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Fonterra’s new strategy is all about cutting the cloth to suit the purse. The new overarching strategy is just the first step on a long path

Fonterra’s new strategy is all about cutting the cloth to suit the purse. The new overarching strategy is just the first step on a long path

Fonterra’s annual report contains no big surprises. The strategy is one of stepping back from consumer brands and global milk pools. This has been driven by necessity. As such, it is a move towards a little Fonterra and away from the vision of a big global Fonterra.

There is an old saying about cutting the cloth to suit the purse. That is where Fonterra sits right now.

There is no indication that Fonterra plans to retain money from milk-price payments in this coming year. However, it is clear that Fonterra does plan to hold back more funds from future profits than it has in the past. That is all very well, as long as profits can first be generated.

In Fonterra’s presentation, there is a specific contrast drawn between historical ‘debt-funded growth’ to a future of a ‘conservative balance sheet’. Also, ‘aggressive growth’ is to be replaced by ‘competitive advantage’. 

It seems that future capital expenditure at no more than $500 million per annum will be similar to current levels of depreciation. That emphasises that it is essentially a ‘no growth’ Fonterra.

The five-year target for the earnings is 50 cents per share. The proposed dividend is 40%-60% of this, implying a dividend of 20 – 30 cents within five years.

Next year’s earnings are estimated at 15-25 cents per share, suggesting a dividend under the new policy of about 10 cents and a similar amount for retentions. That would be about $160 million of retentions, most of which will go to debt reduction.

Fonterra’s dividends do not usually carry franking credits and so these will carry tax liabilities in the hands of investors and farmers.  Next year’s net dividend is therefore already looking very small, even if things do go to plan.

It’s notable that Fonterra’s assets include over $500 million of tax credits, suggesting Fonterra itself will not need to pay much tax for a long time.

In all of this, the first big question is whether Fonterra has identified all of the dead rats that need to be swallowed. Specifically, are there more assets that will need to be written down?

I note that CFO Marc Rivers acknowledges that asset valuation ‘is not an exact science’.

I have previously identified Australia and Chile as places where asset values look shaky. I had hoped to get more clarity around those assets but the annual report is not very forthcoming.

In the fine print of the detailed financial statements, but not in the Annual Report version thereof, there is some information as to the valuation process for Australian assets. They are based on comparative dairy asset sales in recent times. They are not based on value in use.

The problem here is that the overarching Australian dairy situation has declined rapidly in the last two years. It looks to me as if some of the Fonterra assets in Australia, particularly in Victoria, are now becoming stranded.  Just like Beingmate and China Farms, they will be hard to sell. 

I do note that Fonterra acknowledges that Australian valuations reflect an assumed improvement in business outcomes. Time will tell on that one.

The Chilean situation remains opaque. By going to the Chilean accounts (largely in Spanish) as at 31 December 2018 and converting the figures to New Zealand dollars, I estimate that total Soprole assets, including Prolesur have a book-value of around $930 million dollars. The Chilean book-value of equity is around $660.  My Chilean sources tell me they do not think the assets could be sold for anywhere near that.

I note that one of Fonterra’s directors has been telling farmers that Fonterra only has $200 million of Chilean assets in its books.  I don’t think that can be correct. The $200 million would have to be just one part of the fixed assets. I am seeking and currently awaiting clarification from Fonterra.  

It is clear that China Farms is still struggling. This last year it lost $30 million without any allowance for interest or a contribution to overheads. The previous year the loss was $38 million. Production has also declined over the last two years.

Over half of the China farms value relates to livestock. The animals will find a ready market at good prices. The big question is whether anyone will want to buy the infrastructure of a loss-making enterprise.

The current value for Fonterra’s share of Beingmate of $234 million is reflective of the 5.54 RMB market value of Beingmate shares as at 31 July. Since then the shares have dropped around 6%, but these shares are volatile. I note from information elsewhere that Beingmate is now converting itself to be a property developer.

Perhaps the great disappointment from the Annual Report and associated strategy release is that there seems to be little indication to how Fonterra plans to increase its operational efficiency.

I don’t question the operational efficiency of milk collection and processing at many of its plants. Rather, I question the efficiency and costs of all of the other aspects of the business. For example, how does Fonterra plan to reduce its overheads?

