Allan Barber says the inescapable conclusion is that it is the ownership structure, not board composition, inhibiting Fonterra from reaching its true potential

Allan Barber says the inescapable conclusion is that it is the ownership structure, not board composition, inhibiting Fonterra from reaching its true potential

By Allan Barber

Fonterra’s trials and tribulations have led to a rising crescendo of criticism of the cooperative’s performance since the release of the 2018 annual report.

Declining share value and dividend payments, fluctuating milk price, inadequate return on capital, failure to match international and domestic competitors’ financial performance, failed investments, rising debt ratio and overpaid staff are the most notable criticisms.

Recent changes at the top including new chairman and acting CEO have had a positive impact on shareholders’ levels of satisfaction, but the jury will still be out for quite some time before the commitment to reduce debt by $800 million, sell non-core businesses and cut operating expenses can be evaluated. Shareholders appear willing to allow the new team time to show they can meet these commitments, but meanwhile have given notice of their dissatisfaction by electing self-nominated Peter McBride and Leonie Guiney to the board and rejecting all three board nominated candidates.

When Fonterra was established in 2001, there were concerns it was a conflicted political solution to dairy industry and political requirements which would achieve some short term gains without necessarily achieving long term structural and strategic objectives. The Clark government saw the formation of Fonterra as an opportunity to establish a New Zealand business on a global scale in an ironic contrast to David Lange’s view 15 years earlier of agriculture as a sunset industry. The dairy industry saw the merger of NZ Dairy Group, Kiwi Dairies and the Dairy Board as the ideal way of combining the majority of the industry in strong cooperative dairy farmer ownership.

Some of the inherent conflicts are dependence on low-cost milk supply, while paying shareholders as much as possible, the need for corporate style governance within a cooperative structure, and the reluctance to retain profits in a cooperative, particularly for investment in a globally competitive consumer value added business. All these conflicts could be said to defy market logic.

To the outside observer there are large similarities between Fonterra and Auckland Council: both organisations have become too big in the pursuit of targeted efficiencies, high earning staff numbers have grown disproportionately to the identifiable improvements, directors (or councillors) have relatively little influence on the actions of management, and shareholders (or ratepayers) are increasingly dissatisfied.

The most important factor in all large organisations is the relationship and common vision of chair and chief executive. It isn’t immediately clear that this exists in Auckland Council, but in contrast John Monaghan and Miles Hurrell appear to be on the same page with respect to the direction Fonterra needs to take. My impression is this important combination worked well at the beginning with John Roadley and Craig Norgate, followed by Sir Henry van der Heyden and Andrew Ferrier, but appears to have become less functional during the tenures of John Wilson and Theo Spierings. This suggests it is critical for a chairman to choose his own CEO, whereas Spierings was chosen by Wilson’s predecessor.

During Spierings’s time as CEO, the world milk price fluctuated wildly from peaks to troughs, while his V3 strategy to drive more volume into higher value at velocity was unsettling for staff and the volume goal was at odds with concern about the impact of higher dairy production on the environment. In any case it became clear New Zealand had already reached peak cow numbers, which posed the challenge of converting more milk into added value production, as distinct from building spray drying towers.

Where Fonterra has fallen disappointingly short of expectations has been in identifying suitable investments for its scarce capital. While the melamine scandal affected Fonterra’s investment in Sanlu during Ferrier’s spell as CEO, the investment and massive write down in Beingmate happened during Spierings’s term, almost certainly leading indirectly to his resignation. Yet he walked away with an $8.3 million payout, similar to Ferrier’s when he departed in 2011.

The China milk hubs provide a welcome counterpoint to the loss from Beingmate, because, while they may not yet be profitable in their own right, they are critically important to the objective of building market share in China, currently 11% of imports representing 26% of Fonterra’s business. By the time the number of farm hubs has reached the target figure of five compared with two completed and one under construction, this share figure will have more than doubled and Fonterra will have reinforced its strong position in the growing Chinese market.

Another profitable venture has been the shareholding in Soprole, originally acquired by the Dairy Board in 1986, but the success of the investment has been built on the strength of the Soprole brand rather than Fonterra’s family of branded products.

In 2007 then chairman van der Heyden tried to gain shareholder approval for a public listing of Fonterra with 20% outside investment and the balance directly or indirectly farmer owned, a similar structure to Ireland’s Kerry Group. The proposal was withdrawn because of a lack of farmer support. A recent comparison of the respective performances of Fonterra and Kerry provides a salutary reminder this was a massive missed opportunity with Kerry Group’s share market value increasing from $146 million on listing to nearly $30 billion today. Fonterra’s equity has been fairly static and is currently $8 billion.

