Land of milk but not enough money

By Duncan Bridgeman and Nick Stride

Friday 2nd July 2004

Who'd have thought it would pan out like this?

Three years ago Finland's Nokia was at the apex of its success, an international byword for how a small country could break free from commodity resource reliance and develop a world-beating high-value-added enterprise.

At the same time Fonterra was struggling through the final months of its gestation and the merchants of gloom were having a field day.

What was about to be born, they prophesied, was a bloated and unaccountable giant sucking up all the dairy industry's value-added opportunities.

Farmers, they said, would be left struggling to produce ever-greater quantities of commodity milk to offset ever-falling prices, a vicious self-feeding downward spiral.

A "Dad's Army of dairy dons" had missed the opportunity to make the dairy industry New Zealand's Nokia, economist Gareth Morgan argued in this newspaper.

Three years later Nokia is still making headlines but not for its sterling contribution to the Finnish economy. With a product range starting to look frumpy, its market share has fallen below 30%.

The share price, which peaked at E65 during 2000, is dragging along at about E11, prompting the Economist to wonder whether its dominance of the mobile phone industry is coming to an end.

Fonterra, by contrast, seems in rude good health.

When the Jedi programme is completed on track later this year, the co-operative will have sheared more than half a billion dollars from its annual cost line.

Since its formation, the value of its shares, issued at a nominal $3, has risen by an annual average compound rate of 15.8%.

The downstream value-added business is launching a new consumer product on average every week. A Latin American joint venture with dairy products giant Nestlé is going well and Fonterra is about to announce another significant deal in China.

Challenges and opportunities

So chief executive Andrew Ferrier, poached from Canada almost exactly a year ago, feels justified in poking a little discreet fun at those early critics. But he is the first to admit a lot of hard work has still to be done.

To Ferrier's mind, Fonterra's "challenges and opportunities" come under three main headings: communications, capital and internal competition. Boring though they sound, each is a critical and fiercely debated industry issue.

Most businesses would probably see communications as an ancillary function at best and a strange one to have on the top three list of priorities. Their shareholders, after all, are mere providers of capital.

But for a co-operative owned by 12,634 supplier shareholders, most of whom get all or most of their income from the supply relationship, keeping them up with the play is a huge challenge.

So Ferrier spends a great deal of his time travelling the country talking to his farmer shareholders and interested business groups.

One key message is that the co-operative is neither bloated nor unaccountable.

Where in the past only one performance measure mattered dollars per kilogram of milksolids shareholders now have an array.

One is the share value, set by the board from the mid-point of a range calculated annually by rating agency Standard & Poor's.

Another is TSR (total shareholder return), the pre-tax return to shareholders divided by the value of their investment. Excluding foreign exchange hedging, last year's TSR was 10.2%, or 16.7% with hedging included.

A third is an annual comparison of farmers' AMR (actual milk return) against the "commodity milk price" a theoretical construct, also calculated by Standard & Poor's, that identifies the highest price an efficient competitor to Fonterra could pay.

According to chief financial officer Graham Stuart, the gap between the two shrunk in absolute terms in each of Fonterra's first two years and in relative terms in the third.

As Stuart drily notes, Standard & Poor's uses Fonterra's own efficiency as a benchmark, so in the short term at least the co-operative is its own worst enemy.

Capital-raising problem

There's another reason the giant needs to keep in touch.

If the co-op is to keep growing profitably, board and management seem to agree, it will sooner or later outgrow New Zealand dairy farmers' ability to provide equity finance.

This is a point Morgan and others made repeatedly both before and during Fonterra's formation. But it is one Fonterra's farmer-shareholders are going to find hard to swallow.

In short, Ferrier's message is: "This issue isn't going to go away, so don't be surprised to hear us talking about it."

He estimates Fonterra could fund growth for maybe five years. But in the meantime it has to find the best way to raise capital further out and a way to take its shareholders along with it.

"Any inability to access sufficient equity could undermine our ability to realise the full potential of our value-add operations," he told an audience at the Auckland Business School last month.

"That in turn could prevent us from increasing the long-term wealth of our farmers, a challenge in itself given that commodity pricing long term is on a downhill slide."

