Fonterra has three alternatives for its China Farms and none are attractive

This is the second part of a two-part series putting Fonterra’s China Farms under scrutiny. The first part is here

In the preceding article I traced the internal thinking within Fonterra as to why Fonterra decided to produce milk in China. The underlying belief was that Fonterra had the necessary expertise but could not play the desired role within China without having in-country production systems.  By late 2009, having lost its key China partner San Lu from the melamine disaster, Fonterra decided to go it alone with an expansion that would become known as the Yutian hub. From there, additional hubs would be developed.

Fonterra decided it would work towards a supply of one billion litres of China-produced milk per annum and this would require about 80,000 cows milking at any one time. There was an assumption that high-quality milk from these farms would sell at a premium to other China-produced milk. Whether or not Fonterra would also undertake processing operations was seen as a question for the future, but with a likelihood this would occur.

The technology of the new farms at Yutian was straight American.  The milking parlours were classic American parallel parlours which are not seen in New Zealand, and built to a standard of robustness for milking 24/7. Feeding systems were cut and carry total mixed ration (TMR). Sophisticated effluent systems, although not always effective, were installed.

The in-calf heifers came from New Zealand but once in-country they were subsequently mated with American semen to get bigger animals. Sex-selected semen was also used to speed up herd growth, no doubt influenced by the landed cost of cows from New Zealand being up to NZD 5000.

In the years through to 2013/14 most things went well. Milk prices were high and the Yutian farms hummed along. In 2013/14 China farms retuned $21 million EBIT, but alas that was the high point.

What went wrong thereafter has still to be fully elucidated, but there were undoubtedly multiple factors.

To start with, the key expertise in setting up the management systems at Yutian rested with China-based American vet Todd Meyer. Those close to the action would acknowledge the huge value Meyer brought to the Yutian management. However, Meyer was not enthusiastic about leading the scaling-up from Yutian.  He understood the challenges better than Fonterra, and in that environment, preferred to take his expertise to one of Fonterra’s competitors.

Thereafter, Fonterra never had the necessary depth of in-country expertise.

About that time, Lincoln colleague and dairy farmer Marv Pangborn and I were keen to get some of our Lincoln students experienced in these intensive farming systems, and several Honours level students undertook intensive courses in America.  We explored funding these studies on an ongoing basis though Fonterra, given Fonterra’s obvious need for an ongoing series of graduates to work in China.

I had preliminary discussions with Fonterra, but with ongoing leadership changes at China Farms, in the end it did not happen. My judgment is that, at senior level, Fonterra did not recognise the depth of knowledge that it lacked and which it needed to foster.

Fonterra also did not foresee the huge progress that the overall Chinese dairy industry would make with the incorporation of Americana and European technology. I recall one visit I made with a colleague to a Chinese agri-technology company that was linked into the overseas technologies. In their Beijing office, they had 50 design engineers all beavering away on various dairy projects.

So, whereas Fonterra saw itself as having a competitive advantage based on expertise and surrounded by competitors with inferior technology, in reality the story was different. Fonterra’s competitors were developing equal technology but lower operating costs and lower overheads.

At that time, Fonterra had also not fully recognised the challenges of getting premiums for top quality milk that is produced in China. Chinese consumers do not trust their own country’s quality assurance systems, regardless of who is producing the milk.

As Fonterra developed its second hub, Chinese farmgate prices for fresh milk declined. Prices have never returned to those earlier levels. Also, Fonterra found itself having to sell milk on the spot market as it lacked its own supply chain through to market. From there the losses mounted.

Over time, Fonterra’s aspirations were scaled back. As it stands, there is no longer any talk of one billion litres of milk per annum and production in the last year was 312 million litres. Remarkably, total animal headcount (milking and non-milking) in July 2018 dropped to 70,245 compared to 89,213 the previous year.

As with all corporate financial measures, it depends on the rules of the game. In the case of Fonterra’s China Farms, the milk is sold at inflated prices to its ingredients division which then sells it off, without further processing, at a loss. However, those transfer losses are identified in the small print and can be added back in to get a more genuine EBIT loss.

On that basis, the NZD EBIT losses in each of the last four years have been 44 million, 59 million, 37 million and 39 million. Also, these EBIT figures are normalised, meaning one-off mishaps have been omitted.  These figures also do not include any finance charges or contributions to Fonterra’s unallocated overheads which approach $500 million.

There are three options for Fonterra’s China Farms.

First, the business can continue on the same basis as currently. In essence that implies a loss-making operation which does not contribute with clarity to Fonterra’s overarching corporate strategy.