The inescapable conclusion is that it is the ownership structure, not board composition, inhibiting Fonterra from reaching its true potential.


This article first appeared in Farmers Weekly. It is here with permission. Current schedule and saleyard prices are available in the right-hand menu of the Rural section of this website.

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26 Comments

Although it makes for a great story - all three board nominees were not rejected. Peter McBride went through the board process. Farmers elected Peter because he brings skills we need to the Fonterra board. Mrs Guiney was elected because farmers agreed with her vision for Fonterra. Regarding scarce capital - if management and the board stuff up their strategy and large investments it doesn't matter what type of ownership structure your business will be limited to its future. Fletchers is as good an example as any. I disagree with your premise about ownership structure being at the root of Fonterra problems. It has been an unsound strategy poorly executed.

The comparison with AC is telling. In both cases, there is a preponderance of highly paid staffers-for-life, who have their own agendas, are difficult to impossible to remove, and who can aid or block top-down initiatives at their pleasure.

It's a common feature of large organisations, and adds up to an intensely conservative stance: conservative in the internal sense of preserving existing privileges, ways of doing things, and internal fiefdoms; and in the external sense, being relatively blind to external influences and hence slow to glacial to react to changes in these.

In a more conventionally structured business, both these conservatisms would have been challenged and then changed, by some combination of M&A from outsiders who could see the value if things were done differently, and internal shake-ups, usually by a new management team backed by a board willing to wear the temporary blips in performance and reputation.

Little likelihood of these for Fonterra. Or, for that matter, Auckland Council....

I'd suggest that the Co-op Structure is ok (e.g. Tatua) but the issue with Fonterra is its size. As a result its an un-control-able monster that few can understand. Hence why selling of the complex parts (or part of) and focusing on the basics makes sense.

Surely size alone can't be an issue. Fonterra is only 'large' in the New Zealand context. There are larger dairy companies in the world (Nestle, Lactalis, Danone), even larger dairy co-ops (DFA). And outside the dairy industry there are thousands of larger companies.

Yes, management, strategy, governance, etc can be issues and probably are. But size per se isn't the issue and should be an advantage. Insular, fortress-type co-ops might be nice for some risk-averse co-op members, but unless they are exceptional (eg Tatua) they won't go anywhere and be able to innovate to meet customer needs. They will eventually get left behind, to be taken over by integrated corporates (like Goodman Fielder, Talleys, etc or Chinese companies).

The biggest issue with cooperatives is their capital structure. Unlike corporates, the coop members want all the retained earnings paid out in the milk price. It's a very short-term way of commercial thinking (not investing in the future) and until that retained earnings tension is resolved it seems likely Fonterra will remain on the back foot. Actually given this severe handicap, it is a bit of a miracle that they are now the world's fifth largest dairy company. They have succeeded so far despite some vocal inward-looking shareholder/members. And despite some major mis-steps. And despite a lack of adequate retained earnings. Amazing really.

A real failed co-operative is Murray Goulburn. That is what failure looks like, not Fonterra.

And, if some Fonterra co-op members think the Tatua co-op is the model, then they need to realise that Tatua co-op members built up their retained earnings to 19% of their assets whereas Fonterra has always paid out so their retained earnings are only 5% of assets. (Tatua borrows 33% of assets, Fonterra borrows 40%, so that excess doesn't account for the higher Tatua retained earnings.) Want a Tatua-type financial structure? Fonterra shareholders will need to invest in their company. If they won't, they can't use Tatua as the benchmark.

..it's survived. Largely due to the status it has within govt and the ability to set it's own agenda. i.e it is not paying it's own way. The millions now required for water treatment being the latest example, never mind the tax I pay to protect Lake Taupo and all the other remedial work. Then we have the subsidies of irrigation schemes and payouts for diseases, drought relief etc. This industry epitomises private gain at public cost.

rastus while I respect your views and accept that in the past dairy farming benefited at the expense of the environment I genuinely believe that most/all farmers today want to protect and enhance where we live. On one property we have two old shut down cowsheds built on the very edge of streams where the effluent drain ran straight onto the stream bank. That should never happen today. It will take time, not a generations worth, to effect major changes in farmings impact on the environment. But it is happening.

