Fonterra has spent nearly three years stabilising its finances. The focus now has to be on finding the path ahead
It is now approaching three years since Theo Spierings’ departure from Fonterra was announced. The focus ever since has been getting Fonterra back into a stable financial situation. When Spierings left, Fonterra was in big trouble with lots of stranded and unprofitable assets.
That stabilisation process will essentially be completed over the next 12 months. In what direction does Fonterra then head?
The new Fonterra will be a much leaner operation having divested itself of China Farms, Beingmate, DPA (Brazil) and DFE Pharma (Europe). There will still be rough edges in Australia and Chile to be sorted out but Fonterra will overall be in a position of low business risk.
The core business of the new Fonterra is now commodities and specialised ingredients. The specialised ingredients make their way either directly or indirectly into food service. They include items such as mozzarella cheese. They can also include powders formulated for specific purposes.
Fonterra’s fundamental business structure is as a processor of raw milk into a range of products sold to other businesses (B2B). From a business risk perspective, it has an enviable position where it pays its farmer suppliers on a delayed basis and with its farmer suppliers carrying the risk of market volatility.
Essentially, Fonterra clips the ticket for processing the milk. Unless Fonterra does something totally wayward, it must make a profit on those core processing activities. Even if it makes a huge mess of those activities, it can solve the financial issue simply by clipping the ticket harder.
Although there is a formula linking the farm-gate milk price to international dairy prices, Fonterra does not have to pay that price to its farmer suppliers. And those suppliers have nowhere else to go, at least in the short and medium term.
The appalling situation that Fonterra got itself into during the Theo Spierings and John Wilson watch has been analysed by some but more analysis is required. My own perspective is that it arose from deep-seated arrogance within the company as to its own abilities and an unwillingness to recognise and then respond to internal weaknesses. It was a mix of the wrong internal structures and the wrong type of people in some key positions.
For many years, Fonterra sailed along in ignorance. It did not recognise its own incompetence in key areas. Instead, it kept congratulating itself based on believing its own PR. So many of the mistakes were avoidable if they had only listened.
One of the first questions now is whether Fonterra has learned from those mistakes. Achieving financial stability is a huge step forward, but is Fonterra likely to make the same mistakes again?
The Fonterra Board also looks different from three years ago. There is considerable diversity and mix of skills within the Board but the farmer-elected members look very different from the typical Fonterra farmer. Essentially, Fonterra farmers have elected a cohort of directors whose key links to the industry are mainly through family corporates and who in most cases have undertaken their careers off-farm.
This situation is not necessarily a flaw. But it does raise interesting questions of perspective alignment, and the importance of the Fonterra Shareholders Council in monitoring that alignment.
The latest elections saw the reappointment of a finance and accounting specialist who had just completed a three-year term on the Board, and who easily beat all other candidates. The second candidate to be elected is a new Board electee. This second electee is a lawyer with mergers and acquisition experience, who convincingly beat four other candidates. These included a director from previous times who felt there was unfinished business to sort out, together with a previous Minister of Finance, a highly successful farmer, and another accountant-type person.
The key focus of the current Fonterra vision is supposedly on value-adding. However, I see a big gap between that vision and the existing steps to implementation.
Several years go there was a lot of talk about mozzarella. Fonterra had its own revolutionary intellectual property allowing it to make mozzarella cheese much more quickly than other companies. As for production facilities, first there was Mozz1, then Mozz2, and then Mozz3. It cost a lot of money.
More recently, all seems to have gone quiet. The Mozz3 plant was lying idle for quite some time and may still be seriously under-used. Fonterra has said nothing of note thereof. So what is the future with food service mozzarella?
The other big opportunity was to drive through with the A2 project. The lack of progress has been papered over with PR spin. They messed that up in ways they have yet to admit.
Another question lurking in the background relates to capital structure. The existing structure was designed in pre-Spierings days and implemented around the time of his arrival. The key purpose of the new structure was to shift share-redemption risk away from Fonterra itself and onto farm balance sheets.
The biggest risk to Fonterra currently in terms of capital structure remains potential loss of farm-gate milk, with this occurring in an environment where overall New Zealand milk product is not increasing and may even decrease. The shares of departing farmers would normally be taken up by non-farmers as units in the Shareholders Fund. Alternatively, Fonterra could cancel the shares and fund this through either bank debt or bond issuance.
However, to the extent that some Fonterra shareholders are currently looking for a change in capital structure, a key issue in their minds is the capital they have to tie up in Fonterra. It is easy for some farmers to forget the fundamentals of a co-operative. If members want to share in the benefits of the co-operative, then they do have to provide capital to service their share of operations.
A big issue for Fonterra going forward is the diversity of its members. When it comes to voting for directors, it is the big farmers with herds of more than 600 cows, and in many cases business entities of some thousands of cows, who can dominate. They are the ones who produce most of the milk. However, most Fonterra farmers still have less than 400 cows. These farmers have limited voting power.
Right now, most farmers regardless of the size of their operations are supportive of what Fonterra has been doing to stabilise company finances. However, scratch beneath the surface and there is less uniformity as to what Fonterra should look like in future.
Most farmers are probably looking for a low-risk model, compatible with the reality that, relative to their farm businesses, Fonterra is just an add-on. In many cases, those on-farm businesses are highly indebted. From that perspective, and with on-farm regulatory issues a big concern, it is not a time to take on new risks.
All of this means that Fonterra is likely to continue operating within a framework of producing commodities plus specialised ingredients for food service. Trying to develop consumer brands is likely to remain in the background.
Despite the relative simplicity of this framework, I expect there will be interesting discussions around the Board table over the next year in regard to fine tuning what this all means in terms of operations. With the possible exception of A2, don’t expect anything that is particularly visionary.