Allan Barber says Fonterra’s restructure is more about poor strategy than milk price

Allan Barber says Fonterra’s restructure is more about poor strategy than milk price

By Allan Barber*

When Fonterra was formed back in 2001, there was a great sense of optimism about the potential for a New Zealand dairy company to compete on a truly global scale. The industry’s infighting and parochialism would be a thing of the past and the clear intention was to use the greater efficiencies and scale to create a substantially better performing business model.

The big question 14 years down the track is whether that objective has even remotely been achieved. Fonterra is the world’s leading exporter of milk products and the fourth largest dairy processor, so achievement to date appears consistent with the objective. But for many observers there was another, more ambitious expectation: to establish an internationally competitive value added business to compare and compete with Nestle and Danone.

An examination of the dividend from Fonterra’s value added business unit, no greater today than it was 12 years ago with some peaks and troughs in between, confirms the failure to achieve this strategic intent. This begs the question why this is the case. Unfortunately this would have required a different shareholding structure and vision, far more capital and a much earlier start. It was never realistic.

Unlike the two international consumer food giants, Fonterra remains firmly exposed to exchange rates and global commodity cycles, apparently unable or unwilling to transition to a business model based on value added branded consumer products.

When global research group International Farm Comparison Network ranked Fonterra as the world’s leading dairy processor, then CEO Andrew Ferrier said “We may be processing more milk than anyone else, but at 2.7% we still only account for a fraction of the total world milk market. The way we differentiate ourselves is through achieving the best quality, offering the most innovative dairy solutions and delivering product on time to meet our customers’ changing demands. This is our true strength.”

This straightforward statement of strategic intent seems consistent with the cooperative philosophy, which dictates a mindset of maximising the milk payout to meet the demands of its farmer shareholders. However, the tensions between the commodity and value added business models have never been resolved. Under Sir Henry van der Heyden’s chairmanship, the company tried to move to a dual structure with one part being open to external investment and listed on the NZX; this business unit would buy its raw material from the farmer owned milk processing unit for conversion into sophisticated value added ingredients and branded products.

History demonstrates Fonterra’s shareholders were totally against the concept of outside investment in their cooperative and much energy was expended on coming up with the parallel concepts of Trading Among Farmers and investment units for external investors which would set the share price for TAF.

Unfortunately this has proved singularly unsuccessful because the value of the investment units is dictated by the milk price and the dividend by the success of the value added part of the business. The current share and unit price are at a historical low because of the milk price, while the dividend has failed to rise contrary to expectation.

Fonterra has fallen between two stools because it has attempted to follow three business strategies: processor and marketer of commodity milk products, ingredients supplier to consumer goods and food service companies, and brand differentiated marketer. Each of these strategies requires a different set of skills and competencies. The commodity business needs operational and logistical excellence, high quality ingredients require product development and technological competence, and consumer goods demand world class marketing and brand building capability.

The recently announced management restructure, resulting in an initial reduction of 523 staff and savings of $60 million with more to follow, indicates an overhead structure that has blown out of control. Without any informed insight into how this has happened, the misguided attempt to follow three distinct strategies under a single company structure has inevitably necessitated an unsustainably large headcount. This excessive level of staffing has led to an equally excessive number of highly paid managers with 17 earning over $1 million and 4,000 or 22.5% of staff worldwide earning over $100,000.

These figures wouldn’t necessarily indicate inefficiency, provided they delivered value to both classes of shareholder. Current performance indicates this isn’t the case which is why McKinsey has been brought in to recommend structural improvements. The word from CEO Theo Spierings is the job cuts in finance, IT and HR will enable greater market investment in the international market with more customer interface.

Without having enough information to judge, the proposed solution gives no confidence the strategic review has addressed the underlying problems. The present company business model is clearly not working and must change, firstly to slow or reverse the defection of suppliers, which has seen Fonterra’s share of milk production fall from 95% at merger to 86%, and secondly to resolve the conflict between farmer shareholder interests and capital requirements.

The inherent contradiction between cooperative ownership and investment outside the farm gate can only be properly resolved by separating the one from the other. If farmers want to hold an investment in research based ingredients and branded, value added production, this should be a separate investment decision in a separate vehicle.

