It’s time for Fonterra to define the new path ahead

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.

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.
This entry was posted in Agribusiness, Dairy, Fonterra, Uncategorized. Bookmark the permalink.

16 Responses to It’s time for Fonterra to define the new path ahead

  1. I am amazed that the Fonterra model has come through strengthened following the legislative review, rather than weakened, given the poor track record for a venture that was meant to be a NZ champion with the promise of added value, a kind of Nestle of the South Pacific. I have yet to understand what Fonterra has achieved over and above what was going before. If you look at the vineyard business as a parallel, it is as if the government had set up a “Wineterra” in which vineyards sent their product to a central collecting agency that then sent them overseas in bladders of generic wine (sorted by region and grape type perhaps). Instead, what we have is a whole lot of branded wine products gaining prices two or three times wines in bulk and/or poorly-recognised. Meantime Fonterra has handed over the added value to overseas interests, while the wine industry has created its branded products and made much greater returns on their basic commodity product.

    • Keith Woodford says:

      My perspectve is that Fonterra has stabilised and is now a low risk business but it has not been any ‘national champion’, and shows no likelihood of being one. However,the underlying industry wil remain a cornerstone of the economy, despite that not being recognised by many. But a big transformation of production systems will be necessary – there is lot that needs fixing.

      • Surely it is more than a transformation of production systems? Where they have failed is in grabbing the added value. I think commentators on the economy post-COVID think we are going to suddenly go high-tech, when the most obvious advances are in our primary sector adding value.

      • Keith Woodford says:

        Fonterra will never add a lot of value via brands. Those opportunties have largely been lost for a range of reasons. So if it is going to add value, it will have to be via gnuinely differentiated products, mainly at the ingredient level. Given that Fonterrra is largely in the B2B space, any product-attribute differentiation has to be capable of carrying through to the final product. That is hard to achieve for ‘green’ attributes. A2 is probably the one attribute that satisfies that criterion. Most ingredient buyers rate food safety and delivery to specification, followed by reliable delivery (logistic issues) as their key requirements. These requirements must be met, but do not lift Fonterra above the pack when it comes to premium prices and hence added value.
        Companies that wish to be entrepreneurial in relation to NZ dairy products are not prepared to be at the mercy of Fonterra for raw milk supply. This is because of the unequal power relationship. Accordingly, they have to take on their own suppliers. The new DIRA has increased the challenges of enticing suppliers away from Fonterra. Also, when that occurs it leaves Fonterra with stranded assets. In summary, the institutional framework is a mess and acts negatively in relation to the NZ dairy industry achieving its value-add potential

      • I completely agree on the institutional arrangements. But why did our policy community fail to take this opportunity of the decade review to have a proper debate – and for a crucial part of our economy? Where were Treasury, Economic Development, all these great economists prepared to opine at the drop of a hat on house prices, productivity and so on, and yet fail to see what is staring them in the face – that Fonterra is a monopoly that has effectively reduced the chances of production innovation. I only every saw Rod Oram (and the Irish-born Herald columnist) bring up some negative comments. There was one independent consultant, but he was written off. I felt that what they needed to do was a Telecom-style separation. Let the “Chorus” part of Fonterra pick up the milk and pay the cheque, and then allow the “Spark” part grow and innovate and compete against other companies taking up the consumer-oriented part of the business. The worst of it is that this happened under a political tendency that should not be so beholden to agricultural vested interests that it cannot support the larger public interest. The farmers claim that they are targetted by urban liberals, but actually they get a pass on almost all key policies that come their way (including health and safety, food safety (which should not be in MPI), destruction of waterways, generation of emissions etc etc)! What is even more vexing is that farmers are actually being short-changed. They think they are fighting off dreadful socialists dedicated to paring back their incomes, when if you compare them with Kerry’s or almost any major milk-based corporate, they have fallen well behind in their earnings because they are stuck in a commodity business.

      • Keith Woodford says:

        There was some input a couple of years back in relation to DIRA changes, via a committee set up by the Minister. The views were diverse – I was part of the group. However, significant changes were made to the proposals at the Select Committee stage with the support of both sides of the House. Fonterra should feel very pleased with what it achieved at the 11th hour. I could only shake my head in wonder.
        Keith W

      • This was predictable. Despite the rural and agricultural community claiming they are put on by urban and political interests, the truth is that they are generally given very generous treatment. I can hardly think of any recent issues where they have not been able to bend the government to their will. The crazy thing is that it is not in their long-term interests or those of the country. All that energy exempting themselves from health and safety when people on farms have some of the worst injury and death track records because of lax standards on tractors and bikes. How can that possibly be a favour to the farming community? Similarly with the continuing exemption of Fonterra from competition requirements when it has burned up so much wealth and left NZ farmers so far behind their comperes in, say, Ireland with Kerry’s. What kind of favour is that? This is usually where urban parties come in because they can do things rural ones cannot – like introducing and enforcing NAIT!