The new regional structure will create opportunities for strategic redundancies but will also bring its challenges. There is no word on shifting the Head Office from Auckland to a regional centre such as Hamilton, which many farmers would like to see. Many would see that as an action consistent with cutting the cloth to suit the purse.

At this stage, most of Fonterra’s farmer members support the current leadership despite enormous disappointment, frustration and anger at how events have unfolded. However, if this year does not go well, then next year there will be nowhere for the leaders to hide.

Outside of Fonterra itself, there will be many people who will criticise Fonterra’s new strategy of drawing back to something much more basic. It is indeed a sad day. The problem is that Fonterra has made such a mess with its international endeavours that it really has no other option in relation to branded products and the international milk pools.

I find it remarkable that Fonterra is still only playing at the edges of the A2 issue of which there was no mention by Fonterra in its strategy announcement.  I also note that Synlait has now confirmed its milk payments for the 2018/19 year, and with premiums included, its average payment is 23 cents per kg milksolids above Fonterra.  Yili is also paying above Fonterra. Tatua will confirm its payout on Monday and it will be much higher again.

*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 You can contact him directly here. There is more by Keith Woodford on Fonterra here.

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Cutting the ragged cloth was an obvious strategy given the massive losses we were making and our debt position. Focusing on the comparative advantages of NZ milk is great, perhaps embracing designed differentiation along the lines of A2, but also differentiating based on distinct nutritional profile of pasture provenance.

There is comment this rationalisation reflects fundamental cultural change, but I'm not so sure. It would be nice to see the sycophantic shareholders council kicked into touch, and also the candidate assessment panel, that 'evaluates and ranks' potential directors thereby recommending to farmer shareholders, with the blessing of the sycophant council, who to vote for.
In my opinion such expert opinion hasn't served us at all, and contributes to the toxic corporate culture that has resulted in Fonterra arriving at its current position.

The rationale for the Shareholders Council was that with such a large co-oeprative it was not possible for directors to both govern the co-op and also engage sufficiently with individual shareholders. That reality still exists. So I think that there is still a need for a Shareholders Council in some form or other. For the Council to work effectively thee has to be a high level of mutual respect between the Board and the Council, and each has to listen to the other. My assessment is that the Board did not always give the respect to the Council that it should have. And if the Council is to do its job then it has to be recognised as a time consuming and onerous job.
The huge flaw in the director appointment system in the last few years has been that the Board was effectively able to prevent some directors from standing and the dominant clique successfully disenfranchised directors from standing again on two ocassions. That flaw was obvious and the way the power game would be played was predictable from the start. The new system this year is better but still far from perfect.
As for the future, the path is not going to be smooth. The new strategy is built on necessity and not desirability.

The reasoning for council was that farmers would likey not act as normal shareholders would because they were not investors per se but had to own the shares. The Council was supposed to act on their behalf to monitor the board and management and report back to them. This worked well with some early Councils and their chairs but since Coull arrived....not so much.

Differentiating ingredients on the basis of pasture provenance is a tricky one. Otherwise it would already have been done. There are tricky issues associated with pasture provenance definitions, tricky issues with nutritional claims, and great difficulties in carrying that through to the consumer products.There is also a potential issue that NZ milk powder comes from NZ milk plus about 100,000 tonnes of imported lactose which is not pasture-based and which is used to standardise the product.
Differentiating on the basis of A2 is much easier but still challenging. I have been advocating that for a rather long time.

I agree with and respect the work you’ve done on a2 Keith, but the headwinds my farm and the industry face in regards to public perception and international innovation in food, I think we need to do whatever we can to differentiate our milk and secure a premium price. I think promoting the pasture provenance is an obvious choice no matter how challenging, partially based on increasing consumer awareness around nutrition.
Likewise your analysis of Fonterras financial performance is lucid, and I appreciate you sharing it with us. But I disagree with your viewpoint on the necessity of a shareholders council. This body has eroded cooperative values and marginalised supplying shareholders from governance. DIRA has not served the industry or NZ consumer and public at all well, and ironically enough was defended by the Fonterra directors responsible for getting us into this mess. It has eroded the strength of cooperative structure and culture.

omnologo, Fonterra's 'Trusted Goodness' programme is highly rated overseas. But the reality is, that most offshore competitors claim some form of 'grass fed' provenance. In the EU they only need to have their cows outside 120days a year to qualify as 'grass fed'. Fonterra's pasture and grass fed standard is described on page 37 of its 2018 Sustainability Report.