The first step should be a decision by the Board to look seriously at whether TAF and the investment units are actually achieving the desired outcome; if not, as I would expect, the next step should be to establish Fonterra Processing and Fonterra Brands, as suggested several years ago by Professor Keith Woodford. Only then will the two parts of the business have the chance to grow without mixed market signals and conflicted shareholders.


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Allan Barber is a commentator on agribusiness, especially the meat industry, and lives in the Matakana Wine Country. He is chairman of the Warkworth A&P Show Committee. You can contact him by email at allan@barberstrategic.co.nz or read his blog here ».

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A clear and concise description of the current position.
How is Tatua co-op doing at present? They are small and have tried to remove themselves from the commodity business. Does anyone know what their forecast payouts are looking like?
Historically they have been about 10% better than Fonterrra and its predecessors. It would be useful to know how they are fairing in in these circumstances.

Despite all those expensive staff and market insight, they are completely out of touch. Remember their 2015/16 forecast of $5.25 was based on an assumption that WMP prices would jump back up to $3,500.

At the time WMP prices were $2,390 so it is reasonable to assume that their forecast assumed an average price of $3,000. The current WMP price is $1,517 (Contract 1) rising to $1,707 (Contract 6 – Feb 16) so it would appear the market’s current view is that the average price is going to be $1,600.

Applying that proportional reduction to the $5.25 would give an expected Farmgate Milk Price of $2.80.

And that is before factoring stock revaluation losses, overhedging on FX, guaranteed milk price at $5.25 etc. As usual they won't front up the issues and will make optimistic assumptions to give a price of $4.00. But even to hit $4.00 we need an average price of $2,300 for the season, which in turn means the price needs to recover to 3,000. Not many picking that....

I got the impression that that forecast was deliberately inflated. Surely they knew, the government knew and probably most farmers knew that too. Point is, how much additional debt was taken on based on these manipulated/false forecasts? If a substantial sum, then one would think those debtors might have a case for a class action suit against Fonterra?

Fonterra knew last year, that the season ending 2015 payout was going to be low-mid 4s and that season ending 2016 will be mid 3s, at best.

Policy is that the forecast is supposed to be pessimistic otherwise it causes major cashflow problems for farms and suppliers. However such announcements seldom get payrises within the company nor do they favourably affect share prices.

Fair point - they would be well advised to stay close to their lawyers on this, a deliberately inflated forecast could create a false market in Fonterra shares

How about NPDC owned Tasmanian Farms locking in at A$6.33.

Fonterra is never going to be a global consumer goods company. They have very little product development expertise and less marketing skill. They are viewed by the majors as simply a provider of low cost commodities. The consumer goods that they produce here are poor quality products, that are not competitive because of their high cost structure. They bleed hundreds of millions of dollars every time they 'invest' in a company that supposedly allows them access to consumer markets (think SanLu and BeingMate). They lose a ton of money in Australia.

Their competitors (the major companies) have thousands of consumer brands being marketed all around the world. Even if Fonterra wanted to, they are billions of dollars in debt and simply cannot afford to develop the required brands and commit the capital to market and develop the infrastructure and channel. On past performance no-one would be crazy to give them the capital to lose anyway.

In the event that they tried, they would be simply squashed by the major players, and this would be at the expense of the farmers....again. The Fonterra are a co-operative. Their board and management have a duty to provide their farmer 'owners' with the best possible price for the suppliers milk. This means that Fonterra need to accept what they are, and strip back all of the 'me-too' technology and cost structure that they have in place and concentrate on delivering returns to shareholders, and stop their clueless hit and hope strategy that will only serve to be the end of Fonterra.

Time to look elsewhere to develop another growth platform consistent with doubling our agricultural exports by 2025 focus?

Mr Key has the answer.

A new flag is "gonna be worth billions" to New Zealand, Prime Minister John Key says. Read more

I wouldn't have believed it if I hadn't seen it written in black and white.

Recently I suggested that John Key should nail his comment "I'm not particularly worried about China" to a cross and use it as a grave maker.
Well here's one from your link that might be apt for the 'cross' on his own grave
"My legacy, I think, will be the economic management of the country, the way we stood behind Christchurch, so many other things. Hopefully my positivity as a prime minister."

As long as Key has Labour and the Greens behind him, then the Nats will slip back in. And if Labour get in it will be same but worse until Nats return for the next decimation.