      • Here is a guy who was inspired by the wine example of niche, branded added-value products: A relative of mine says that dairy farmers are price takers, which is true – but why not try to get out of that trap with a bit of innovation that trades on NZ’s special qualities and reputation? Or maybe that is all a chimera!

      • Keith Woodford says:

        It will be interesting to see where Southern Pastures getsto over the next few years. It is not an easy road they have chosen. I hope they succeed, but only time will tell.
        Keith W

      • I agree. It is probably a long shot and will inevitably fail as have other added value attempts, and the standard farming interests will pat themselves on the back. But what kind of satisfaction is that?!

    • David Porter says:

      Hi Keith, Peter,
      I’m coming in a bit late to this conversation but, for what it’s worth, a couple of points I’ve noted.
      1. I’ve banged on about this before but the profile of NZ’s milk production makes developing premium markets mighty tough. The premium consumer markets all need a steady supply of product. Unless NZ farmers flatten the production curve or Fonterra partners with Northern Hemisphere companies with spare milk in May/June/July, it will be tough to develop brands. Ask Peter Cullinane if he wants 15 litres of milk in October for every litre in June and then market it all at the top end of price. As Keith points out, the best space is at the ingredient level.
      2. The Irish model, e.g. Kerry, Glanbia etc. has reduced farmers to price takers as there is a share price to consider so dividends need to be paid. The only power farmers have over their “co-op” is standing outside the gates demanding a better price, e.g. and (admittedly old) Kerry co-op is now in negotiations to buy back the commodity processing part of the plc. They’ve no chance of buying back the consumer/ingredients part of the business they sold which now has a stock market valuation of around €20b.
      3. The UK Milk Marketing Board is a good example of what might have happened to the NZ dairy industry upon the demise of the Dairy Board if Fonterra had not been set up. There is now little to no ownership of the processing assets by the farmers. Dairy farmers have been split into two categories, those with direct supply contracts to supermarkets and those supplying commodity outfits. The difference in price is around 20% better for supermarket suppliers but they are chosen location nearest to the processing sites and are willing to submit to compliance/production profile/environmental constraints which would very much please GenToop and her cohorts.

      It sounds like I’m trying to defend Fonterra; far from it. Possibly because it has monopoly powers it has been moribund for most of its life. But, because New Zealand must trade internationally, it must swim with the big boys and needs some scale to do so if they want to shift some 20b litres of milk. New Zealand wine is a good example of the possibilities of small scale processing/marketing and the winemakers have been excellent at differentiating their product from the rest. It is difficult for me to see how more than just a few NZs dairy farmers could do the same with their milk though. Some farmers complain about the cost of having their capital tied up in shared assets like Fonterra. Just wait until they find out the cost of setting up their own!

      • Keith Woodford says:

        Thanks David
        I think we may be in agreement that Fonterra has got itself into a space where the path forward has to be ingredients, with these being differentiated from competitors to the extent this is possible. Eseentially it is ‘commodity plus’. I think Fonterra understands this but has not really made it explicit. I don’t think the Government understands this very well at all, in particular the limits on value-add within this framework.
        Keith W

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  3. Peter Leslie says:

    Hi Keith – given the recent outcome from the Farmers survey, what options do you see for the Board to adjust the capital structure? How likely is it they retain the status quo or do they need to make a change and it is simply a matter of taking on more debt (probably via the bond market) and buy back the shares in the Shareholders Fund?  It would seem unlikely that Farmers will want Fonterra to raise equity from them to finance the fund. Interested to hear your thoughts,

    • Keith Woodford says:

      I have not given a lot of thought recently to the capital structure.
      The responses to the farmer survey were much as I expected.
      I would probably be inclined to maximise bonds at this time and minimise bank loans.
      I have never been a great fan of the FSF but there is an old saying about ‘strategy before structure’.
      Probably the big question right now is how should Fonterra protect itself against a loss of say 15% of its supply. I am not saying that will happen, but it is something that has to be thought about.
      The other big risk for Fonterra right now is the China relationship. If we get caught in the backwash from global politics between China and the US/Australia then it won’t be nice for Fonterra.
      I remain an optimist about overall dairy demand but only if those geopolitics don’t get in the way.
      Fonterra has one a great job of stabilising the ship but that still leaves some big questions as to the future.
      Also, Fonterra still has some issues to deal with in both Chile and Oz. Victorian assets look like they could be over-valued to me.
      So in among all of the above, I have not really given you an answer. Rather these are the issues I would need to do some more thinking about.
      Keith W

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