The second option is to build an integrated value chain in China as originally planned. However, that will require a great deal more investment capital for processing, market logistics and brand development, plus a level of expertise that Fonterra is yet to demonstrate. In the current environment, this will be a hard sell both to Fonterra’s farmer shareholders and the banks.

The third option is to get out of the China milk production business. That requires assessment of whether producing milk in China is central to Fonterra’s overall strategy.

Fonterra’s China Farms are valued in the books at NZD 748 million of which livestock are worth $280 million. The big question is whether these values are realistic?

In the case of the livestock, the values are probably realistic as there is a functioning market to identify these values. In the case of property, plant and equipment, there is more uncertainty.

Fonterra values its China Farms using discounted cash flows based on the estimated long-term value of milk in China. It uses a price of 4 RMB per litre whereas prices in recent years have been around 3.5 RMB.   According to the fine print (NZD 23 million decline in value for each 0.02 RMB decline in milk price), reworking the cash flows at 3.5 RMB would knock $575 million off the value.

Despite the shaky numbers, there may well be local Chinese buyers who think they can turn these assets to a profit. What Fonterra needs is for two such companies to get involved in a bidding war. There is really only one way to find these things out, and that is to out up the ‘for sale’ sign.

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About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
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7 Responses to Fonterra has three alternatives for its China Farms and none are attractive

  1. Howard Moore says:

    Hi Keith, having spent some years in China involved in dairy farming, Fonterra’s farms are typical of Chinese dairy farms that have failed to fully integrate forage production and milk production and overly rely on imported alfalfa hay to complement locally produced maize silage. Given 75% to 80% of costs on Chinese farms are feed costs (where alfalfa (Lucerne) hay is used as a key feed ingredient), the high costs and loss making on Fonterra’s farms are simply due to that – as with most other dairy farms in China. The problem of converting the existing Fonterra China farms to integrated forage and milk production with the benefit of lower effluent disposal costs is that the farms do not have adequate land associated with them. Imagine setting up a confinement farm in NZ with very little land and then buying in all the feed. Even at $6.75/kg MS it would be extremely hard to make it profitable.
    Given the existing farms are stuck with out adequate land and the consequent high feed costs, the solution I would suggest is to integrate their milk production with milk processing as do their major competitors. Mengniu + China Modern Dairy for example. Also Bright Dairy etc.
    That could be complemented by all future farms being designed with adequate land to provide the forage required to meet the farms’ feed requirements. Pretty basic principle of profitable dairy farming.
    Howard

    • farmerbraun says:

      Back in the day, say the fifties, it was reckoned that you needed 60″ of rain a year, preferably evenly spread; a good loamy soil; sunny skies most of the time; no more than one cow per acre; good pasture management skills, and enough subdivision; appropriate soil amendments; et cetera.
      Taranaki and Waikato were thought to fit the bill, geographically speaking.
      I wonder how the land in China measures up.
      Continuous cropping for forage seems much less sustainable than pastured dairy.

      • Keith Woodford says:

        Farmer Braun,
        There is no land in China that meets those criteria.
        Continuous cropping can be sustainable but only if there is a return of nutrients.
        The problem with pasture is that the Chinese growing season is short as temperatures move quickly from very cold to very hot.
        KeithW

    • Keith Woodford says:

      Howard,
      I agree with your comments re feed costs.
      Fonterra tried to outsource the production of local feed but it has proved to be more challenging than they expected.
      Yes, any buyers for these farms are likely to be existing processors. The problem for Fonterra is they have neither local experience nor ready investment funds for the processing plant.
      Producing milk in China is always going to be expensive, and their lies Fonterra’s opportunities for NZ-produced products
      KeithW

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  3. Hi Keith

    “the milk is sold at inflated prices to its ingredients division which then sells it off, without further processing, at a loss.”

    How did you get the price which it should have been sold to the ingredients division at? Was it by looking at local milk prices in China?

    Cheers,

    Will

    • Keith Woodford says:

      William
      Fonterra uses a price of 4 RMB as the long term price in their asset valuations – this can be found in the small print.
      For consistency, and given the wording they use, this almost certainly is the transfer price they re using.
      The local price is about 3.5 RMB, and I have assumed that price, but this number does not affect any of the other numbers I have provided.
      These numbers tie in with the loss that the ingredients division makes from on -selling the milk, but this overall loss is explicit in the fine print and does not require any assumption by me as to the selling price.
      KeithW

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