Fonterra isn't a co-operative. They control information that comes out of Fortress Fonterra and dictate terms to their "members". Just look at last seasons payout to Australian Suppliers and what was paid out to Nz supplier-shareholders. The Australian providers received more than 10% higer price on the number (ie without even taking currency rate into account)

Some of the co-ops forming Fonterra had excellent product development systems. These were thrown out/unsupported by management as not the direction of the company. They were "SPOTted/Baby Belled" off to Ingredients and Brands to be run by corporate agenda rather than as successful companies (seriously who would pay a massive premium for a luxury food brand and then change the ingredients to make it taste like crap!) Fonterra Corporate has always been far more focussed on the next board meeting, getting international recognition, playing political ball, than it has about customer or market development - to Fonterra, rubbing palms in China is "product development", not looking at consumers and getting premium priced product to them. Just look at what they do - sponsoring field days, giving away milk to win media support, setting their global Auction in the US one of our smallest customers, climbing into the Australian market during their "milk wars" with no plan more than piggybacking supply on to existing channels, setting up top IP hazard in China in direct competition with their own shareholders and suppliers. This is privilege-think at it's most aristocratic most self absorbed.
They openly declared they wanted to be the 1-stop shop for everything dairy and the master of everything that they do. What company can afford such excess? Let alone one making their way on commodities market. Do you see IBM or Facebook trying to be everything social, and doing everything social to anyone? Even Google and Amazon don't try to be everything to everyone. Heck even the biggest banks in the world don't deal with individual accounts. But not Fonterra, let's run retail stores, lets have free advisors roaming the country, lets sponsor all ITO training, lets pay for all initial inspections through bulk contract, lets supply all the vats and fit them, lets sponsor SkyTV channels for broadcasts that could be done on a single email, Run massive meetings to tell (not discuss) our suppliers what "our industry" is doing. Times are tough - lets repaint all those retail stores. Lets relabel all the farm numbers (at company & farmer expense) , lets paint all the tankers....twice. Support multiple industry good organisations...and not actually KPI or monitor their effectiveness except for image...... Even run news and forums for employment and consultancy. In fact lets do everything except their friggin job.

"When Fonterra was formed back in 2001, there was a great sense of optimism about the potential for a New Zealand dairy company to compete on a truly global scale. The industry’s infighting and parochialism would be a thing of the past and the clear intention was to use the greater efficiencies and scale to create a substantially better performing business model."

Correction.
When Fonterra was formed the Hawera coop had just made extensive borrowings to seize another coop by economic takeover, and was in the process of mounting an expensive campaign to do the same to Tararua (Pahiatua/North Wairarapa)

It was realised that if NZ dairy co-ops continued to resort to cannaballising and fighting each other off then NZ dairy would continue to shrink and be left behind by foreign technology and marketing, as we were already suffering very badly from lack of premium revenue and technological stagnation (as our competitors received both from their government).
It was painfully obvious to those with eyes willing to see it that the factories were getting older and while our top plants were winning the worlds highest honours they simply weren't making enough profit to keep up with tradeable profit and provisions for depreciation (most co-op farmers were relying of capital gain or lifestyle farming). The larger companies (Hawera, Hamilton) were doing well by going for bulk commodity, selling cheap into a small market, with some inventive trade deals.

It was not "with a great sense of optimism" but one of "dread and fear", Allan.
That got Tui co-op to take a proactive merger step rather than go broke paying lawyers to fight off the bigger co-ops. Sadly the staff couldn't see the advantages and felt sold out and the best left for greener pastures. Leaving a company culture orientated entirely on their previous make it bulk in cheap and dump everything you can on the market. That and the political desire to crack the processing sector open to passive investors (NZX) was the foundation for Fonterra.

If you were there you know the truth, not just the official histories.

"The larger companies (Hawera, Hamilton) were doing well by going for bulk commodity, selling cheap into a small market, with some inventive trade deals."

"If you were there you know the truth, " then you would know that neither Kiwi nor NZDG sold anything cheap - in fact they didn't sell anything, they just took what ever price the Dairy Board gave them

which makes it the cheapest price available.

Thy didn't go to market like some of the other co-ops were doing and establishing brands and exploring relationships direct to stores and looking at building a distribution chain to the market.