Maybe it is CO, but honestly I wouldn't know, as I've only heard that anecdotally from Fonterra employees. Pasture provenance is all about nutritional differentiation based on distinctive amino acid and long chain fatty acid profiles. It is so much more than what Trusted Goodness articulates. If Trusted Goodness is not reflected in a significantly higher payout , it is nothing more than (more) vacuous sloganeering. No I don't swallow the rhetoric coming from the chairman and ceo that performance has been good, based on parity of payout with the northern hemisphere. That is nothing more than a cynical deflection from actual woeful performance. Fake news if you will.

We aren't the only country that can lay claim to 'pasture fed'. In terms of marketing you are expecting Fonterra to say some of their product is better than some of their other products, as not all farms would likely qualify on 100% grass fed?
NZ dairy receives a premium to others on the global market anyway - check out the gdt results in detail. But more and more we are being told we have to justify the premiums because others are making similar claims to their products and are cheaper. I heard that recently from our hort marketer too. Gummy bear Hero wrote on this site recently that they were buying in Irish butter because it was cheaper. At the end of the day most people want healthy food but the reality is few are willing to pay a premium for it. And if they are NZ isn't the only country in the ring.
I believe that in the future the premium will be for the holistic provenance story - environment, animals, people, milk quality etc. After all you can be a good all grass farmer but lousy at one or all of the others.

Your last sentence resonates CO, but I don't believe it will be enough to set ourselves apart from competing dairy producers. Our pasture provenance, minus maize, grain and PK could be our fundamental difference, and if we received relative value, it would go along way to addressing environmental sustainability concerns. Not many competing dairy producers have a pasture based system comparable to NZ, and I think we need to shout our comparative advantage to the heavens.

Agree re Shareholders' Council unless they can find some independent Councillors who are not controlled by the board and management. The Council is currently run by a member of Fonterras legal team who is managed by Fonterras legal team!! How Coull and his cronies let that happen is beyond belief.
They put all proposed comms through Fonterra legal and get castigated if there is anything Fonterra don't like, its outrageous.
Then the head of people and culture keeps their job and the rest of the exec team bar1 carry on as if they can save the place even though they were the ones that were steering the ship in to the rocks the whole time.......sigh

new strategy sounds like old hat,putting the chequebook in the drawer certainly worked back in the day.we have gone global now and the chinese arent stuck with a bunch of old factories in the middle of nowhere so while they are holed up in fort fonterra their suppliers will slip away.

Suppliers slipping away is the aim of DIRA.

Casual Observer,
DIRA is actually aimed at ensuring that Fonterra does not abuse its market power here within NZ. There have been and still are two parts to that. One is trying to ensure that individual farmers are not abused through Fonterra's monopsony (single buyer) power and the other has been and is about Fonterra's monopoly (single seller) power in relation to the local consumer market.

Although we hear a lot about the so-called cost to Fonterra of having to take on all milk, the reality is that Fonterra has always fought hard to get every litre it could. They have always played hard ball in that regard, and there are stories to be told. As for having to supply 'start ups', once the 'square curve' anomaly was sorted out, then Fonterra has always received a fair market price for this milk.

One of the reasons that companies like Yili and Danone have set up their own operations is that they have learned that Fonterra does play hard ball whenever it can, and that they cannot risk being in a position of reliance on Fonterra. Similarly, if new companies do come into NZ, then that will be the reason why. It is a natural consequence of Fonterra's aim right from the start to exert market power.

My comment Keith was in the vein of 'DIRA is there to ensure competition.' You aren't going to get competition without Fonterra losing suppliers. So do you consider a fair price to be the basic milk price, or a price that includes a loss of profit due to not being able to process that milk in their own factories and on sell it in to higher markets off shore. Is there any recognition in lost opportunity costs?

