White elephant

By Rebecca Macfie

Friday 1st November 2002

You wouldn't have found Dr Mike Matthews swanning around at last year's "Catching the Knowledge Wave" conference. The Tatua Cooperative Dairy Company's chief executive was too busy down at its Morrinsville plant capturing the value of milk through research and development, high-value branded consumer products and nutritional compounds. What's more, Matthews is all too familiar with the decades of hard yakka that go into creating a genuine knowledge company to be tempted to package it into cute clichés for the benefit of a talkfest.

On the other hand, his dairy industry compatriot Fonterra chief executive Craig Norgate talks about the knowledge economy quite a bit. Norgate is a member of the Knowledge Wave Trust and Fonterra was a sponsor of last year's conference. It's a matter of public record that he and the other folk at Fonterra want to "play a leading role in helping New Zealand catch the knowledge wave" by moving the dairy industry off the commodity price cycle and "capturing the value of milk".

But despite the talk of adding value and the glamour attached to dairying during a decade when huge tracts of South Island pastoral land have been stocked with cows, Fonterra remains a commodity-driven business. By Norgate's own reckoning, up to 80% of its business continues to be commodities. So much for capturing the value of milk. As Tony Baldwin, Fonterra sceptic and leader of the former National Government's Producer Board Reform Team puts it in a commentary on the co-op's annual report, Fonterra is largely capturing the value of grass.

Compare that with the unglamorous meat industry, from which many of today's dairy farmers have fled - it has transformed itself in little more than a decade from a commodity business to 90% value-added - and you start to get a feel for just how far Fonterra has to go.

Here's another little irony: the case for Fonterra was sold to the public, the politicians and the dairy farmers on the basis that the sheer size of the megamonopoly would lift dairy farmers' returns and boost the economy. But now Norgate cites the fiery, independent Tatua as a model for Fonterra. Really - it's right there in his speech to Fonterra's annual meeting in September. Providing a skeletal outline of the long-awaited Project Galileo - the strategic planning exercise being done under the tutelage of international consultants McKinsey and Co - Norgate says one of the key themes for Fonterra will be to use the company's knowledge of milk to develop innovative specialty dairy products. "This effort will address the needs of the most sophisticated ingredients consumers in a manner similar to what Tatua has done, with great success."

The story of how Fonterra has so far failed to deliver on its promise and how well the two independent co-ops - Tatua and Westland Milk Products - have fared by contrast this year has been told so many times that even city slickers could probably recite the figures by rote: Tatua paid its farmer suppliers $6.80 per kilogram of milk solids, Westland paid $5.43 and Fonterra paid $5.33 (and the company's grievous financial performance means Fonterra would have paid farmers less if it hadn't used a $50 million top-up from company reserves).

While Westland's payout was respectable enough, Tatua's created an overnight sensation. Predictably and patronisingly, it was written up as the minnow that had outsmarted Big Brother. For Tatua, the limelight has been unwelcome and uncomfortable. It has no interest in upsetting its large neighbour, with whom it enjoys a range of commercial processing and marketing relationships.

But behind the simplistic comparisons lie serious questions about whether Fonterra can ever achieve what Tatua has; about whether big is necessarily better. Even against its own benchmarks Fonterra has fallen short. As part of the convoluted regulatory framework set up to keep the megamonopoly honest, financial analyst Standard and Poors sets a theoretical benchmark for what an efficient commodity milk processor would pay its suppliers. This is called the commodity milk price (CMP). Against this, Fonterra's actual milk price, or AMP (the commodity portion of the payout), is measured. Standard and Poor's CMP for this season was $5.45; Fonterra's AMP was $5.06. That equates to $432 million in wealth suppliers have missed out on.

But let's assume these are just short-term efficiency problems - a merger blip - and look at the signs that big is better. In terms of the promised benefits of economies of scale and removal of duplicated facilities, there are signs things are coming along nicely for Fonterra. The company promised the megamerger would deliver $300 million annual economic benefits by 2004 - that's $200 million from economies of scale and $100 million from adding value to milk. Apparently, Fonterra is ahead of target to reach the $200 million figure.