Fonterra has been looking at other global scale co-operatives, of which there are only a few around the world. These have used various mechanisms for example, spinning out subsidiaries and keeping a majority shareholding but with only mixed success.

On one thing Ferrier is adamant: Fonterra will always be a co-operative. "It's a long-running debate and the board is very engaged in it. I think we can go quite a long way further than most people think."

Even so, any major change will need approval by 75% of shareholder votes cast.

Benefits disputed

Not everybody is impressed. Federated Farmers vice-president Charlie Pedersen, who milks 1200 cows in the Manawatu, believes Fonterra's value-added business hasn't delivered to dairy farmers the benefits that were hoped for.

He doubts whether the local dairy industry will ever have the cash required to drive product further up the value-added chain.

"I'm hugely proud of what Kiwi dairy farmers have achieved but Fonterra is playing a game that chews up huge amounts of capital and we are still not sure whether it can deliver the benefits."

Fonterra's capital structure presents two major threats, he says.

The rise in share value, which includes the value-added part of the business, will put increasing pressure on farmers' decisions on whether to produce more milk. Farmers could decide to simply cash in their shares and switch to the next possible land use, he says.

"No farmer will milk cows for the same return as he could get for finishing lambs or beef cattle."

Pedersen is also unimpressed by the three-year share price rise. "Fonterra's luck has been that most dairy farmers don't have a direct comparison of what they would make if they were in some other competing land use."

Pedersen is in the position of being able to compare different gross margins through having half his farming enterprise in dairy and the other half in cropping and finishing stock. His comparisons make sorry reading for champions of the dairy industry.

"I can say now, and I've said it for the last 10 years, that as far as return on our capital is concerned, our non-dairy enterprise has outperformed the dairy farm almost every year."

Boosting the value-added bit

Reaching consensus can be a lengthy process, Ferrier concedes. "One does not go out to challenge a fundamental principle of co-operative ownership without preparing a compelling argument."

But it's an argument, he reckons, that needs to be found.

Morgan's main criticism of co-operative ownership of the dairy industry, and of the legislative change that enabled Fonterra's creation, was that the industry would be starved of the capital needed to move away from commodity products and into value-added production.

Dairy farmers receive dividends from their investment in the profitable downstream (value-added) activities bundled in with the milksolids price. But they can increase their revenue in only one way, Morgan argued just before Fonterra's creation, by increasing the milksolids supplied that is, milking more cows.

"And as we all know, they do millions of additional kilos of the stuff are produced as farmers respond to the 'super-charged' price they receive for milk.

"The price of raw milk might not change, but so long as that dividend from downstream rises, so will the output of farms."

That argument has also been recognised. Fonterra's annual report now shows how much of the payout comes from the actual milk return the price Fonterra pays at the farm gate for a bucket of milk and how much comes from Fonterra's "profit," the value margin the co-operative has extracted from further processing, branding, and marketing.

At present, the value-added part of the mix is just 12%. But with all the long-term trends pointing to a steady shrinking of commodity prices, Ferrier says it has to get much bigger.

"If you look at the value-added contribution per kilogram over 10 years, it's been more or less consistent. But the businesses have doubled in size."

How best to make the value-added bit bigger is still a bone of contention.

The one-a-week new consumer products pipeline is one way, and it feeds into the acquisition of new markets such as China.

Acquisitions of consumer dairy products companies are constantly under consideration, Ferrier says. Australia is an obvious target.

"We want to grow there but we have to find value-accretive ways. Recent acquisitions [by other industry players] have been fully valued."

Joint ventures such as the Dairy Products America initiative with Nestlé a source of outside capital that doesn't upset farmers are another part of the mix.

"We and Nestlé recognised that neither of us was that strong in South America," Ferrier says. "We had the manufacturing process and expertise, they had milk powder plants, so one plus one equalled three."

"In Asia we compete head-to head."

Like any three-year-old, Fonterra has the world before it but an awful lot still to learn.

Since Fonterra's formation, the value of its shares, issued at a nominal $3, has risen by an annual average compound rate of 15.8%.

The downstream value-added business is launching a new consumer product on average every week

Comments from our readers

No comments yet