Keith Woodford explains why all options for Fonterra’s China Farms are unattractive

By Keith Woodford*

This is the second part of a two-part series putting Fonterra’s China Farms under scrutiny. The first article is here.

In the preceding article I traced the internal thinking within Fonterra as to why Fonterra decided to produce milk in China. The underlying belief was that Fonterra had the necessary expertise but could not play the desired role within China without having in-country production systems.  By late 2009, having lost its key China partner San Lu from the melamine disaster, Fonterra decided to go it alone with an expansion that would become known as the Yutian hub. From there, additional hubs would be developed.

Fonterra decided it would work towards a supply of one billion litres of China-produced milk per annum and this would require about 80,000 cows milking at any one time. There was an assumption that high-quality milk from these farms would sell at a premium to other China-produced milk. Whether or not Fonterra would also undertake processing operations was seen as a question for the future, but with a likelihood this would occur.

The technology of the new farms at Yutian was straight American. The milking parlours were classic American parallel parlours which are not seen in New Zealand, and built to a standard of robustness for milking 24/7. Feeding systems were cut and carry total mixed ration (TMR). Sophisticated effluent systems, although not always effective, were installed.

The in-calf heifers came from New Zealand but once in-country they were subsequently mated with American semen to get bigger animals. Sex-selected semen was also used to speed up herd growth, no doubt influenced by the landed cost of cows from New Zealand being up to NZD 5000.

In the years through to 2013/14 most things went well. Milk prices were high and the Yutian farms hummed along. In 2013/14 China farms retuned $21 million EBIT, but alas that was the high point.

What went wrong thereafter has still to be fully elucidated, but there were undoubtedly multiple factors.

To start with, the key expertise in setting up the management systems at Yutian rested with China-based American vet Todd Meyer. Those close to the action would acknowledge the huge value Meyer brought to the Yutian management. However, Meyer was not enthusiastic about leading the scaling-up from Yutian. He understood the challenges better than Fonterra, and in that environment, preferred to take his expertise to one of Fonterra’s competitors.

Thereafter, Fonterra never had the necessary depth of in-country expertise. 

About that time, Lincoln colleague and dairy farmer Marv Pangborn and I were keen to get some of our Lincoln students experienced in these intensive farming systems, and several Honours level students undertook intensive courses in America.  We explored funding these studies on an ongoing basis though Fonterra, given Fonterra’s obvious need for an ongoing series of graduates to work in China.

I had preliminary discussions with Fonterra, but with ongoing leadership changes at China Farms, in the end it did not happen. My judgment is that, at senior level, Fonterra did not recognise the depth of knowledge that it lacked and which it needed to foster.

Fonterra also did not foresee the huge progress that the overall Chinese dairy industry would make with the incorporation of Americana and European technology. I recall one visit I made with a colleague to a Chinese agri-technology company that was linked into the overseas technologies. In their Beijing office, they had 50 design engineers all beavering away on various dairy projects.

So, whereas Fonterra saw itself as having a competitive advantage based on expertise and surrounded by competitors with inferior technology, in reality the story was different. Fonterra’s competitors were developing equal technology but lower operating costs and lower overheads.

At that time, Fonterra had also not fully recognised the challenges of getting premiums for top quality milk that is produced in China. Chinese consumers do not trust their own country’s quality assurance systems, regardless of who is producing the milk.

As Fonterra developed its second hub, Chinese farmgate prices for fresh milk declined. Prices have never returned to those earlier levels. Also, Fonterra found itself having to sell milk on the spot market as it lacked its own supply chain through to market. From there the losses mounted.

Over time, Fonterra’s aspirations were scaled back. As it stands, there is no longer any talk of one billion litres of milk per annum and production in the last year was 312 million litres. Remarkably, total animal headcount (milking and non-milking) in July 2018 dropped to 70,245 compared to 89,213 the previous year.

As with all corporate financial measures, it depends on the rules of the game. In the case of Fonterra’s China Farms, the milk is sold at inflated prices to its ingredients division which then sells it off, without further processing, at a loss. However, those transfer losses are identified in the small print and can be added back in to get a more genuine EBIT loss.

On that basis, the NZD EBIT losses in each of the last four years have been 44 million, 59 million, 37 million and 39 million. Also, these EBIT figures are normalised, meaning one-off mishaps have been omitted.  These figures also do not include any finance charges or contributions to Fonterra’s unallocated overheads which approach $500 million.

There are three options for Fonterra’s China Farms.

First, the business can continue on the same basis as currently. In essence that implies a loss-making operation which does not contribute with clarity to Fonterra’s overarching corporate strategy.

The second option is to build an integrated value chain in China as originally planned. However, that will require a great deal more investment capital for processing, market logistics and brand development, plus a level of expertise that Fonterra is yet to demonstrate. In the current environment, this will be a hard sell both to Fonterra’s farmer shareholders and the banks.

The third option is to get out of the China milk production business. That requires assessment of whether producing milk in China is central to Fonterra’s overall strategy.

