Fonterra not in control of global strategy

After several years of uninterrupted success in building a dominant dairy trading business, Fonterra hit a series of icebergs during 2008. The problems have been well documented – SanLu, abandoned capital restructuring plans, tumbling commodity prices, lower payout forecasts, questions about the online auction system – and the impression is one of loss of control of the long term direction of the business.

Farmers who supply Fonterra depend on their company for their livelihood and, apart from those who gain election to the board or the Shareholders’ Council, have no influence on anything except their own milk supply. The payout is their benchmark for judging how well the company is performing and for the last three seasons the news has all been good, until the last few months at least. Dairy farmer prosperity has been in stark contrast to that of sheep and beef producers, with the inevitable result being a massive change from sheep to dairy, particularly in irrigated parts of the South Island.

Now there are signs of an improvement in sheep farm profitability on the back of a dramatic reduction in sheep and export lamb numbers and a lower exchange rate, which coincides with the sudden fall in dairy prices. There is a real possibility the payout will drop to $5 a kilo or less, at which point highly leveraged dairy farm investments will barely break even. This of course is the nature of commodity markets and, just like the meat industry, the dairy companies will get the blame for a market downturn.

But surely the dairy industry was meant to have found the magic answer to fluctuating commodity prices! Commentators were falling over themselves to praise the co-operative dairy industry, especially Fonterra, contrasting it with the appallingly destructive behaviour of the meat companies. The meat industry needed to become more like dairy – all problems would be solved by forming one big, preferably co-operative, meat company.

At the same time the dairy industry since Fonterra’s formation has been evolving into a more competitive model, taking advantage of the legislative requirement for Fonterra to allocate a proportion of its milk supply to other companies. This enabled smaller, more innovative dairy companies to establish a production base while they built their own supply chain. This has underlined a major flaw in the ‘big is best’ theory of industry restructuring which is to imagine big companies can produce all large breakthroughs in new technology, as opposed to innovative smaller companies.

The collapse of the Whole Milk Powder (WMP) price, graphically illustrated by Fonterra’s monthly on line auction, has emphasised how commodity dependent New Zealand’s dairy exports are. With the highest percentage of dairy exports in WMP, dairy farmers are just as vulnerable to commodity downturns as any other agricultural enterprise, and arguably more so than lamb producers.

Therefore the faster New Zealand grows its high-tech sector capable of turning milk into high value nutraceutical and food ingredient products the better, because logically Fonterra doesn’t have a mortgage on the ideas and technology required. For example Ingredient Solutions, based in Taranaki, is currently seeking $27.5 million in a share offer closing on 23 January which will be used to set up a milk fractionation processing plant capable of using membrane separation technology to produce a range of high value milk ingredients for food companies. Ingredient Solutions will buy milk from local suppliers who are allowed under the Dairy Industry Restructuring Act (2001) to supply 20% of their production to processors other than Fonterra.

This type of development, combined with other competitors like Dairy Trust, Open Country Cheese and Kaimai Cheese, gives dairy farmers options where to send their milk without being locked into supplying one big processor and the resulting obligation to buy shares to match production. It ensures a competitive raw material price, based on each processor’s ability to find profitable markets for their products.

This model is more akin to the meat industry which had to negotiate its way through the minefield of subsidy removal, plant closures, cut-throat livestock supply competition, market volatility and seasonal variations to reach its present position.

It seems unduly optimistic if Fonterra thinks it has all the right strategies for the dairy industry. It must identify clearly how best it can use its strength to return wealth to its shareholders. Given the small size of the domestic market and its dependence on overseas trade, it must assess whether its present strategies, value added production, overseas investments and on line auction system, are appropriate.

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