for their leather. Well, unless the company can then sell the leather jackets for a princely price, it's probably in trouble. But the 'shareholders' don't mind because they are making a good quid flogging their leather.

The problem is that our mythical leather jacket business will soon encounter another business in this big wide world that's not got shareholders who are selling leather to it for the top price and will therefore be paying less for the raw materials and will therefore produce lower priced jackets. And our leather jacket business WILL go OUT of business.

I fear that because of the basic distrust of the corporate Fonterra by its shareholders, those shareholders will think it is 'crying wolf' about struggling as a business until it's too late.

Corporate Fonterra has been its own worst enemy. Its communication with the public and with shareholders is generally clouded by fog. It is very, very, very hard to get a handle on how that company is doing as a business - or even what it is doing. That its shareholders would be suspicious of it and disrespectful should come as no surprise.

I'm not a shareholder in Fonterra because I can't be because I'm not a farmer. And I'm sad I'm not a shareholder in Fonterra because as someone who lives in this country I AM actually a shareholder by proxy whether I want to be or not, courtesy of the very bad government decision to put all our milk in the Fonterra pail back in 2001. We are ALL shareholders, or at least stakeholders in Fonterra because of its importance to our economy.

Dismantle it

That's why the Government should widen this DIRA review and examine whether it would be possible to arrange for a dismantling of Fonterra.

Now, there might be arguments about meddling and what's legally permissible - but remember the DIRA itself was a legal precedent, which rode over the concerns that the Commerce Commission had about the creation of Fonterra.

If Fonterra and its shareholders cannot be convinced of their own volition to break the company into two - one a commercial enterprise and the other a milk processing operation - then I think this Government needs to have the steel to stand up and restructure the industry itself again, in an attempt to right the wrong made in 2001.

And it's all right saying, well, we can look at this later there's no hurry.

To be honest, I don't think we've got much time. The rest of the world is moving quickly. We need to move too.

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45 Comments

Its also anti-competitive. If Fonterra pays more for the milk supply, this will effect Synlait and Westland. If they have to pay more to secure milk supply, this then flows through to their customers like A2 Milk. If companies like A2 Milk are forced to pay higher prices for milk powder they will (a) either go broke or (b) shut down in NZ and move their infant formula business to Australia, the UK or the USA where they have cheaper supplies. And just like that, a $10B NZ business is gone from NZ.

Westland pays it suppliers an 'honest' price - that is, what the company can afford. There are only limited areas of Westland that Fonterra would/do take suppliers from as there are areas that it simply isn't efficient for it to do so.

Synlait only pays what it has to in order to keep suppliers - it may well be able to afford to pay suppliers much more, but as a corporate only pays what it has to. This is true for all corporate suppliers. It is interesting that Danone pays 15c above Fonterra - whatever the milk price is - perhaps this suggests that corporate processors can afford to pay more, but instead choose to bank the extra profit?
Synlait has only a small number of A2 milk suppliers - maybe interest.co can ask it how many as I have heard approx 12 prior to this season. It maybe a $10B business, but how much of that remains in NZ - farmers get around 20c/kgms more for supplying A2 to Synlait which is around $2-3/kgms less than Fonterra pays its organic suppliers.

The advantage for banks in particular, is that the corporate processors don't require shareholding. As one non Fonterra supplier told me 'At meetings we are told that we choose to be their suppliers, however, there are some who are there at their banks choosing.' (by way of explanation - some Fonterra farmers who are in strife due to debt, are told by their bank an option to remain on farm is to sell their Fonterra shares and use those funds to reduce debt and switch supply to a corporate processor with no shareholding requirements)

Excellent article. The idea that farmers as suppliers will acquiesce in reduced milk payments in order to build equity in the value added part of the business is laughable.

These are the ones that will want to keep / can't afford anything but the status quo:

Reserve Bank data shows dairy sector debt has gone from almost $29 billion in 2009 to $40 billion.
DairyNZ estimates that about 30 per cent ($11-$12 billion) of dairy debt is carried by 10 per cent of dairy farmers. Between 45-50 per cent ($18-$20 billion) of debt is carried by 20 per cent of the highest indebted dairy farmers.
An average farm producing 150,000 of milk solids would have over $3.2 million in term liabilities and be paying about $200,000 in interest payments a year or $1.30/kg.

https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=116...

When the original concept of Fonterra was proposed many argued the structure was flawed and would not deliver for the very reasons outline in this excellent article, those concerns have been bourne out. The farmers interested were always conflicted the Clarke Govt should never have sanctioned it.

Become a farmer.

I think a bigger issue for Fonterra, which won't be helped if it gets broken up as you suggest, is that it has to pay the same milk price whether the farmer is just down the road from the processing plant or at the top of the Coromandel. Also, I could be wrong, but I believe that anyone can set themselves up as a Fonterra farmer (so long as they pay in equity) even if they live on a gulf island. Whether or not it's broken up, there is a need to change the whole mechanism by which farmers are paid.

