[This post was first published in the NZ Sunday Star Times on 16 February 2014]
The key strategic decision for New Zealand dairy companies is whether to focus on commodities or value-add products. The value- add strategies include both specialised ingredients and consumer brands.
Commentators are often quick to argue for a consumer brand strategy in line with the messages contained within the elementary textbooks. In practice it is not so easy. Brands require a lot of capital and require good understanding of consumers. That is not always easy when the consumers are some 10,000 km or more from New Zealand.
Traditionally, New Zealand’s natural competitive advantage has been in commodities. Indeed Fonterra has been the supreme producer of commodities. Until recently, our historical cost of production at farm level has been lower than other developed countries. Also, Fonterra has been able to capture scale economies in processing which no one else has been able to match.
For the smaller companies, competing with Fonterra with base level commodities is challenging. Even when Fonterra makes mistakes, it is very difficult to out-compete Fonterra in the commodity business.
In contrast, the small Waikato-based Tatua Co-operative decided some thirty or so years ago that its key focus would be specialist ingredients and business-to-business marketing. This has meant investment in the science of dairy products and working closely with companies that do have brands. Their key successes have been with protein products such as the caseinates. In particular, they have linked with Japanese nutraceutical companies who now rely on Tatua and are prepared to pay a premium to retain the security of a trusted relationship. In most but not all years, Tatua farmers get paid more than Fonterra farmers.
Open Country, which is now New Zealand’s second biggest dairy company after Fonterra, started out as a cheese company with aspirations for premium quality. However they soon found that it was easier to market cheese in bulk than in consumer packs. And then they found that to manage the market risks they had to diversify into milk powder commodities. So Open Country is now predominantly a milk powder company. Despite the advantage of all their plants being modern, they have to work very hard to compete with Fonterra.
Synlait has chosen a somewhat different strategy, focusing primarily on the premium end of the powder markets, including infant formula. But even then they have kept away from developing their own brands, instead producing branded products for other companies to market. They also have an advantage operating in Canterbury, with its concentration of large dairy farms.
In the early 2000s, Fonterra made a big play about reducing the number of its brands from the more than 100 that were bequeathed to it from the Dairy Board. Instead, Fonterra planned to take on the world by focusing on a small number of so-called ‘power brands’. The new Brands Division was led by imported consumer expert Sanjay Khosla. Then, a few years later the drums went quiet, and Khosla departed to pursue other interests. Privately, the word was that Fonterra decided that it was 50 years too late to take on the likes of Nestlé, although that was never said publicly. So the new focus was to be on specialised ingredients, with a particular emphasis on the USA. Subsequently, that endeavour also faded as American companies developed their own expertise with ingredients, and the USA is now the number two exporter (after New Zealand) of dairy products. So Fonterra is back where it started as a predominantly commodity company.
Ironically, the wheel has now turned again and huge new opportunities for branded products have emerged in China. However, New Zealand has been slow relative to the big European companies to grasp those opportunities. Also, the sad reality is that even Fonterra, despite its size, does not have the capital resources to dominate either the big local companies or the big internationals. Other New Zealand companies are now dipping their toes into the branded waters, including Westland with its Easy-Yo yogurt, and A2 Corporation with its ‘A2 Platinum’ infant formula, but in the greater scheme of things these endeavours are small.
So the reality going forward is that we are likely to remain dependent on commodities for our future prosperity. At one level this is disappointing, but the overall outlook is still positive.
The reason for this positivity is that China is desperately short of milk and this situation is unlikely to change in the foreseeable future. The overall market prospects are stronger now than they have ever been. In fact, local Chinese production of milk is actually less than six years ago just before the melamine scandal. This is because small farmers have been rapidly exiting the dairy industry, and either moving to the cities or retiring. Meanwhile, the new large scale industrial dairy farms have been growing in number, but too slowly to take up the slack. Also, finding reasonably priced feed is a big challenge. So unless the Chinese decide they do not want to consume dairy products, then we are in a medium to long term commodity sweet spot.