Is there a future for Oz Fonterra as Fonterra’s finances unravel?

Fonterra’s announcement that it expects a loss of around $600 million or more for the year ended 31 July 2019 has big ramifications for Oz Fonterra.  With overseas-milk pools now lying outside the central focus of Fonterra’s new strategy, and with Fonterra seriously short of capital, the Australian-milk pool and associated processing assets look increasingly burdensome.

If Fonterra were to divest its Australian operations, then it would demonstrate that Fonterra really is retreating to be a New Zealand producer of New Zealand dairy ingredients. It would also reinforce the notion that consumer-branded products are now largely beyond its reach.

This strategic position is close to where Fonterra was in around 2006, when it decided that it was 50 years too late to take on the likes of Nestlé.  It did have both Australian and Chilean operations at that time but they were smaller than now. It also took on an initial shareholding in Chinese San Lu at that time, but essentially Fonterra saw itself as a New Zealand-based co-operative.

Thereafter, Fonterra began increasingly to see itself as an international dairy powerhouse. That perspective drove the strategy for more than ten years, but the implementation was woeful.  

Stepping back to something more modest will be disappointing to those who saw Fonterra as a ‘national champion’.  However, it now looks like the only option, given the hole that Fonterra has been digging for many years.

In recent years, Fonterra has been processing about two billion litres of Australian milk each year. For a short period, it became the largest Australian dairy process with a market share of around 23 percent. The Australian operations have underpinned much of Fonterra’s consumer-branding strategy.

Fonterra used to describe Australia as a ‘home market’. This was built on the notion that the local New Zealand market was too small to be the necessary beach-head for global consumer markets.

Consequently, although the Australian production has only been around 10 percent of Fonterra’s total production, it has been much more important in terms of consumer-ready products.

Fonterra is now caught in two Australian pincer movements. The first is that Australian dairy production is in both short and long-term decline. In part that is due to drought, but it goes deeper than that, with structural change that includes both broader economic pressures and loss of irrigation rights.

The second pincer is that Fonterra is now losing market share to its rivals. In a market where companies are competing for milk supply, Fonterra is operating from a weak position.

Overall, it looks increasingly as if Fonterra is well down the track to losing at least 500 million litres per annum of its previous supply, representing a decline of around 25 percent. That decline has potential to accelerate.

Fonterra advised the Australia Competition and Consumer Commission (ACCC) in December 2016 that its Australian equity was $AUD one billion. Since then, Fonterra has invested further in Australia. As a comparison, Fonterra now has total global equity of less than $NZ 6 billion.

Fonterra plans to now write down its Australian assets by $NZ70 million. That does not look enough.

With speculation in Australian dairy circles that there will be a least one Australian processor casualty, then Fonterra is widely identified as a potential candidate.

Part of Fonterra’s problem is that it has dug such a deep hole. There has been a series of mis-steps, based on poor understanding of on-the-ground realities. The mis-steps go right back to the initial buy-in to Bonlac around the turn of the century, started by the Dairy Board. However, that was just the first mis-step of many.

The harsh reality now facing Fonterra is that no-one will want to buy a non-profitable business with stranded assets.

This current situation is very different to the situation some two years ago when Murry Goulburn Co-operative finished digging its own hole. At that stage there were no stranded assets and so there was good competition for Murray Goulburn, with Canadian company Saputo coming out the winner.

The consequent complication for Fonterra is that in the absence of buyers, Fonterra becomes vulnerable to much bigger write-downs in the value of its Australian assets. This in turn puts a lot more pressure on Fonterra’s New Zealand balance sheet with implications for its overall financial ratings.

In that environment, the pressure comes on to sell more and more assets. In that environment, the financial structure unravels.

It’s never good to be selling assets in a fire-sale. This is part of a broader problem for Fonterra that apart from Tip Top, which sold remarkably well, its other dispensable global assets are all struggling to find buyers.

Given this conundrum, the decision path inevitably leads back to what else Fonterra might be able to do to raise more cash.

Some commentators are suggesting that Fonterra might separate off its consumer brands in another company. That starts to sound somewhat like a good bank and a bad bank solution as occurred internationally at the time of the GFC. The bad company might include Soprole, DPA Brazil. China Farms, Beingmate and Oz Fonterra. 