Casual Observer,
There are some situations in which opportunity cost could be relevant. In Fonterra's case it would be unlikely to relate to value-add because the marginal milk comes from commodities, not value-add. But there could in the future be a case for opportunity cost relating to stranded assets. However, the amount of DIRA milk is very small in the greater scheme of things. If we exclude Goodman Fielder it must be well under one percent of total NZ milk. In my opinion, Fonterra's complaints about DIRA have been a way of distracting farmer attention away from much more important things.
Keith W

time to close down the Chinese farms, surprised they didnt include them in this round of right downs.

Keith, you comment on the Synlait payout but you include incentives. Their basic milk price is $6.40 and Fonterra's was $6.35. Both companies pay incentives, so if you are going to use 'averaged' payouts for one company you need to include 'average' payouts for all. But then it becomes a rather useless number as not all suppliers will receive it. Therefore basic milk price is the only true comparative. Incentives are optional extras and in some case not available to all suppliers.

What incentives do Fonterra pay? They have always taken the penalise option to incentivise.
I agree with Kieth on using the basic price plus incentives to compare and would love to see Fonterra pay for the likes of grass fed as oppose to penalising for PKE.

red cows, I thought the farm you sharemilk on was a Fonterra supply. Fonterra suppliers can choose to supply for incentives like colostrum, winter milk, A2 and Stolle are ones I am aware of but there may be others. They used to do Halal but I think they have stopped that now. Some are region specific such as A2 and Stolle. We consistently beat the Fonterra announced payout due to fat to protein ratios. Given that other processors include incentives despite half their suppliers not making the average, the only true calculation is basic milk price. I know some Miraka suppliers that when they introduced incentives, said the only way their farms could met all the incentives would be to barn their cows. Likewise it wasn't that long ago only 20% of Synlait suppliers were accredited to their 'Lead with Pride' programme. It would be interesting to know what that figure is now, as I know others are signing up to it. So if we stay with the 20% figure only 20% of their suppliers could reach the maximum of all incentives. That's why I say all companies have a basic milk price and that is what should be shown as payout. Anything over and above that is up to suppliers to pick and choose but that is the only price that is relevant to all suppliers.

Casual Observer,
I agree that comparing payment systems is somewhat of a minefield. For example, in the case of Yili they pay much bigger advance rates and their suppliers greatly appreciate that. Also, each company defines a kg of milksolids in terms of its own company supply ratio of fat and protein and that can influence relativities depending on the price specifics of fat plus protein.
To the best of my knowledge, the comparisons I made have reasonable validity. To the best of my knowledge they do not include winter payments for either company. They include Synlait's 'Lead with Price' and thr A2 premiums. Synlait's winter payments are generally higher than Fonterra's and they increased this year but that willnot show until the 2019/20 dairy year.
Open Country uses a different system again.
It would be nice to have a comparison for all of the companies that took into account the a+b-c together with any lactose payments and other elements. It would need to be done for at least three different herd profiles - say Jersey, Kiwi Cross and Friesian - to allow for different fat to protein ratios.

The Fontera fiasco goes to the root of how businesses succeed. The co-operative business model will not succeed in the long run because the management are separated from the producers (dairy farmers) who hand their product over to a different species ( professional managers) who don't have a passionate stake in the co-op or the astuteness to make strategic decisions. And you can't teach gut shrewdness.
The same thing happens with companies; look at Fletcher's: The original Fletcher was the driving force behind the success of that company and it was only the momentum created by that Fletcher which enabled it to carry on for another couple of generations until it became totally independent and brought in 'professionals' who may have had academic credentials but lack the astuteness and passion of the original owner.
The same with small businesses where the owner has to be at the 'coal face' 24/7. As soon as he steps away and runs the business under management then sooner or later the business is doomed.
I see the incredible passion and work ethic of business founders the likes of John Hynds of Hynds Pipes with whom I went to school in a South Auckland suburb; he has virtually seen off the Australian competition in NZ and employs over 600 here and in Australia. He will be well over retirement age but still keeps his fingers firmly on the pulse.
The so-called management high-flyers whom are hired to run these companies and co-ops are more often than not more like bureaucrats than the astute business owners who can not only manage the company but can navigate it into the future.

