Keith Woodford explains how Fonterra’s Australian operations must now be centre stage to Fonterra’s financial unravelling

Fonterra’s announcement that it expects a loss of around $600 million or more for the year ended 31 July 2019 has big ramifications for Oz Fonterra.  With overseas-milk pools now lying outside the central focus of Fonterra’s new strategy, and with Fonterra seriously short of capital, the Australian-milk pool and associated processing assets look increasingly burdensome.

If Fonterra were to divest its Australian operations, then it would demonstrate that Fonterra really is retreating to be a New Zealand producer of New Zealand dairy ingredients. It would also reinforce the notion that consumer-branded products are now largely beyond its reach.

This strategic position is close to where Fonterra was in around 2006, when it decided that it was 50 years too late to take on the likes of Nestlé.  It did have both Australian and Chilean operations at that time but they were smaller than now. It also took on an initial shareholding in Chinese San Lu at that time, but essentially Fonterra saw itself as a New Zealand-based co-operative.

Thereafter, Fonterra began increasingly to see itself as an international dairy powerhouse. That perspective drove the strategy for more than ten years, but the implementation was woeful. 

Stepping back to something more modest will be disappointing to those who saw Fonterra as a ‘national champion’.  However, it now looks like the only option, given the hole that Fonterra has been digging for many years.

In recent years, Fonterra has been processing about two billion litres of Australian milk each year. For a short period, it became the largest Australian dairy process with a market share of around 23 percent. The Australian operations have underpinned much of Fonterra’s consumer-branding strategy.

Fonterra used to describe Australia as a ‘home market’. This was built on the notion that the local New Zealand market was too small to be the necessary beach-head for global consumer markets.

Consequently, although the Australian production has only been around 10 percent of Fonterra’s total production, it has been much more important in terms of consumer-ready products.

Fonterra is now caught in two Australian pincer movements. The first is that Australian dairy production is in both short and long-term decline. In part that is due to drought, but it goes deeper than that, with structural change that includes both broader economic pressures and loss of irrigation rights.

The second pincer is that Fonterra is now losing market share to its rivals. In a market where companies are competing for milk supply, Fonterra is operating from a weak position.

Overall, it looks increasingly as if Fonterra is well down the track to losing at least 500 million litres per annum of its previous supply, representing a decline of around 25 percent. That decline has potential to accelerate.

Fonterra advised the Australia Competition and Consumer Commission (ACCC) in December 2016 that its Australian equity was $AUD one billion. Since then, Fonterra has invested further in Australia. As a comparison, Fonterra now has total global equity of less than $NZ 6 billion.

Fonterra plans to now write down its Australian assets by $NZ70 million. That does not look enough.

With speculation in Australian dairy circles that there will be a least one Australian processor casualty, then Fonterra is widely identified as a potential candidate.

Part of Fonterra’s problem is that it has dug such a deep hole. There has been a series of mis-steps, based on poor understanding of on-the-ground realities. The mis-steps go right back to the initial buy-in to Bonlac around the turn of the century, started by the Dairy Board. However, that was just the first mis-step of many.

The harsh reality now facing Fonterra is that no-one will want to buy a non-profitable business with stranded assets.

This current situation is very different to the situation some two years ago when Murry Goulburn Co-operative finished digging its own hole. At that stage there were no stranded assets and so there was good competition for Murray Goulburn, with Canadian company Saputo coming out the winner.

The consequent complication for Fonterra is that in the absence of buyers, Fonterra becomes vulnerable to much bigger write-downs in the value of its Australian assets. This in turn puts a lot more pressure on Fonterra’s New Zealand balance sheet with implications for its overall financial ratings.

In that environment, the pressure comes on to sell more and more assets. In that environment, the financial structure unravels.

It’s never good to be selling assets in a fire-sale. This is part of a broader problem for Fonterra that apart from Tip Top, which sold remarkably well, its other dispensable global assets are all struggling to find buyers.

Given this conundrum, the decision path inevitably leads back to what else Fonterra might be able to do to raise more cash.

Some commentators are suggesting that Fonterra might separate off its consumer brands in another company. That starts to sound somewhat like a good bank and a bad bank solution as occurred internationally at the time of the GFC. The bad company might include Soprole, DPA Brazil. China Farms, Beingmate and Oz Fonterra. 

 It would be remarkable if anyone wanted to take on a company in that form. More likely is that each will have to be hocked off separately.

Ten and more years ago I was an advocate of Fonterra splitting into a two-company model, with a processing co-operative and a second value-add company that was investor-focused. Alas, the days when that could have been the answer have passed.

The other alternative is that, one way or another, farmers will have to stump up with more capital. That prospect would be highly unpopular with farmers, many of whom have their own debt and balance sheet issues to deal with.

Until now, I have been resistant to the notion that Fonterra’s problems might be solved by reducing the milk price.  My reasoning has been that this would simply paper over the cracks and inefficiencies in the food service and consumer businesses.

However, with the cracks now turning into crevasses, there may be no other option. In fact, Fonterra has already done this twice since implementing the current capital structure in 2012. But this was in a very different socio-economic climate. And this time the amount would have to be considerably greater.

All of this arises from more than ten years of group-think combined with massaging of messages. It seems that Fonterra believed its own propaganda. At farmer level, it was effective.

Most of Fonterra’s farmer directors have travelled widely on formal visits to the markets but have never done enough of their own footslogging away from the company propagandists. Fonterra’s external directors were also the wrong type of people.

Within the last year, there has been increasing acknowledgement from within Fonterra as to the difficulties that it faces. However, there is still too much defensive messaging. It is very hard for corporates to resist a public-relations culture of story-massaging that comes from deep within the corporate DNA.  

The time has come when Fonterra needs to lay out absolutely everything in front of its farmer members.

*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. Previous article on Fonterra’s challenges can be found at https://keithwoodford.wordpress.com/category/fonterra. You can contact him directly here.