Zespri in theory has the same issues as Fonterra, but doesn't get into the same problems. Partly because it's less complex, partly because its growers are OK with being paid based on revenue earned (so want Zespri to maximise its profits), and partly because they have outsourced the middle of the supply chain (packhouses).

Yes anyone can become a fonterra supplier but who would want to be one when they don't earn enough money? Contrast that to Tatua who are a highly profitable cooperative and smarter as they restrict (?) licences to supply tye cooperative. Zespri also does this.

Well someone on a Gulf island may want to since all the other farmers are effectively subsidising their transport costs. There are definitely dairy farms at the top of the Coromandel that just shouldn't exist from an efficiency standpoint. The whole Fonterra model needs to be rethought IMHO.

In my opinion, the Fonterra's structure is wrong only because there are too many small shareholders. It does not allow the shareholders to control the management team.

In such a case, management ignores the company's priorities and acts in their personal interests.

That sounds like the NZ govt.

If the farmers had voted years ago to allow Fonterra to borrow so it could create a separate stand alone high value consumer dairy brand they would all be reaping a nice dividend from that business too This would’ve allowed Fonterra to establish higher value branded direct to consumer products which would’ve resulted in consumer demand through brand awareness over many years by now. Any shortfall in one payment to farmers would be easily offset by increased payment from the higher value revenue stream created by higher vale products. The same scenario could also be applied to NZs export of raw logs instead of creating higher value
brands using NZ timber but instead logs are shipped to places like Korea who add the value and reap the bigger revenue
Fonterra was knobbled by it own dairy farmer share holders and this is the result many years later a decision made long ago haunts the future of not only Fonterra but NZs economy
Do not fret NZ the other countries I reside in also have extreme failings

You had me convinced until I remembered fonterra lost about $700 million with just poor management.
Just as well the farmers didnt give them carte blanche in my opinion.
The farmers may consider the Zespri model as the next attempt?

Interestingly I was at a meeting in a non dairy area about doing business in China. One speaker who was very familiar with doing business in China had been explaining that it is not for the faint hearted. They went on to say that while Fonterra gets a bad wrap, it's experiences are not exclusive to them and that many international companies have similar problems.

Ah, the Zespri model where it has almost exclusive exporting rights to all kiwifruit - almost the old Dairy Board model which was thrown out when Fonterra was formed. Imagine the outcry from Synlait, Miraka, Danone, OCD etc if they were told that only Fonterra could export their product and it had to be under the Fonterra label.

When it was set up I could never understand it. It seemed to me like the Japanese amalgamating all their car manufacturers. Ie it would kill innovation and competition.

Absolutely right. However, socialism is all about killing innovation and individual endeavour and the last thing they want is competition. So, they create monopolies and create endless regulation and bureaucracy that are barriers to entry and effectively kill competition and small business. It’s a proven way to make a society poorer on average.

Haha, I thought that was a definition of capitalism.

I think your confusing poor company structure with plan old poor management. All the nessacary things were in place to head of down the value added route but management time and again decided to ignore the research and development in favour of the humongous powder driers as that was much easier. Pre Fonterra if you look you will find a number of companies that headed down that risky path and you'll also probably find those plants still operating. Farmers as shareholders we're quite prepared to back this strategy, Fonterra managers obviously not so much.
That Fonterra has been badly managed is in no doubt and as to what the heck they're playing at the moment I've no idea (coup maybe). But blaming the milk Suppliers I think is barking up the wrong tree.

Labour has said they intend to review DIRA and I assume the board is now in caretaker mode.

Perhaps bad management but the structure is fundamentally wrong. Unprocessed milk has very little value farmers essentially demanded the value add after processing be reflected in the milk price they received, the dividend. All this achieved was to create a wall of milk, dairy farming wherever physically possible, what to do with all this milk turn it into low value milk powder. As the article says the production and processing of milk need to be separate.

So your essentially saying producers should not be allowed to own processing/manufacturing as they would want to make money of it, producers should only take what they are given by the process owner and be extremely thankful for it.
That's the exact reason the co-operative formed in the industry, while I may not like what it has developed into axactly at this point the idea that we must become low paid peasant you can $&@@/($.

I cant imagine cooperatives being stopped retailing but is it that worth while?
The cooperative Alliance only shows a profit of $30M on a turnover of 1.5 Billion.
They dont have the legislative privileges of Fonterra of course.
So Govt could remove all those advantages and wish you well.
Probably you would end up like Alliance.

What are those legislative privileges that Fonterra has pws?

The way the dairy industry is going it has potential to end up as dysfunctional as the meat industry.

DIRA ...the act.
To the best of my knowledge alliance has no such legislation but from memory it had rather a lot of goverment funding...i never knew the details..

Further to that the new coop as Fonterra was called in the legislation, was set up with the knowledge it was to be the dominant dairy producer for the country, that is a very handy starting point for a co-op

Further to funding the alliance the producers put up 10.% and the meat producers board put up 80% , I guess every bit helps and they werent carrying much debt.