And let's assume that the raft of global joint ventures - with Nestlé in the Americas, Arla in Europe and Britannia in India - will give Fonterra the sort of global clout needed to exercise genuine market power. But when it comes to adding real, sustainable value to milk in the way that Tatua has and Westland (which has recruited former Tatua Nutritionals chief executive Barry Richardson as its new boss) hopes to achieve, profound obstacles appear to lie in Fonterra's path.

Fonterra is a creature of statute, constrained by a raft of regulations imposed as the quid pro quo of being granted legislative exemption from the Commerce Act when the merger of Kiwi Dairy, NZ Dairy Group and the Dairy Board was put together last year. And one of those regulations is the obligation to take all milk produced by dairy farmers from anywhere in New Zealand, regardless of whether the market wants it. Richard Laverty, marketing manager for NZMP, Fonterra's processing and ingredients division, calls it the "white wave of milk". Last year that wave grew by 6%. He estimates the annual growth increment alone to be around six times the total volume Tatua processes in a year.

Laverty insists that virtually everything Tatua does in the area of high-value nutritional compounds and branded consumer dairy products is also being done by Fonterra - it's just that their impact on total profitability is diluted by the huge volumes of milk Fonterra has to deal with.

Dairy farmer Mark Masters, formerly spokesman for the anti-megamerger group Farmers for a Better Dairy Deal, believes the "colossal" gap between the Fonterra and Tatua payouts is the result of years of producer board control and open-ended entry to the industry. "I and others have been saying for years that unless the dairy industry addressed the issue of supply it would be the victim of its own success and it would condemn its shareholders to mediocre incomes. That's exactly what's happened ... That $1.47 gap between Tatua's payout and Fonterra's represents a tremendous loss of economic opportunity for New Zealand ... The investment capital that has gone into bigger and grander plants to process more and more milk should have been invested in research and development."

Masters points out that Fonterra's legacy companies, NZ Dairy Group and Kiwi, weren't required by statute to take all the milk that farmers chose to supply, but that was the effective result of the Dairy Board's single-desk status. In an industry wedded to single-desk control, it would have been untenable to have refused access to a new supplier because there was no other way for that farmer to sell their milk in a regulated market. To have refused new entrants would have been the quickest way for proponents of the single desk to have cut their own ideological throats.

Tatua, by contrast, decided long ago to seize control over the flow of milk by refusing to take new suppliers unless that would result in demonstrable benefits for the shareholders. Its supplier base has remained roughly stable for the past 10 years, although incumbent suppliers have increased their milk production to the tune of 22% in the past five years. All its 132 suppliers are concentrated in close proximity to its Morrinsville plant.

Tatua also did what Masters says the rest of the industry should have done - poured money into research and development rather than bigger and better milk powder plants. A potted history of Tatua is instructive. Neil Dewdney, chief executive of Tatua for some 20 years until the mid-1990s, says the company predicted in the mid-1970s that the industry would coalesce into one or two large dairy co-ops. While small co-ops all around Tatua were frantically merging in order to find economies of scale, Dewdney and his board decided to remain independent and rejected all merger overtures.

"We could see that you either have to be the biggest or the smallest, and if you are going to be the smallest you have to be the smartest. So we decided in the mid-1970s that if we wanted to stay around we needed to change direction and do high-value dairy products."

By the late 1970s Tatua had its first major added-value run on the board - the iconic aerosol cream-in-a-can product that was developed on a shoestring and is still going strong today. Dewdney says the product was hugely successful and was the platform for further successes. Next up was the development of bag-in-a-box products (similar to the then revolutionary wine cask) for products like cheese sauces and soft-serve ice cream.

In the meantime, Tatua became known for its technical capability, and the Dairy Board would regularly come to it for small trial runs of experimental products. The culture of science and value-added success became an embedded part of Tatua's personality. By the early 1990s the company had decided the next frontier was to start carving milk up into its constituent parts and selling them as high-value bioactive compounds to the nutritional and pharmaceutical industries. One of these, lactoferrin - a milk protein with iron binding properties - is used in geriatric goods and infant formula, and sells for around $US300-$US400 a kilogram.