..yes of course many are onto it. I also know many retired farmers who spend their spare time planing trees and setting traps on various projects. The mess commenced when Nat, aided by Fed farmers and the dairy boys decided China could take all we produce and bet the house on it. Should have stayed with the low cost family farm model and focused on brand distinction via our clean green etc.

So the bankster Key ensured he debt enslaved as many farmers as he could. Think big as per muldoon all over again. Beats me why farmers have remained National voters?

You obviously missed last years election campaign. Who else was asking for their vote?

Why have farmers remained National voters?
My lighthearted response is that to be accepted at the local you HAVE TO drink beer, watch rugby and vote National - oh and occasionally go home and look after the animals.
Human nature - Everyone wants more than what they have. Nationals message is - look what the big boys have - one day you too could have all this.

Murray Goulburn failed because of poor management decisions supported by their board. Not because they were a cooperative.
They had a comparatively loyal farmer base similar to Fonterra's in NZ who just wanted a competitive milk price. The issue is that in NZ Fonterra farmers financial benefit has historically come from capital gains in their farm values reflecting increasing milk prices. The success of Fonterra should be reflected in a lift in share price - either through increased profitability or successful investment of retained earnings. Neither is being achieved at the moment and that is a large part of Fonterra's weakness.

You are more likely to get a lift in the share price if the shareholders invested in the company (that is, built up their retained earnings to Tatua-like levels, rather than taking almost all of it out in the milk price). Returns come after investment. It is backwards to starve the company of investment and then point to poor returns.

However isnt that how many companies now operate? ie concentrate on supporting (or boosting) the share price today rather than invest for tomorrow? For me this is why I think the share market is now simply perverse, its not doing the job it was created to do, and in fact is arguably actually destroying value and companies.

Poor returns can be a sign over over-investment. ie when you look at how badly the "real" economy is doing there is simply no rational argument to invest.

David - Fonterra has had money to invest. It just has a history of doing it poorly. If as you claim Fonterra is paying too much for it's milk price how come Open Dairy and the myriad of other manufacturers can pay similar levels and be profitable? Are you suggesting the Talleys are a charitable trust with dairy farmers the beneficiaries? . Might it be because of Fonterra's poor strategy - poorly executed?
Another issue is Fonterra sold the shares to the public as a cash return investment and being unwilling/unable to upset the investment community they pay too higher % of company profit as dividends thereby lessening their ability to retain earnings to invest for the future.

I am not arguing that Fonterra hasn't stumbled recently. Most companies do occassionally. Nor am I arguing that they can't do better. But 5% retained earnings is trivial and far too low. OCD, Talleys, GoodmanFielder, and any other corporate will have built up huge retained earnings by investing in their company - something that Fonterra's members haven't allowed them to do. And in the end a severe cost applies from such a relentless strategy. That cost flows to coop members in low and decreasing returns. Short-term thinking shareholders are bad for any company and Fonterra is no exception.

Fonterra should have at least $3.6 bln in retained earnings now (probably more if they matched their corporate rivals). But they are operating on $934 mln. That is a starvation diet for a business of that size.

David your assertion that it is farmer shareholders that are not allowing Fonterra to retain earnings is comical. It is poor governance that has resulted in the retained earnings policy. Pray do tell how was the capital accumulated that created the industry prior to deregulation and re-regulation to form Fonterra?

Far from comical. Shareholders control the board. The board decides the retention policy. The board chairman is a farmer-shareholder voted there by the co-op members. There's an oversight Shareholder Council. As you well know, there has been much debate and many elections. There is regular company-shareholder engagement, at many levels. Can't escape the consequences of that shareholder influence.

"Much debate"? I wouldnt call most of what ive seen and heard debate. Any company structure that delivered the standard of spin and utter bollocks and shut down dissenting opinions in the way Fonterra has in the last ten years would see the company in this exact same position. As an example there has been No room for any voice to say chasing volume is wrong, anyone saying such has been ruthlessly ridiculed.

Directors voted to retain as little as possible so that the most money could be paid out to their own farms so that they could service the interest on their farm bank debt - this is the sole reason retained earnings havent happened. Directors were only focused on their own personal debt due to the massive growth in the milk production which had to be funded by someone - in this case Fonterra!!!
Hence via Leonie Gurney was dumped by the board and is now re-instated by back on the board.

When a Company, does not recognise its own overheads are to blame, along with the poor decisions they have made. along with the reliance on taking a beating from clients that gouged them, small wonder we have issues with Fonterror,

That we have to pay over the odds for butter, cheese and all Dairy Products to feed their stupidity is galling.