DIRA is a double edged sword especially 18years after it was enacted and the government (current and previous) keep shifting the goal posts. e.g. Fonterra has lost enough supply in the South Island to trigger DIRA exit clause for the South Island, but rather than honour that, the current government has rolled DIRA over and will now 'review it'. DIRA is a Clayton's piece of legislation - something governments allowed to be put in place but also something they had no intention of honouring if the exit clause(s) were triggered.
Having to supply competitors with raw product at cost price - whether or not they had their own supply base, and open entry/exit provisions, especially as its still a requirement after almost 18years and a multitude of independent companies have been set up. e.g. Mataura Valley Milk didn't attract the number of farmer suppliers it was seeking so it is entitled to 50m/l/yr of milk from Fonterra a basic milk price.

Totally agree on DIRA goalposts changing. I think though from Fonterras point of view they need to be carefull what they wish for. My understanding is they have done very very nicely out of supplying and processing for their "opposition" in the local market, hence Synlaits entry there, likely a government would look closely at how they work with the supermarket duopoly. Supplying the likes of Mataura is not as onerous as it was, with a three year limit but that should have long gone. And their long whinge about taking all and every supplier doesn't stack up, isn't there a limit on how near to their last supplier they need to be?

Not all the farmers would become shareholders of the processing part of the business, they currently own it and would receive a dividend in addition the price paid for their milk. As shareholders their interest is then focused on the processing side adding value.

1

Absolutely , Fonterra needs to be broken up , its at conflict with itself around its irreconcilable dual objectives

Mm there is a lot of farm debt to be serviced thru all this restructuring, and the bovisis thing is costing a lot of money too
Was easy to get stuck into the meat industry as was very little debt then
Wonder what the banks are thinking

Overseas as a Fonterra shareholder we are told by others in the industry, how lucky we are and how other farmers would like to have our model. In NZ we hear that Fonterra must be broken up.

I would love see a detailed plan on how by taking on the likes of Kraft, Nestle, Danone, Parmalat etc a split company could do better, by those that promote this. Because in the real world that is the competition and they have much bigger pockets than any split off company will.

So David H my challenge to you is back yourself and show us the numbers that prove if Fonterra was split off we would be/would have been, better off as shareholders after all, it is farmers who are the shareholders, not NZ Inc.

But for good measure he could show NZinc gain.
Reality will more likely be another cheap foriegn sell off and channeling of profits overseas.

Have faith redcows. We have begun a new year. :-)
Maybe it is time to have a clean sweep and change auditors as well. ;-)

Agree CO
Auditors are well over due for change 18 years is far to long ,$6 million fees makes for nice comfortable relationships with top table and the shareholders pay the bill

I guess we all know where this is liable to lead to.

In the words of Fred Dagg
"If if it were'nt for your gumboots where wuld you be..."
Throw off your shackles, reject Federated Farmers and join the the big world that owes you nothing...
Like the rest of us...

Its worth looking at. Like many of us I have friends and family who are farming, mine don't understand how the corporate, processing, export or innovation side of the cooperative works they focus on milk in the vat and money in the bank thanks very much. Which makes me annoyed at seemingly endless dinnertable conversations about the latest payout...I have several friends with commercial and scientific experience in the cooperative and in their opinion it seems the impact of sustaining the payout at levels to cover high farm debt is a severe drag on the ability of the cooperative to move forward into greener pastures as it were. Indeed in the recent restructuring where the 500 or so staff were symbolically culled from the corporate side of the cooperative to show farmers that senior management were serious about keeping the payout high by reducing staff expenses...they all left and took their valuable expertise elsewhere, so there goes a massive amount of corporate knowledge up in smoke. Meanwhile the payout has languished anyway.

My view, they borrowed and grew on the assumption there would be growth, everything is rosy with growth, take the growth away and it's groundhog day, going around and around on the wheel with no escape.
There has been growth for ever, so why would we ever think it would end?

The delusions of grandeur associated with growth seem to go back to Henry the Eight' time when a weaver employing 100 men, maybe in Newbury, weaving bolts of cloth for europe in record numbers.
For his next act he led them off to a battle in support of the king, it not recorded how many of them survived.
Thats capitalism for you...

If it was Henry VIII times I would have thought "decapitalism" would have been his schtick, with all the "off with his head" goings on.

Our man was probably aware of that which is why he went...
Henry was much like our modern political tough guys, confiscated assets of the church and sold them to his mates for example..
Nothing has changed.

I don't think Fonterra was the wrong thing to do at the time of its inception. Farms were still in the hands of individuals and families, the rise of the huge corporate farms was yet to manifest itself.
Now it may not be exactly fit for purpose so maybe some changes are needed, such as Fonterra being able to tell the guy who is wanting to convert MacKenzie country into a vast factory farm to go take a flying leap, and maybe, yes it could do with splitting, but I think more than anything we must protect it from foreign takeover.

Yeah lets do more to screw over farmers, they deserve it.