One of the implications of Tatua committing itself to this path was that it had to create new manufacturing capacity well in excess of its actual milk supply. Although it sounds almost counterintuitive - after all, most companies want to match capacity pretty closely to supply to ensure efficient use of capital - Dewdney says Tatua needed to be able to carry on developing new lines and deliver small runs of specialist products at all times of the year. If a customer in Japan wanted a small run of lactoferrin smack in the middle of the peak milk season, Tatua had to be able to deliver.

That climate of heavy investment continued through the 1990s. "We've spent $50 million over the last seven years, and that's probably about twice the rate Fonterra invests per litre of milk," says Matthews. He says it's all about creating an "enabling" environment, where the right resources, plant and people are in place to seize opportunities. "We could handle a couple of thousand litres more at peak season than we actually do. That's hugely important. If you have a set of assets that are flexible, adaptable and can make a range of different products, it means you can just as easily be handling a complex requirement from Japan in October [the peak of the milk season] as in June."

The strategy works. Tatua made $1.61 in revenue for every $1 of assets last year. Fonterra made $1.17. Revenue per employee was $760,000 at Tatua and $700,000 at Fonterra (see "Small is efficient").

Fonterra, like its legacy companies, is always likely to be constrained by the four- to five-month peak milk season - a nervy, intense period where all hands are required on deck to simply process that white wave of milk. As one observer put it, the staff in the large milk plants become consumed by the sheer adrenaline rush that goes into having to process vast volumes of milk every day. Milk is unique in that respect - it's not like fish that can be left in the sea or lambs that can be left in the paddock if there is a production bottleneck.

The manufacturing bosses at the big plants are said to be notoriously unhelpful to boffins from the research and development department who want to do a small test run in one of the big plants during the peak season. "Providing the kind of environment where you can isolate them from these sorts of pressures is hugely important," says one observer. "There are a whole lot of structural and attitudinal issues in Fonterra that they are going to have to look at very seriously."

Fonterra's detractors and supporters alike say it is exceptionally good at this massive peak season processing task although, ironically, Tatua still processes more milk solids annually per employee than its rival - by 64,000kg versus 55,000kg in the past year (see table). But Fonterra's production-driven culture creates an entirely different internal ethos and focus to Tatua. As one industry insider put it, comparing Tatua and Fonterra is like going to an athletics meet and wondering why the shot-putter can't run as fast as the sprinter.

So, are there fatal flaws in the Fonterra model? Is our largest company forever consigned to be a commodity producer? Is "value-added" for Fonterra going to continue to mean adding calcium to milk powder for the Asian markets? Fonterra says not. Laverty says Fonterra is already a vibrant player in the nutritional compounds market, to the tune of around $US20 million a year. "But it only uses a little bit of the wall of milk ... All the elements that are generating Tatua's higher milk price you will find in the Fonterra portfolio and I think you will find they are of equal scale, if not bigger. But then that is diluted down because of the huge tail of the commodity business."

Laverty also points out that the total world market for bioactive milk extracts like lactoferrin is extremely small, so it's not just a case of tipping more and more production into those niches. He says while the nutritionals market is an important area for development, Fonterra is also working on adding value by forming relationships with international clients to develop tailored products and services.

And he says Fonterra acknowledges the need to ring-fence and incubate its specialist product development areas. Fonterra Enterprises looks after long-term research and development projects, and a new Health and Nutrition Unit has been created to push forward projects based around extracting valuable milk compounds with potential in areas like bone health and immunology. Alexander Toldte, managing director of Fonterra Enterprises, rejects the suggestion that Fonterra's scale is an obstacle to expanding the value-added end of the business. "Scale actually helps, because it gives you presence in markets and it allows you to have a much bigger research and development spend ... If you have the obligation to take every last litre of milk, you also have to sell a lot of basic commodities. But selling commodities doesn't get in the way."