 It would be remarkable if anyone wanted to take on a company in that form. More likely is that each will have to be hocked off separately.

Ten and more years ago I was an advocate of Fonterra splitting into a two-company model, with a processing co-operative and a second value-add company that was investor-focused. Alas, the days when that could have been the answer have passed.

The other alternative is that, one way or another, farmers will have to stump up with more capital. That prospect would be highly unpopular with farmers, many of whom have their own debt and balance sheet issues to deal with.

Until now, I have been resistant to the notion that Fonterra’s problems might be solved by reducing the milk price.  My reasoning has been that this would simply paper over the cracks and inefficiencies in the food service and consumer businesses.

However, with the cracks now turning into crevasses, there may be no other option. In fact, Fonterra has already done this twice since implementing the current capital structure in 2012. But this was in a very different socio-economic climate. And this time the amount would have to be considerably greater.

All of this arises from more than ten years of group-think combined with massaging of messages.. It seems that Fonterra believed its own propaganda. At farmer level, it was effective.

Most of Fonterra’s farmer directors have travelled widely on formal visits to the markets but have never done enough of their own footslogging away from the company propagandists. Fonterra’s external directors were also the wrong type of people.

Within the last year, there has been increasing acknowledgement from within Fonterra as to the difficulties that it faces. However, there is still too much defensive messaging. It is very hard for corporates to resist a public-relations culture of story-massaging that comes from deep within the corporate DNA.  

The time has come when Fonterra needs to lay out absolutely everything in front of its farmer members.

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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14 Responses to Is there a future for Oz Fonterra as Fonterra’s finances unravel?

  1. Mike McIntyre says:

    That’s fine, take from the milk price but that will hasten the demise.

    They will lose supply anywhere there is capacity.

    I get the nervousness but that would be a nail in the coffin.

    Mike McIntyre

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    • Keith Woodford says:

      Mike,
      As I said in the article, it will indeed be very unpopular.
      But unless Fonterra can pull a rabbit out of the hat, then the alternatives are very limited.
      Even if all off-shore assets are sold, then the balance sheet may still be weak.
      Your thoughts?
      Keith

  2. Hi Keith,

    The other thing you are missing is on the ground in Australia farmer sentiment is strongly against Fonterra over what it did in following Murray Goulburn (MG) to drop its milk price. If it hadn’t it would be the largest processor in Australia today. It saved $100m to lose $500m if not more.

    Don’t disagree that milk price is only option but they are on the Westland or MG path and whether its 3 or 5 years it is looking baked in to be sold to the Chinese. It could however be hastened if NZ suffered drought conditions and a decline in milk supply. One of the other bad decisions they did was spend $100s of millions on “optionailty” which was never going produce a return on capital (by defition). It was done for purely political reasons – they didn’t want to ever not be able to pay the theoretical milk price because they didn’t have capacity to turn 100% of their supply into WMP.

    Fonterra suffers group think as they always make redundant those who question strategy or performance. They tolerate extremely poor behaviour/bullying from senior leaders. Many decisions are made in the interests of individuals and not the organisation. One of the comments many former employees have made to myself is the bigger the ******* the more likely you are to be promoted. Many many of its best leave Fonterra to competitors with no small desire to return the favour for how they were treated. Don’t underestimate this impact on the co-ops performance over last ten years.

    I don’t think exiting consumer goods is a great idea as it will make prices so much more volatile but with the current board and leadership they have no hope of being effective – they just don’t understand what good looks like in this space. I agree they should have split of consumer food service years ago into maybe a 50:50 JV or listed entity. The Consumer/ Food Service business would regularly get starved of capital over the years and so had to operate on a shoe string budget and never had a chance for success when you had directors with no understanding of what was needed to facilitate growth in emerging markets and would default to their bread and butter – build a bigger dryer.

    Their best option would be to work on a drastic plan X – which would need government approval to deviate from current legislation but is its only hope for survival. Look at what milk they would take as close as possible to their plants to maximise returns, understand which plants make money and restructure Fonterra into a good co-op and a dead co-op and remove the many layers of ineffectiveness focussing especially on those who have made the culture so toxic.