As you say Keith, there are many variables within each processor's system. The only constant they all have is a basic milk price. Average is meaningless, median would be of more value, but again because some suppliers can choose to take part and some cant, the only relevant price is basic milk price. If Gerard Hutching at Stuff can show basic milk price plus Synlait incentives, & Fonterra dividends (though not incentives) there is no reason can't either. It has more context. Let's face it, the only people this really matters to are farmers, and in some cases farmers bankers. Some farmers have no choice when their bankers call, but to move from Fonterra so that they can sell their shares and retain farm ownership. Others move, or chose not to supply for other reasons. I know sharemilkers supplying OCD after supplying Fonterra, who say their cashflows are so much better. But if they need any environmental advice, they wish they were back with Fonterra. Farmsource deferred payments were much appreciated by some farmers I have spoken to. So it isn't just one thing.
I understand Synlait headed to a Southland processor this winter to access winter milk as they are now the supplier to Goodman Fielder for their South Island fresh milk, and Synlait were reportedly saying they were short of milk for their contract. So I'm not surprised they are offering more than Fonterra.;-)
A+b+c sounds ok until you realise that it would have to be calculated for an 'average farm' (if there is such a thing) as there are various management systems with farming and farmers have different skillsets e.g. some can get high production from Friesians, some from kiwi cross cows. Some are very good grass farmers, some a very good at high input. So lets use the KISS system and use basic milk price as the comparative, but if you wish to include incentives/dividends etc they can be a 'plus'.
I am curious - are Synlait paying the same to their North Island suppliers, as they do to their South? At one time OCD paid North and South differently but don't know if that is continuing.

So, it is a sell recommendation ?

I don't think its all that bad. $20 Billion in annual sales is a good start, the payout seems digestible, the losses weren't good and lessons have been learnt. I think given the run down nature of tiptop, the sale price was excellent news and the part selldown of DFE also delivered a handy sum and remains part of the asset base for future development. Speaking of which the overall stability of the cooperative seems sound and if a conservative approach is maintained in years to come the business should do well enough to continue on its way forwards. The biggest threats to the business are externalities like toughened freshwater standards and dairy foods suddenly becoming naff in the eyes of global consumers and to that end its farmers by showing the best they can be in response to those issues that is most critical now.

When (EU) quotas were first introduced in 1984 the Irish and New Zealand dairy industries were of roughly comparable size. While Irish milk output remained flat under quotas, New Zealand's output quadrupled to an estimated 23 billion litres in 2018/19. Now, with quotas gone, Ireland is playing catch-up. Irish milk output is soaring, with 2019 likely to be another record-breaking year. When EU dairy quotas, which had artificially restricted Irish milk output for 31 years, were abolished at the end of March 2015, farmers moved quickly to increase production. Milk output jumped by 13pc to almost 6.4 billion litres in 2015 as the sector moved to make up for lost time. And milk output just kept on rising. It hit almost 7.6 billion litres last year and is now widely expected to reach at least 7.8 billion for the full year, with output up by 8.6pc in the first three months of the year. That's a 40pc rise in output in just five years. Further strong growth is being widely predicted, with... a 10-billion-litre Irish dairy industry "in sight". As Irish dairy farmers move to make up for the time lost during the more than three decades of quotas the template is very much that of New Zealand.

They are pumping it out, but are they getting sustainable prices for it? Dairygold has announced that it has reduced its milk price for August supplies.......Last week, both Glanbia and Lakeland Dairies announced reduced August milk prices of 28.5c/L including VAT, and 30.03c/L including VAT respectively. .......Kerry Group base price for August milk supplies remains unchanged at 29.5c/L including VAT.
Commenting on the price, the co-op said: “Despite the moderation in milk supplies, the global dairy market continues to be hit by weak demand across a range of products as a result of significant Brexit trade uncertainty and US-China trade wars.

It’s notable that Fonterra’s assets include over $500 million of tax credits, suggesting Fonterra itself will not need to pay much tax for a long time.


Don't worry Kate, it's suppliers will be paying tax ;-)

Please tell me that Keith is writing a book about this Fonterra mess.

GenXY, These will give you an understanding of farming and of where dairy has come from. ;-) In a historical sense of cooperatives, what has happened in Fonterra, is nothing that untoward. I heard an ex dairy Board person say, that they lost many more $$ than Fonterra, but back then it wasn't made public knowledge.