Toldte and Laverty both argue that pulling the legacy companies into one giant co-op will help harness the manufacturing resources of the industry so that they can be used in a more effective way to promote value-added returns. Previously, as Laverty - a former Dairy Board staffer - points out, every time the board wanted to have a new product manufactured there was the vexed issue of which co-op to offer it to. "You couldn't just give a specialised product to one of them because the other would complain and there'd be a big fight ... the good thing about the merger is we now have control of the manufacturing environment."

Okay, so Fonterra now has a streamlined manufacturing infrastructure. It has skills and potential in the high-value-added area of nutritional and pharmaceutical supplements. It boasts a raft of branded consumer products sold on the world market under names such as Anchor, Fernleaf and Chesdale. And, yes, it spends $100 million a year on research and development - more than any other private sector organisation in New Zealand - and it has a pipeline of biotech and genetic research aimed at discovering and exploiting the health benefits of milk's many constituent properties.

Yet the ratio of commodity product to value-added remains stubbornly fixed at around the 80:20 mark. And thus far, despite the talk of capturing more of the value of milk, Fonterra has yet to give either its 13,000 shareholders or an anxious public a clear set of targets for improving that ratio. Manawatu dairy farmer Malcolm Bailey, a member of Fonterra's Shareholders Council, says the industry has been stuck on that 80:20 ratio for at least a decade. He believes further significant changes to Fonterra's structure are essential if serious long-term improvements are to be made.

"The way Fonterra is structured at the moment, its ability to grow into value-added businesses is fairly limited in the sense that we are still expecting milk flows to increase - perhaps at 2-4% a year. And Fonterra has to just keep taking that milk."

The crunch issue is capital. Developing new products and finding new markets for value-added products is expensive, but under Fonterra's current structure, its farmer shareholders are the only potential source of new capital. Farmers already have to pay the equivalent of $4.85 a share for every kilogram of new milk production - that's around $30,000 in new share capital each year for a farmer like Bailey. So the prospect of raising yet more equity from the existing shareholder base to fund a much higher research and development and product development spend seems faint - particularly when they are staring down the barrel of a sharply reduced $3.70 payout in the coming season.

Ironically, the original merger strategy document put together by the dairy industry and its adviser McKinsey and Co back in 1999 recognised this very problem. It predicted the industry would need to source $4 billion in equity capital to fund value-added activities, and envisaged splitting this part of the business off from the core farmer-owned cooperative to allow this to happen. But in the three-year political bunfight that preceded the creation of Fonterra, this message was lost, and all the assets of the three legacy organisations - ranging from milk powder plants to websites and offshore subsidiaries - were collapsed into the one amorphous farmer-owned cooperative.

Bailey says now Fonterra is up and running, it's critical the next phase of structural change is ushered in. In simple terms, he believes it's appropriate for the core functions of milk collection and immediate processing to be held in a farmer-owned cooperative structure, but that the value-added activities need to be broken out into a structure that allows for outside equity to come in. However, Bailey, a former Federated Farmers president, understands the dairy industry's historical commitment to farmer ownership and control well enough to realise that such a proposal would face huge resistance. "The implication is you would be corporatising Fonterra and we wouldn't have control over it ... But at the moment, lumping all the assets into one fair value share owned by the farmers is a pretty blunt instrument."

How much support there is within Fonterra for Bailey's view is hard to know. Norgate's outline of Project Galileo gives little hint of board and management thinking in this area, and he was too busy to talk to us for this article. However, he did tell the International Dairy Federation symposium in Paris in September that the cooperative would "continue to grapple" with its capital structure over the next few years. It was questioning whether to establish an "alternative channel" for shareholders wanting to increase their exposure to Fonterra's international consumer brands business, New Zealand Milk.

No doubt while Fonterra and its stakeholders argue it out, Tatua will just keep on capturing the value of milk. And, just maybe, a few other canny operators will see the potential for replicating Tatua's nimble and far-sighted strategy and will set up greenfields operations in competition to Fonterra. After all, it's a deregulated market out there.

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