It's not a structural problem. Just make the right bloody decisions. Pre Fonterra dairy companies and the Dairy Board grew on retained earnings, Tatua still retains heaps. Fonterras deliberate paying out almost all earnings and concentrating on volume growth were decisions that many felt were wrong long term and said so at the time.
Those at the top knew better and were highly rewarded for that stance.
Perhaps the only structural failure was with the shareholders council and its absolute ineffectiveness in reining in the boards decision making.
The article notes 26 % of Fonterra production goes to China and this is a plus, personally in terms of growing the co-op and its future stability I'd see it as a huge minus.

It isn’t the board and it isn’t the ownership. Everybody knows it’s the executive that runs the show in any one corporate and with scant regard to what’s above or below them. Bob Jones is right, boards are a waste of time. All capable executives know how to get around chairmans and directors, and how to fob off shareholders.

If you belive that, it is because shareholders are abrogating their role and responsibility. You think that happens in a normal corporate with major institutional shareholders? No, that is why many large corporates become powerhouses and great investments. Good tough governance. Fonterra's structure gives shareholders clout though the SH Council in a way most other corporates don't. Individual shareholders have little to complain about from the structure to 'direct' management and strategy. The real problem is that the group-think among shareholders is for their own farm businesses and not for the long term industry health. Are suppliers good shareholders? Not great evidence there.

Yes, individual shareholders may be able to be 'fobbed off', but as a group that shouldn't be possible. If it is, the SH Council is not doing its job. And voting shareholders are focusing on the wrong stuff.

Give Fonterra proper, normal retained earnings so that it can compete from strength. Don't always raid the cookie jar. Management isn't doing that. But shareholders can and have done that.

Yes David that is exactly the question, or more exactly the rub. “Are suppliers good shareholders?” The Sh Council may well have the ability to offer “clout.” But is it not much more than the good old old bug bear of a committe in so much that it depends entirely on the acumen, application, attitude and agenda(s)of the individual member(s) and like all committees, any one member or even better, troika can dominate proceedings over time. Personally had much experience with farmers’ cooperatives dating back to the seventies. I was in several senior executive roles. The executive, or let’s say management if you like, knew full well the worth of keeping the board well away from the staff and in all that time, apart from staged well fed annual shows etc, I never encountered a supplier. Don’t want to be seen as expansive but you have to concede that the “executive” have been seen far too often to run away with the spoon of late. Think Enron, Lehmans. I think a culture of self interest is pervading, and the ambition of filling one’s own pockets while the sun shines, rather than the good of the employer, the company, is hugely threatening to the traditional chains of command that used to hold everything together. Thanks for the chance to vent.

David I question the value we get from the independent directors and whether they are adding value around the Board table. Four independent directors plus the Chair only need one more and they have a majority. Do they actually vote based on independent thought or do they always vote with the Chair? If the latter then we have too many of them.
Shareholders are asked to ratify them but we never see them outside of the AGM. I believe that this means there is a real disconnect between them and shareholders, though their relationships with institutional FSF investors may be strong - but FSF investors don't vote in the elections.

For the good of Fonterra, the company, we do need a stronger retention position. But will the shareholders accept that? Time will tell.

It will be interesting to see what the new look Board does in regards to the review of all things. Will it throw out the golden egg(s) to satisfy the debt reduction goal of $800m? Will it become the cornerstone shareholder in Westland? Will we see an announcement like OCD recently advised its suppliers, of a payment range where the lower range now is sub $6? etc etc

Insightful point on the role of the independent directors CO. I wonder what the council would say to such an observation?

David Chaston, I acknowledge your points about Fonterra suppliers reaping what the sow, but contend that your knowledge and therefore appreciation of cooperatives, their purpose and strengths is scant.

You didn't comment on how the dairy industry grew to be the economic force it was before the formation of Fonterra. As red cows pointed out, it was through retained earnings. And although I concede that suppliers have to reap what they sow, your opinion that the shareholders council gives suppliers clout is a joke, and unfortunately illustrates your ignorance of the machinations of Fonterra, perhaps due to their unrelenting propaganda.I don't think I'd be alone in the observation that the shareholders council is full of spineless sycophants, who've done nothing to hold the board to account. They certainly don't represent me. Representation on Fonterra is proportional to share backed milk solids, and is therefore skewed in favour of larger scale more corporate orientated suppliers. They are the ones that incumbent board members butter up prior to elections.