This is the first of a two-part series putting Fonterra’s China Farms under scrutiny. In this first part, the focus is on the origins of how Fonterra managed to entrap itself in its loss-making China Farms project.
Fonterra’s new leadership team of Chair John Monaghan, CEO Miles Hurrell and CFO Marc Rivers has made it clear in recent farmer meetings that debt reduction is a priority. All options are supposedly on the table. However, the only way to achieve rapid debt reduction is by selling non-strategic assets. In that context, Fonterra’s China Farms must surely be lined up in the cross wires.
Fonterra’s China Farms have been loss-making for at least four years. Accumulated losses over that period, using market prices rather than internal transfer prices, total NZD $179 million EBIT. These losses are before any contribution to Fonterra’s unallocated overheads of nearly $500 million per annum or paying interest on the borrowed capital. More detail on that in Part 2 of this series.
Given the ongoing losses, hard questions have to be asked about the strategic importance of these farms. Was it ever important for Fonterra to be producing milk in China? Even if that was the case, is it still important?
Fonterra’s China Farms go back to decisions made around 2006, with the first cattle shipped there in 2007 to the Hangu Farm. This was part of the joint venture with San Lu, and the only part of that venture to survive the 2008 melamine disaster. Soon thereafter, Fonterra embarked on further farm development at what is now known as the Yutian Hub.
To find out why Fonterra wanted to build farms in China. it is helpful to study a report by the Commercial Steering Group of the NZ-China Dairy Project, written in 2007, at a time when the first cows were on the water. The project report was never formally published, despite having a nice glossy cover, and written for a general audience. It was overtaken by events. I was part of that NZ-China Dairy Project.
There were nine organisations represented in the project, with Fonterra chairing, and NZ Trade and Enterprise (NZTE) playing a key role from in the wings. Various agricultural technology companies were the other major participants, plus two university academics of which I was one. But the overall drive for the project was Fonterra and the then Labour Government who were working together with a vision of “NZ Dairy Inc”.
The starting point was a belief that “playing a key role in China’s ‘dairy revolution’ presents exciting opportunities for New Zealand”. An early assumption was that “liquid dairy product, including fresh milk, UHT milk and yoghurt, will continue to be the largest growth segment”. There was also a belief that “Export opportunities to China for dairy commodities may stagnate. The question for Fonterra is how to capture the opportunities in China without growth in traditional exports.”
From there, it was easy for Fonterra and the Government to reach a conclusion that Fonterra needed to be a strong “Number Three”, (presumably behind Yili and Mengniu) in milk production in China.
As stated in the report, “Fonterra must access between 4% and 6% of the total milk production in the Chinese market by 2015”. This statement, supposedly written by the group, was in fact guided from the highest levels in Fonterra and the Government.
From elsewhere in the industry, there were some cautionary thoughts. For example, one quote in relation to ancillary businesses, credited to an anonymous “Managing Director of a Livestock Business”, was that “China is not an easy market…. If we can avoid going there we will”.
In fact, that comment was from Craig Norgate, former Fonterra CEO but at that time Managing Director of PGG Wrightson, who for whatever reasons wanted nothing to do with the project. There is indeed an irony there, given the subsequent journey of PGG Wrightson.
Given the dominant ‘gung ho’ perspective within the group, it was an easy step to think that New Zealand had lots of expertise, and that there was a “dairy knowledge base in New Zealand that is second to none”. Also, working on a collaborative basis, “policy experts from within the Ministry of Foreign Affairs and Trade (MFAT), the Ministry of Agriculture and Forestry (MAF) and the Ministry of Economic Development (MED) are well placed to share their experiences with their Chinese counterparts”.
My own involvement with the project started mid-way through the work, with a call from NZTE asking me to join the team. When I asked what my role was to be, NZTE said that they did not actually know, but that Fonterra had asked for me. We agreed that clarification would be sought.
It turned out that the project was, amongst other things, identifying opportunities in China for New Zealand-style grassland farming systems. China-based consulting teams were developing some glossy reports indicating that “the south-central provinces contain areas that would be very suitable for traditional New Zealand grass-based dairy systems”. Indeed, that part of the project was referred to as ‘The Waikato Project’ based on the notion we could recreate the Waikato in China. My task would be to critique those proposals.
Critiquing the proposals was easy in a technical sense. In fact, the proposals were nonsense. But from a group dynamics perspective, I did have to be a little careful. After all, the beautiful graphs and diagrams had been prepared by a world leading international management consultancy company, which both before and since has made many millions at the expense of Fonterra. Other data came from NZTE folk who knew a lot about trade but nothing about geography and farming systems.
There was another part of the project where I was totally unsuccessful in changing the dominant perspective. That related to the notion of producing UHT milk in New Zealand and shipping it across to China.
The dominant perspective was that exporting UHT milk was a crazy idea. The conventional thinking was that transporting long-life milk would be killed by the transport charges. I saw things differently, with good premiums possible. Ten years later, the wheel has turned and Fonterra does indeed have a significant business exporting UHT milk from the Waikato to China.
Given the impracticality of creating a new pastoral Waikato in China, and the perceived impracticality of shipping UHT milk to China, the logical outcome for Fonterra was to focus on intensive factory farming in China to get the quality milk they wanted. And this is what happened.
China’s first farm at Hangu, in association with San Lu, had some fundamental design flaws. However, drawing both from this experience, and from the ashes of the melamine disaster, Fonterra decided that it still wanted a Chinese source of milk. That meant having farms where Fonterra had total control over milk quality.
Someone at Fonterra had the wisdom to recognise that American technology and expertise rather than New Zealand technology and expertise was the way ahead, and that technology was bought in. For some time, the results from the Yutian hub looked promising, but then everything turned to custard, at least in a financial sense. That story is Part 2 of this series.