Fonterra and the two-company model

[This is the fifth and last post in the current series on Fonterra. It was first published in the Fairfax NZ Sunday Star Times on 1 March 2015 under the title ‘Don’t cry over spilt milk’ and then republished online in ‘Stuff’ under the title ‘Culture is king over strategy for Fonterra’. (Choosing the news title is the prerogative of the editors, not the author. Sometimes they use my supplied title and sometimes they don’t.)]

In recent weeks I have been writing about the key issues that Fonterra faces. This week I will look at one specific strategy to deal with those issues.

There are two key issues that stand out from the rest. The first is that Fonterra is trying to be good at too many things. It is trying to be a processor and marketer of commodities with a focus on cost and logistical efficiency. It is trying to be a supplier of specialist ingredients based on science and technological innovation. And it is trying to be a marketer of fast moving consumer goods based on entrepreneurial flair and panache. It is performing well with the first, but struggling with the other two.

The second key issue is that within its current structure, Fonterra lacks the capital to take on its global competitors for branded products.

These issues are not new. Together with my Lincoln University colleague and Fonterra farmer Marvin Pangborn, I wrote about these issues back in May 2007 in ‘The Dairy Exporter ‘. We said then that Fonterra would suffer if it tried to become expert in everything. And we said that Fonterra lacked the capital resources to grasp the emerging opportunities in fast moving consumer goods.

Our solution then, and my solution now, is a two-company model. For descriptive ease, I will refer to these companies as Fonterra Processing and Fonterra Brands.

Fonterra Processing would be owned by its farmer suppliers who would supply capital in proportion to their milk production. The company would be a co-operative, with a very clear aim of maximising the price of milk back to its farmer members. It would process the milk into a range of commodities and also specialist ingredients. The shares would appreciate over time but capital gain would in all likelihood be modest. The benefits would flow to farmers via the farm gate milk price and by the underpinning to farm values that this would provide. In essence, this is the key outcome that farmers want.

Let there be no doubt that the current role of Fonterra and the future role of Fonterra Processing, as the company that determines the farm gate milk price, is extremely important. Investor oriented non-cooperative companies, such as Synlait, Open Country and Oceania, all set their farm gate milk price relative to what Fonterra pays. Without Fonterra and its overarching influence, there would be insufficient competition at the farm gate to ensure a fair price to farmers.

Whereas Fonterra Processing must remain a co-operative funded by farmers, Fonterra Brands needs a different structure that can bring in additional capital. It would initially be majority owned by the farmers, and Fonterra Processing might itself retain a modest cornerstone shareholding. However, farmers would be free to sell their initial shares on the open market, and in all likelihood there would be equity capital raisings on the sharemarket.

The two companies would have separate directors and separate management. In all likelihood they would have both short and long term supply and purchase agreements in place with each other. Whereas Fonterra Processing would be trying to maximise the sale price for commodities and ingredients, Fonterra Brands would be aiming to minimise the purchase price. Accordingly, there would be normal commercial tensions between the two.

Some people may wonder why the companies need to be separate. The answer goes back to strategy and culture. Each company requires a fundamentally different business culture. It is all very well to have both strategies in the same company, but in reality it does not work. A business can only have one culture. And as the CEO of one of our Crown Research Institutes observed to me in recent weeks, albeit in a different context, culture always dominates strategy when they come into conflict.

If Fonterra had moved to the two-company structure back in 2007, both the dairy industry and New Zealand would now be in a stronger position. It could have avoided many of the mis-steps of the intervening years.

Moving to this new structure in 2015 would be more complicated than it was back in 2007. This is a consequence of the hybrid structure introduced in 2012, misleadingly named “Trading Amongst Farmers”. This structure includes both farmer shareholders and non-farmer investors. Also, lost opportunities of the last few years can never be regained.

But the two-company structure remains achievable and can provide a pathway forward.
Moving to a two-company structure also has its risks. Perhaps the most important one is that New Zealanders and the New Zealand fund management companies might fail to invest in Fonterra Brands. In that case, Fonterra Brands would essentially become an overseas owned company. But if New Zealanders choose not to invest, then they can hardly complain about New Zealand’s future being based predominantly on commodities. It is New Zealand, and not the farmers, that needs to take responsibility for dairy’s value-add.

Despite my enthusiasm for the two-company model, I am far from confident it will happen. My mail in response to earlier Fonterra articles suggests that within the industry there is indeed a widespread belief that the current structure is only interim. However, neither the industry nor the Government has a clear vision as to the best path forward.

[Earlier posts in the Fonterra series were ‘The evolution of Fonterra‘, ‘Fonterra’s journey‘, ‘Fonterra’s global reach’, and ‘Fonterra’s three-way dilemma’ ]