A Fonterra thought experiment: where to from here?

Since the turn of the century, New Zealand dairying has been growing rapidly. Currently, the industry produces about 75% more milk than back in 2000. However, the world of New Zealand dairying is now changing and the growth tide has turned.

The forces of change are both economic and environmental.

In the short term, it will be economic factors that determine production. This year we are already seeing North Island but not South Island production decline. There is a strong likelihood that overall production will decline further next year as many farmers try to manage their cash flows by reducing cow numbers and bring support stock back on-farm.

However, in the long run it will be environmental constraints that limit growth. Quite simply, in most parts of the country the days of converting sheep and beef farms to standard seasonal-supply dairy farms with on-paddock wintering are largely over.

Although most farmers are currently focused on short term issues, there is a fundamental question as to how Fonterra will fare longer term in this new environment.

Over the last 15 years, although Fonterra’s milk supply has grown by about 45%, its market share has declined from about 96% down to 85%. With Synlait currently expanding its supplier base, and Oceania also expanding its processing capabilities, this market share is almost certainly going to decline further over the next two years.

In all likelihood, companies such as Synlait, Oceania and Yashili will continue to expand in the medium and long term in response to opportunities for value-add products aimed at China and other parts of Asia. In an overall environment of declining supply, this means Fonterra gets hit from both sides.

The investor-owned growth companies will focus on what they perceive as Fonterra’s Achilles heel, which is the requirement that every farmer should be paid the same price of their milk. Accordingly, the investor companies will focus on large farms in the major dairy regions, and will ignore the small farms and far-flung regions which are more expensive to service.

So how will Fonterra compete, given that, in contrast to the investor-focused companies, Fonterra is capital-constrained?

When Fonterra brought in TAF (Trading Amongst Farmers) in 2012, it acknowledged that capital growth would now come largely from retained profits. The problem is that those profits have not been great, and both farmers and investors in the Fonterra Shareholders Fund are clamouring for dividends rather than retentions.

Borrowing is already up near maximum levels, having increased $2.6 billion in the last year, so there is minimal freeboard there.

Given these capital constraints, Fonterra will be forced to largely stick to its existing knitting.

Accordingly, I have been doing a ‘thought experiment’ as to how Fonterra might fare should both national production and Fonterra’s market share continue to decline. The idea with a thought experiment such as this is not to precisely predict the future, but to test resilience of the system under adversity.

The specific scenario I have chosen to test is where Fonterra’s processing volumes decline from 1.6 billion kg milksolids as in 2014/15, down to 1.2 billon kg at some time in the future. This could be through a combination of lower national production (such as a 20% decline) combined with a loss of market share (down to say 78%). Or it could be from a smaller overall decline of say 10% (perhaps more likely) but Fonterra’s share thereof dropping to 70%.

In this situation, what would happen to the 400 million shares associated with the lost 400 million kg milksolids?

Well, under TAF there are two options. The first option is that investors come in and buy the earning rights to these shares, with legal ownership held in a Fonterra trust structure. The problems here are two-fold.

First, investors will be wary of the fundamental value of these shares in a situation where Fonterra has over-capacity in its processing facilities. One only has to look to the meat industry for some history as to what happens to profitability in those situations. Also, investors would now own rights to about 500 million shares (including 100 million rights already owned via the Fonterra Shareholders Fund). That lies well outside the parameters of TAF as currently envisaged, and in practice Fonterra would no longer be a co-operative.

The second option would be for Fonterra to buy back the shares. That would be even more problematic, as where would the money come from?

So this little thought experiment leads to the conclusion that Fonterra would be caught between a rock and a hard place. Once farmers realised this, then the flight to other investor-owned firms by the large and processor-proximate farmers could become a flood, constrained only by the milk supply needs of those companies, leaving behind the small and distant farmers.

The above thought experiment is not new to me; I have been wondering about it ever since TAF was designed. Fonterra said at the time that they had stress-tested TAF, presumably with their own thought experiments, or those of consultants. But I really do wonder if they thought it through.

The mantra at the time was that TAF would remove redemption risk – which is exactly the scenario I have tested here. However, it has always seemed to me that it would only work for modest redemption, including the ‘in and out’ of shares which was occurring in drought situations.

So the question becomes, have I omitted a strategy which Fonterra can use to remove the risk and which is consistent with its co-operative structure? My current thinking is that there is no such strategy for Fonterra. In essence, the die was cast the day that TAF was introduced.

Prior to TAF, it was always possible for Fonterra to retain part of the milk cheque to finance growth. This is what Tatua does. Its farmers have long understood the importance of reinvestment. As a consequence, they have got themselves into the happy long-term situation where they can continue to retain profits and still smash Fonterra in the cash payout that farmers receive.

In contrast, even prior to TAF the dominant culture of Fonterra was to ‘pass through’ almost all profits to farmers. That was the way that farmers wanted it, and the directors of that time failed by not standing up and telling farmers that it was a dangerous philosophy that would expose them in the long term.

The big problem for Fonterra now is that its company culture and structure is locked into a business environment created when the tide was rising. Very simply, it lacks the flexibility and investment capital to deal with the new environment.

A key feature of Fonterra‘s strategy in recent years has been to focus on whole milk powder. Using Fonterra’s own data, the production of whole milk powder more than doubled between 2008 and 2014, from about 550,000 tonnes to almost 1.2 million tonnes. Much of this was absorbed by China, which increased its imports of Fonterra whole milk powder imports more than ten-fold from about 40,000 tonnes to almost 500,000 tonnes. After going quiet (from over-supply), China is now back in the market again. It is the rest of the world which is largely absent from the market.

A key problem that has never been acknowledged by Fonterra, and never been explained to farmers, is that much of this powder has gone into and still goes into reconstituted UHT milk. Presumably Fonterra must always have known the final destination, but most people did not.

There is nothing wrong with reconstituted milk if it were not for the fact that this milk is typically not labelled as being a reconstituted product, which by law, according to my Chinese colleagues, it should be. If I put myself into the shoes of the relevant Chinese officials, and seeing a need to manage the pain being felt by their local production industry, then the first thing I would do is to enforce their existing laws in regard to product-labelling of reconstituted UHT. Oh dear!

So how will Fonterra respond? In public it will respond one of two ways. It will either say nothing or it will attack the bearer of bad news. But neither of those responses will solve anything.

Behind the scenes, Fonterra must surely be agonising about how to find a path ahead. In the medium term (beyond the next year), it may well be protected by global dairy industry restructuring – as long as China does not implement its own laws. So there could be another golden period ahead in the medium term. But in the long term, there is a dilemma to be faced.

In all of this, we should not lose sight of the fact that New Zealand has a long term role supplying dairy products to Asia. It is the choice of products, and the way we do it that counts.

The other irony is that all New Zealand dairy farmers need Fonterra to be successful. Given the fundamental imbalance of power between individual farmers and large scale processors, it is Fonterra that sets the farm gate milk price. Investor-oriented companies then have to match this price if they want a supply of milk. So Fonterra remains of critical importance to the whole industry. We need it to be successful.