    Keep up the great analysis Keith.

    A former insider

    • Keith Woodford says:

      Suppressedevidence
      I don’t think splitting the co-operative based on plant economics is legally feasible. All suppliers have to be treated equally. Much easier (albeit still challenging) to separate off the branded products, but that may not contain much of real value.
      I don’t think any Chinese company would be interested in taking over Fonterra. They much prefer to take smaller steps. And it would be just as politically difficult for the Chinese as for NZ if that were to occur.
      It does seem to me that some of the key influential people in relation to some of the biggest stuffups were people who are still in the organisation. And those people do now seem to have been promoted. There are three key people I look at in that light.
      KeithW

      • Don’t disagree about legal challenges. Essentially though farmers where there is competition will go elsewhere as the competition will pay more as they have value add which Fonterra will have none soon. A declining milk pool with the same overheads will push milk prices down fast forcing a greater discrepancy vs competitors. So you will end up with the same outcome Fonterra will be the dead co-op as it will be left with the farmers no-one else wants and are expensive to service and are selling bulk A1 commodities in a market which has moved on. You could end up with a forced carve up except the best bits will already be gone and although Chinese might not take the whole thing in one go they are always interested where they can see long-term opportunity and have a link into demand in China.

        The political challenge will be 5000 screaming farmers getting paid an awful lot less than their other farming friends with banks breathing down their necks as they are leveraged to the hilt – looking at a Yili type deal where they are promised good milk prices and the opposition saying we can’t sell off our farms to foreign interests. If government get forced to choose between farmers being able to pay off the banks and copping flak for selling to overseas interests vs a serious currency crisis due to a significant amount of non-performing loans in agriculture and farmers rioting on them I suspect the sale will go through.

        You’ve got my email so happy to swap notes on some of those key influential people.

    • Keith Woodford says:

      Suppressedevidence
      You have got me fooled as to what your email address might be.
      Perhaps I am not connecting the dots somewhere.
      KeithW
      kbwoodford@gmail.com

  3. David Porter says:

    Thanks for the article Keith. It lays bare the problem Fonterra has in Australia. I thought that the international expansion strategy was the right one but, as you say, they went about it the wrong way. It is a real pity as they might have been able to replicate what Kerry and to a lesser extent, Glanbia in Ireland have achieved i.e. that you’re shareholders no longer depend on their own milk supply but are getting a steady return from overseas operations. The only difference is that the New Zealand farmer shareholders would retain control and not flog off the shares like the Irish farmers did to bring in expansion capital.
    A pity for all concerned and I hope (likely in vain) that someone (or many) will pay for their folly in setting back Fonterra by decades.

  4. G Helou says:

    Great notes as always Keith.

    On Fonterra Aus assets, the whole industry will be glad to see the end of Dennington which was using 1960s technology (and older) and hideously expensive to run (featuring manual cleaning of an open top drier).

    The domestic phallus measuring competition that led to the expansion of Stanhope with no certainty of future milk supply will go down in Fonterra’s history as one of the worst decisions, simultaneously chasing Mozzarella supply in Europe via the Dutch Dairy “mafia”.

    Let it be known that the best performing dairy processors in Australia are those that are selling Cream to Fonterra…

  5. Tom Hunter says:

    It was around 2013 that I concluded that Fonterra was never going to be able to successfuly execute all those grand strategic plans from the turn of the century.

    I looked at it pretty simply: the idea of having a dividend from shares as a supplement to the actual milk-solids income sounded good; it meant the company would be focused on all that “value-add” stuff. As that improved over time the dividend would steadily increase, which would also increase the value of the shares, thereby making it easier for Fonterra to raise capital and borrow. In effect, each Fonterra farmer would be a micro-version of the company itself; lower and declining proportion of basic commodity business and income, with a rising share of “value-added” product business and income.

    But by 2013 I was done, and the following two seasons, with a terrible global commodity market and resulting record low payout, was simply a confirmation of Fonterra’s strategic failures. Sure, the zero-interest emergency loan was nice, but such should not have been needed if the strategies had worked. Effectively, for all the talk and the billions of dollars spent, we were in no different a position than the late 1990’s with Hamilton Co-op, Kiwi Co-op, others and the Dairy Board.