Thank you :)

Kieth I have a question; With the current state of affairs, how does the farm gate price for milk solids stand? I have no idea how it is calculated but if Fonterra is not making the level of profit from their products that they need to, then surely it must drop? What then effect would a falling farm gate price have on farm values?

The milk price is based on the market price for the so-called reference products minus the processing cost for an efficient processor.
The main debate in recent years has been about the correct cost of capital which is a function of what is called the 'asset beta' or riskiness of the processing and commodity business. One can get into all sorts of arcane arguments about that!
The choice of asset beta does affect the processing charge which is a transfered cross (deducted) from milk revenue and transfered into profit.
Fonterra's profit comes mainly (apart from the toll charge for processing commodities) from specialised ingredients, non-reference products, consumer products and food service. Fonterra's current situation is a consequence of, in aggregate, performing poorly in these areas. In contrast, the payment to profit from processing commodities is close to guaranteed with very low volatility.
In a normal situation the milk price should not be affected by changes in profit. But if things really turn to custard the the strategy of last resort is to take money from the milk price.
If money is taken from the milk price, then it builds farmer-owned assets at the cost of farm cash returns. But for sharemilkers, it is simply taking money away from them which arugably is very much theirs!
My reluctance to see money transferred from the milk price (beyond a legitimate toll processing charge) to profit is because it can act as an escape from facing up to how awful the so called value-add part of the business has been run.

Same executives as were there while the losses were made and supported the past CEOs decisions voted themselves nice new jobs rather than taking responsibility for the loss of over $ 4 Billion of shareholder value.
Hurrell telling National radio that he doesn't want to look back.....really You just lost shareholders over 4 billion, maybe have a look back, pack your and your executives desk and let someone with true business experience (not just 18 years in a monopsony) take over.

Some of these directors and CEOs did have real business experience and they still screwed it up. Question is how do we hold them accountable?

Spot on here. It is a real worry that the future capital will also be spent using the same process and will be approved by the same lot. From memory, Kelvin and Christina were in charge of China when Fonterra invested funds. Now Kelvin is head of Fonterra ROW? Talk about accountability. If they appoint Christina Zhu as the China MD, wow just wow and a good sign how Fonterra CEO and Board hold staff accountable for their bad decisions. Remember this story in Stuff in Sep 2018: Loss-making Fonterra splashes out on 5-star China conference One hope that Fonterra senior appointments will not be done based on who they know as opposed to what they know.

Not sure of the logic being all that sound in moving HQ from Akl to Ham. If I was a trader or analyst running the global trades the last thing I'd want is to relocate to Hams. Imagine that, you'd probably have self entitled cockies wanting to traipse through the place in their redbands, helping themselves to the coffeemate and stopping at your desk to abuse you for not getting the most recent payout another 10cents higher....

Don't the Queen St farmers already do that, minus the redbands?

So getting rid of the $100,000,000 head office is the first thing to do then ? YES thats $100 million!!!!!!!!!

And its leasehold , not even fee simple !!!!

Good write up Keith as always. New strategy and operating model is a forced one aimed at cost cutting + no money to expand anyway. But one thing is sure, millions will be spent to figure out how on earth to cut numbers to suit new reporting regions. Watch this space. Fonterra has to address the seemingly weak governance issue. This performance debacle was partly driven by incompetent bunch of Farmer Directors giving a free hand to management. The revised strategy has been written by the same team who wrote the previous one! So expect no change in performance. yes, the colors and font type have changed. Fonterra need Directors who have skin in the game (with debt) and also who are capable of asking the right questions from management. Not easy to read and digest all the Board papers that come their way. Farmers need to ask the hard questions at the meetings. No amount of strategy and leadership change will do any good without improving Governance across the business decision making and in BAU processes. The current CEO and Management team did not have the courage to call out the previous CEO led decision, so the current lot is equally responsible I would say. We should ask the Board and management to clearly explain how the new strategy and operating model going to improve performance. Ask them to explain step by step with committed time frames. Please do not accept long winded and stupid answers. Press on until you get the correct answers. Make use of the meetings and raise your voice for the sake of farming community and NZ economy.