Fonterra’s China Farms are valued in the books at NZD 748 million of which livestock are worth $280 million. The big question is whether these values are realistic?

In the case of the livestock, the values are probably realistic as there is a functioning market to identify these values. In the case of property, plant and equipment, there is more uncertainty.

Fonterra values its China Farms using discounted cash flows based on the estimated long-term value of milk in China. It uses a price of 4 RMB per litre whereas prices in recent years have been around 3.5 RMB.   According to the fine print (NZ$23 million decline in value for each 0.02 RMB decline in milk price), reworking the cash flows at 3.5 RMB would knock $575 million off the value.

Despite the shaky numbers, there may well be local Chinese buyers who think they can turn these assets to a profit. What Fonterra needs is for two such companies to get involved in a bidding war. There is really only one way to find these things out, and that is to out up the ‘for sale’ sign.


*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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33 Comments

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10

Just curious: I assume a NZ owner cannot own land in China. A Chinese business or individual can own NZ land so they have the option to convert from dairying to orchards, cattle, tourism, housing, factory, etc. They also have the opportunity to sell at a profit or loss to whoever they want to whenever they like. Is business between NZ and China on a level playing filed?

No

NZers forever have been told NZ Dairy is the leader in world dairy technology
Anyone who has seen a mega American dairy farm knows otherwise
If I was a cow ( yes I’ve been called far worse ) I would prefer being a NZ dairy cow in NZ
Wide open spaces to roam free mean less stress on the animal leading to no stress hormones in the milk
There you go Fonterra a free piece of advertising
NZ is simply the best place on the planet for cows
Sadly Fonterra is too fixated on China

No because the farmers lobby and politicians wouldn't let that happen. Doesn't matter to them what becomes of the country. Dont want to make the PRC angry

...This is a joke, right?

Lapun and others,
The issue of land ownership is somewhat of a red herring to Fonterra's issues.
But putting that aside, the differences in land ownership between NZ and China are not quite as great as sometimes pretended.
Even in NZ, owning land is different to owning anything else. There are constrained use rights and the land may not be destroyed.
In China, land is held under long term lease. Although not totally explicit, there is a widespread belief that these leases will be renewable. And foreigners can acquire these leases for business purposes.
Having said that, there is no separation between the judiciary and the other arms of Government which creates great potential for power imbalances!
KeithW

Thank you for an informative comment. This is why I keep returning to this website - there is always plenty to learn.

Won't be long now before our agricultural industry is wholly controlled/owned by the Chinese Communist party/govt

I'm guessing that Chinese owned farms in New Zealand are doing very nicely thanks!

E.g. Synlait...

Yep, so the Chinese took 51% control of Synlait in 2010 and within 8 years the competition has been hamstrung by debt and bad decisions in foreign markets while they continue to profit. As a nation we have been such mugs - It would be interesting to see how many foreign workers are involved in making Synlait 'competitive.' How many houses did David Chaston say were registered as occupied but with no-one paying rent or a mortgage? 70,000 I think it was.

Nic.
My recollection is that Chinese-owned Bright holds 37% of Synlait. They became holders when Kiwi investors declined to support Synlait's planned IPO about 8 or 9 years ago. They have a considerable presence on the Board but they have no executive staff or factory staff here in NZ. Synlait itself does very little overseas marketing - they mainly produce both consumer-ready infant formula (IF) and IF base materials for other companies. The most important of these marketing companies is The a2 Milk Company which owns 17% of Synlait.
KeithW

Hi Keith

Here's an article from the Otago Times in 2010. I see it refers to the processing and marketing divisions of Synlait . It's interesting that 3 of the 6 largest dairy producers were already majority foreign owned by 2010. Synlait then went about competing in China against Beingmate (the Fonterra subsidiary). Who would you put your money on?

https://www.odt.co.nz/business/chinese-take-51-synlait-stake

A 2010 source is completely out of date. Synlait has been restructurede from then, after some struggles. You can easily look up Synlait's shareholding on the Companies Office website. There are ten major shareholders. Bright Foods has 39% and is the largest. No-one else has more than 10%.

So assuming (big assumption) we don't have to pay someone to take the farms off our hands - a sale at current milk prices using Fonterra's own valuation model would incur another $470m writeoff or roughly $40k per NZ Fonterra farmer?

You'd have to say that the past actions of Fonterra staff and/or directors involved in these China investments is bordering on criminal to say the least.................. Heads must roll, there is a total loss in confidence of Fonterra's structure, board and senior management! We need a broom through the whole business and start again - to have an interim CEO and a new Chairman who are both products of the system that created this mess isnt a positive way forward.