!!!! Remember peeps, we're talking PRICE here, not COST !!!!

For a Buffet commoditiy you need to lowest _cost_, not the lowest _price_

Now that's a pretty good analysis Cowboy. There was no interest in innovation as practiced by Tui and BayMilk etc that only cost large RnD money, crush it.
I'd add the two NI companies were exporting their smashngrab policies to the south.
I've said it before and still think it, the culture that thrived then lives on.
Mention was made of the need for investment from outside, not surprising really. The other coops use retentions Fonterra never did. And when they got outside money what sort of production did they invest in? Why WMP of course.

Many of the smaller coops were doing interesting things, like animal feeds and sportsdrinks and medicinals (such as initial work at isolating lactoferrin). They were also working tightly with Animal Research and Dairy Research Institutes but government wanted to privatise/private-public-partnership those Crown assets which really through a spanner in the works, as the smaller coops saw that they had no real value in pursuing bulk WMP as the margin simply wasn't there for their volume AND foreigners could compete with them on their own market by simply lifting production in two or three farms. The push was to get higher margin products developed, that it wouldn't be worth the big US/Europe farms investing in - ie two or three good niche products well branded from NZ could be the "Champaign" or "Beluga" of the world, bringing in huge profits, for modest production, that the huge factories wouldn't bother with because of scale. Such high end product is much easier to move and seldom requires giant ego...I mean Infrastructure and marketing wank to create (two things the small coops didn't have funding or risk appetite for).

But no. Fonterra. big investment. Stink Big thinking. driven from the top and political agendas. and with no personal responsibility...

My Dad used to get really pissed at me for questioning the Greatness of Fonterra, our saviour. Now I think he's seeing it.... They hoped to promote the best to the top to run that end of the business, but got people at the top completely out of touch with how business and money actually work (ie not on policy, and cash does matter.) There's very very good reason I'd never ever let Fonterra have a sniff of equity in my business.

yeah sorry Tararua, not Tui. Tararua was the dairy, Tui's our beer :D Cant imagine why the beer jumps to mind first....

Can someone please assist ?

Do Fonterra charge individual farmers their actual costs of collection or is this averaged so a single farm at say the tip of the Coromandel peninsula is charged these same as a farm alongside the factory ?

An unwillingness to charge members their true costs is generally indicative of a co-op mentality which invariably leads to cross subsidies and inefficiency.

As Buffett has stated - The only valid strategy for a commodity business is to be low cost delivered to the customer.

At the margin - maybe there are farms so distant from the processor with such high transport costs they should not be in dairying.

Farmers are not "charged" for milk collection.
It is all part of the co-op ethos.
Similarly, new members do not pay the full joining fee to cover the benefit of existing processing plants (and potential new plants required to handle the new supply).
It is all part of the bigger is better ethos to encourage new supply.

Originally under DIRA Fonterra was required to pick up anyone who wants to supply. They are still required to pick up any milk - and do so long as the farm is within 10kms of an existing supplier or they can make a profit from the milk. Hence they refuse to pick up milk in the Lake Hawea, Otago, area.

There are situations where they charge e.g. Winter milk was offered to Southland suppliers this year - extra $1.40/kg less transport charges to the Clandeboye factory.

Way way back in the day dairy farmers used to take the cream cans and milk cans to the factory on horse drawn cart, and with the expansion of dairy by government gifting uncleared land to willing labourers the farmers who was felling bush and trying to establish fences did not have money or time to take the cans into the factory, so the factory sent around a wagon to pick-up the cans. Due to small farms and lack of refrigeration, the factories were tny and the travel distances short (and rough).

When private motor vehicles and trucks became cheaper and before warrant of fitness, it was common for techy farmers to buy small trucks and delivery vans, and ties trays or rip off canopies to carry their milk to factory.
Many of the smallest cheese and butter factories (which might be the size of a car garage) were closing down and tests using sulphuric acid had been developed to determine the amount of milkfat per gallon (to offset some farmers who would add water to get a higher payment). It was at this time the first co-ops were allocated by the government. This was to utilise the new technology, to enable coolstores, and for product safety. It was a prudent response to NZ not having the wealth privately to setup such services/business and to prevent commercial interests setting up and getting a stranglehold of farmers and food production.......
There were also what were called "The milk can wars". Some coops did better in some markets than others. A quality cheese could bring in many times more than a poor butter, so some coops did better and paid out more. Some farmers were larger, and some farmers incurably corrupt or lazy. So the top price co-ops would woo supply of the most profitable suppliers from other co-ops. This created a civil shooting war, wagon-jackings, ambushes, sabotage, and yes, shootings.