    My only regret is that I did not move fast enough. I did escape last June, after the share price had dropped to around $5, down from $6.50 in January 2018, and certainly I escaped ahead of the gathering disaster of $3.35 (and lower soon I’d bet). But it was still a hit to debt-reduction plans and as I’ve been saying to people, while I’ve managed to escape a bomb-laden building to stand perhaps 100m away, and will not get killed in the coming explosion and collapse, the question is whether I’m far enough away to escape the resulting shrapnel and debris?

    In other words, while private companies have long said they will pay prices for milk that are competitive with Fonterra, the thinking was only on the upside. When Fonterra starts going down will “a competitive milk price” be interpreted by those companies as following Fonterra’s price down? Why would they not drop their prices when they’re operating in the same commodity world (obviously not talking about the likes of Tatua). What proportion of their suppliers would they be willing to allow to go to the wall if the result is simply a stronger base of suppliers who’ve managed to buy up the dying ones cheap? Same volume of supply for less cost! What would be the problem from their perspective?

    • Keith Woodford says:

      Tom,
      I agree that non Fonterra companies apart from Tatua and perhaps Miraka can be expected to follow any decline in the Fonterra payout.
      By chance, today I was looking at a 2007 document from Fonterra which set out how in the 2006/07 year Fonterra paid a milk price of $3.87 plus a value add component of 59c. Back then the value-add component was significant. The fair value share was valued at $6.79. Fonterra had 12 billion of assets and equity of around 8.46 billion (6.79 X 1.246 billion kgMS). The particular document I was looking at was Fonterra’s first document to farmers proposing brinig in non-farmer investors. The argument was that Fonterra could not stand still and neeeded additional capital beyond what farmers could supply. It was a time when Henry VDH and Andrew F were running the ship. I reckon it was about the time that things started to go wrong, but for a long time the cracks were not evident to most people. Fonterra were lready buying into San Lu but the melamine crisis ws still a year away. By the end of 2008, with the GFC and Fonterra desperstely short of capital, the wheels were starting to fall off.
      KeithW

  6. alan andersonh says:

    Keith

    RE: Fonterra Supplier Shared-UP shares

    Can you help me out with my understanding here please

    Do banks, or have the banks loaned farmers loans to acquire farmer-supplier Fonterra FCG shares and used those shares as security over part of the loan

    The picture I am seeing is a farmer-supplier acquiring FCG shares at $6 per share 2 years ago, the banks taking security over the shares which are now worth $3.20

    Are the banks carrying the loans or does Fonterra provide the loan. I’m assuming the farmers mostly borrow to share-up rather than have the readies to acquire them

    What is happening now – are the banks concerned?

    Alan

    • Keith Woodford says:

      Alan
      The common situation is that the banks provide loans to farmers and the banks take security over all of the the farm business assets including the Fonterra shares. The problem now is that many farmers have very high debts relative to their assets, and with Fonterra shares declining in value this puts additional squeeze on farmers from the banks, because of reduced asset backing for the loans. A useful ananlogy is the straw that breaks the camel’s back. Banks are now requiring many of the farmer clients to repay capital as well as interest and this is really hurting. Some farmers also have loans directly from Fonterra going back to around 2015 but this is very minor in the greater scheme of things.
      KeithW

  7. alan anderson says:

    Keith
    RE: Fonterra Supplier Shared-UP shares

    Can you help me out with my understanding here please

    Do the banks, or have the banks, loaned farmers loans to acquire farmer-supplier Fonterra FCG shares and used those shares as security over part of the loan

    The picture I am seeing is a farmer-supplier acquiring FCG shares at $6 per share 2 years ago, the banks taking security over the shares which are now worth $3.20

    Are the banks carrying the loans or does Fonterra provide the loan. I’m assuming the farmers mostly borrow to share-up rather than have the readies to acquire them

    What is happening now – are the banks concerned?

    Alan

  8. Pingback: Fonterra has milked dry its Chilean cash cow | Posts from Keith Woodford

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