Heads will roll with a big fat bonus stuffed in their mouths.

the trouble like a lot of mutli nationals the lack of respect for local knowledge, going in to china with a "we know best" attitude always ends in disaster.
people moan about china requiring a local partner for foreign companies, but without it a lot more of them would have gone bust quicker
Fonterra's problems I suspect is not listening to what they are being told, and I suspect that is why they lost the vet
my personal opinion is to get out of china, except for sales to Chinese suppliers or distributors, hand over the local sales to the locals, let them clip the ticket and both sides can grow and make money

A bit too much is being made of that vet - Fonterra had some very knowledgeable people involved in that business who were passionate about its performance. There are actually a number of issues that has made the trading conditions for the China Farms very difficult that Keith hasn't alluded to (either out of courtesy or lack of knowledge) that explain how it has ended up in its current loss making predicament.

Have you thought about operation difficulties in terms of hiring, training and managing local labor as well as dealing with local governments/ government officials? That is the another major reason contributing the failure of the whole project. Operating a business in the rural area of China is a complete different picture. There is almost 0 "rule of laws" in those areas. If you take that into the account. Option 1 and 2 are immediately no need to consider. Combined with current global geopolitical change that American has initiated, existing from business in China is the best option although there will be big loss. It is better than a longer pain which will be damaging Fonterra farm brand. Or maybe get our leader Winston to "discuss" with Chinese government to get a "reciprocal" solution, treat and protect our NZ business properly in china otherwise Fonterra will quit.

Kiaroira
In China you must go to a state customs & labour bureaucracy to request permission for your imports / exports
The State monitors everything very closely & knows exactly what your business is doing
Don’t forget China has a target of 2025 to be a tech super power

'local labour difficulties? Hiring, training & managing local labour? Use the Kiwi approach - employ plenty of immigrants - cheaper and more docile. Market forces where scarcity puts up prices is not allowed to apply to Kiwi labour.

There were no issues with labour in the first hub (Yutian) that were detrimental to the potential of those farms - other than labour inflation running at somewhere between 15 and 20%. The only other aspect that had to be dealt with regarding labour was the accommodation and dining facilities that had to be provided at a moderate increase in capital cost to a facility that had sufficient local labour. Invariably though, a good portion of the labour force travelled for 100’s of miles around to get to work.

There were no issues with labour in the first hub (Yutian) that were detrimental to the potential of those farms - other than labour inflation running at somewhere between 15 and 20%. The only other aspect that had to be dealt with regarding labour was the accommodation and dining facilities that had to be provided at a moderate increase in capital cost to a facility that had sufficient local labour. Invariably though, a good portion of the labour force travelled for 100’s of miles around to get to work.

Comment withdrawn. Mistaken.

Overlord,
I can find no evidence that the new CEO was ever in charge of Fonterra's Asian business
KeithW

Apologies. Comment withdrawn. Wrong ID.

Apologies. Comment withdrawn. Wrong ID.

On that basis, the NZD EBIT losses in each of the last four years have been 44 million, 59 million, 37 million and 39 million. Also, these EBIT figures are normalised, meaning one-off mishaps have been omitted. These figures also do not include any finance charges or contributions to Fonterra’s unallocated overheads which approach $500 million.

this is horrific... Sounds like they have their head in the sand on this one...
Throw in interest on,say, $400 million ( book value $700million ) and overhead charges… say $20million/yr and the losses might be $60 million …or more.. per yr..

How on earth will China Farms trade its way out of this mess..?? I cant see it ..??

Very insightful commentaries, Keith. The underlying issues are no surprise to me and very "Fonterra."
Do you know if the farms receive any (Chinese) government subsidies? This would usually be the responsibility of the local partner, so given they went alone after Sanlu, I expect the subsidies stopped from there also?
These are the only way to make the business viable if they choose to continue. Beingmate, for instance, is being propped up entirely by subsidies at the moment.

Simon P,
If you have sound information that Beingmate is receiving subsidies, I would love to hear it.
My own reading of the tea leaves is that Beingmate is attempting to keep its head above water by selling assets.
Any subsidies are more likely to be from a provincial government or other local government rather than central government, and the support may well be opaque. It will be made on the basis that Beingmate, from the perspective of that local government, is too big to fail..
KeithW

It was a Chinese language media commentary I believe that noted (I think maybe NBR as well) that although Beingmate turned a profit in the first half of 2018, that came from asset sales and subsidies as sales were way down.
Indeed, the company will be drawing these through the local government, but it is not necessarily opaque or because it is "too big fail" (no Chinese company [let alone a private one] is too big to fail). There are many subsidies available to Chinese companies and many ways to claim them. If Fonterra is not receiving any despite running a huge farming operation, then they really are clueless and should sell it all and be done. A local SOE will happily snap it up and immediately claim subsidies on the operation, leverage the subsidiary up against new improved financials, develop the land and manufacturing then take the whole thing IPO. Surely this was Fonterra’s original plan? Or did they really just want to milk cows in China?? PS - I will find the Chinese media link and post back.

Here is the link to the Chinese language analysis:
https://baijiahao.baidu.com/s?id=1609688946552265021
56.5m from asset sale, 47.9m from gov subsidies. There are more figures of interest in there as well.
Regards
Simon