Around that time advances in roading, welding and vehicle design meant tanker trucks were becoming available in New Zealand. It didn't make sense for a single farmer (herd size 20 - 70 cows) to own a whole tanker truck, but it made excellent sense for the co-op to purchase one and do the rounds, thus getting rid of the heavy (and easily upset) milk cans, freeing farmers for the long haul to town (and compulsory smoke and chin wag with the other farmers). Methods to sample test the milk were invented (and then rapidly improved!) and this eased up the problem of the milk can wars, as did government intercession on co-op area and supply rights. (ed: also there were significant delays, milk spoilage as only a few wagons or trucks could unload at one time, and only small amounts as each farmer delivered only one or two farms production at a time - it was not uncommon to have over a dozen wagons waiting in a queue for their turn at the dock - and that's not including truck breakdowns or injuries) this made processing difficult (each load had to be measured by factory staff) and the wait added to spoliage issues in the warmer months (no refrigeration, just "brass hat" coolers in the dairy )

The value of the tanker truck was increased significant when it became possible to mount refrigeration onto the truck and ensure milk was properly chilled during carriage. This technological advance was quite expensive (IIRC a refrigerated truck cost about the same as a moderate sized farm at the time) and required skill technical help to keep it working. And it was a major job to clean it out when it failed.

As each farms need was by volume, and each farm was paid by volume of milk fat provided, it made sense that the co-op just deduct the cost of operation from the milk pool. Those with the biggest need were effectively charged more because their portion of the expense was more. Having the coop supply the service rather than a third party meant the service was operated at true cost. That true cost was both a bonus (better farm returns to marginal commodity businesses) and a typical NZ failing (there was no profit margin involved for a third party service contractor to grow the economy). However the NZ coops were very diligent and colonial in their attitudes so the system worked well.

Until the corporate farmers and outside corporate investors become involved, where service and farmers become a cost, rather than the foundation of the operation.

However _distance_ has never been charged, as it appears problematic.
In the beginning of tanker trucks and tankers it wasn't relevant. Full and drivers were cheap costs compared to the tanker and product got good returns so the cost was a small expense.
With the advent of Fonterra, they have a hard enough time to get the foreign written software to get the tankers turning the correct way let alone building costing into the system (as of last year the software still tried to pick up all milk using a right hand turn (across traffic) on it's optimised loop. But because of the way Fonterra and it's computer systems were set up (corporate top down rather than co-op distributed) it is very difficult to change the system especially for things like distance calculations (ie the routes and pickup optimisations change without notice, or even human reason)

PS - this is called "knowing your market" helpful if you're looking for cycles in industries.

THX !

Oh dear - average vs marginal costing. One of the fundamental laws of economics.
The certain route to failure.

It's going to be very very difficult to change this mentality.

But change it will with great pain and much gnashing of teeth and wailing.

Read Evans-Pritchard in The Telegraph for the story of oil and the Saudi's problems. Lots of parallels with milk trying to defy the inexorable forces of time and compound interest.

Banks lending to allow their own interest payments won't work - Pixxing in the soup as they say in Holland.

My guess is with the excess supply situation it's much like iron ore and try and find someone who thinks
it's going back to over US $ 100 anytime soon.

Cheaper as in cheaper dairy farms on the way - just timing now.

If only that was their only problem.

dairy farms are quality land. It won't get significantly cheap as the buyers won't be in it for the operational return.

Tatua continues to do well with their specialty value added strategy.
Word is last season will end up being $6.80-$7.00, and this year currently maintaining a $6 forecast.
A great wee company.

If the dairy struggles for a few years is it possible the chinese may buy fonterra?

Normal behaviours is they'll give it loans. back a cartel of loans from supporting banks, bail them out once (possibly twice), then "offer" to buy the debt and some equity.

And I bet Fonterra will fall for all the promises... because our government won't protect us from such activity. didn't when crafar sold, didn't for power stations, didnt for forestry, didn't for auckland housing, won't for fonterra.