Fonterra – right question, wrong answer

Fonterra’s trials and tribulations have led to a rising crescendo of criticism of the cooperative’s performance since the release of the 2018 annual report. Declining share value and dividend payments, fluctuating milk price, inadequate return on capital, failure to match international and domestic competitors’ financial performance, failed investments, rising debt ratio and overpaid staff are the most notable criticisms.


Recent changes at the top including new chairman and acting CEO have had a positive impact on shareholders’ levels of satisfaction, but the jury will still be out for quite some time before the commitment to reduce debt by $800 million, sell non-core businesses and cut operating expenses can be evaluated. Shareholders appear willing to allow the new team time to show they can meet these commitments, but meanwhile have given notice of their dissatisfaction by electing self-nominated Peter McBride and Leonie Guiney to the board and rejecting all three board nominated candidates.


When Fonterra was established in 2001, there were concerns it was a conflicted political solution to dairy industry and political requirements which would achieve some short term gains without necessarily achieving long term structural and strategic objectives. The Clark government saw the formation of Fonterra as an opportunity to establish a New Zealand business on a global scale in an ironic contrast to David Lange’s view 15 years earlier of agriculture as a sunset industry. The dairy industry saw the merger of NZ Dairy Group, Kiwi Dairies and the Dairy Board as the ideal way of combining the majority of the industry in strong cooperative dairy farmer ownership.


Some of the inherent conflicts are dependence on low-cost milk supply, while paying shareholders as much as possible, the need for corporate style governance within a cooperative structure, and the reluctance to retain profits in a cooperative, particularly for investment in a globally competitive consumer value added business. All these conflicts could be said to defy market logic.


To the outside observer there are large similarities between Fonterra and Auckland Council: both organisations have become too big in the pursuit of targeted efficiencies, high earning staff numbers have grown disproportionately to the identifiable improvements, directors (or councillors) have relatively little influence on the actions of management, and shareholders (or ratepayers) are increasingly dissatisfied.


The most important factor in all large organisations is the relationship and common vision of chair and chief executive. It isn’t immediately clear that this exists in Auckland Council, but in contrast John Monaghan and Miles Hurrell appear to be on the same page with respect to the direction Fonterra needs to take. My impression is this important combination worked well at the beginning with John Roadley and Craig Norgate, followed by Sir Henry van der Heyden and Andrew Ferrier, but appears to have become less functional during the tenures of John Wilson and Theo Spierings. This suggests it is critical for a chairman to choose his own CEO, whereas Spierings was chosen by Wilson’s predecessor.


During Spierings’s time as CEO, the world milk price fluctuated wildly from peaks to troughs, while his V3 strategy to drive more volume into higher value at velocity was unsettling for staff and the volume goal was at odds with concern about the impact of higher dairy production on the environment. In any case it became clear New Zealand had already reached peak cow numbers, which posed the challenge of converting more milk into added value production, as distinct from building spray drying towers.


Where Fonterra has fallen disappointingly short of expectations has been in identifying suitable investments for its scarce capital. While the melamine scandal affected Fonterra’s investment in Sanlu during Ferrier’s spell as CEO, the investment and massive write down in Beingmate happened during Spierings’s term, almost certainly leading indirectly to his resignation. Yet he walked away with an $8.3 million payout, similar to Ferrier’s when he departed in 2011.


The China milk hubs provide a welcome counterpoint to the loss from Beingmate, because, while they may not yet be profitable in their own right, they are critically important to the objective of building market share in China, currently 11% of imports representing 26% of Fonterra’s business. By the time the number of farm hubs has reached the target figure of five compared with two completed and one under construction, this share figure will have more than doubled and Fonterra will have reinforced its strong position in the growing Chinese market.


Another profitable venture has been the shareholding in Soprole, originally acquired by the Dairy Board in 1986, but the success of the investment has been built on the strength of the Soprole brand rather than Fonterra’s family of branded products.


In 2007 then chairman van der Heyden tried to gain shareholder approval for a public listing of Fonterra with 20% outside investment and the balance directly or indirectly farmer owned, a similar structure to Ireland’s Kerry Group. The proposal was withdrawn because of a lack of farmer support. A recent comparison of the respective performances of Fonterra and Kerry provides a salutary reminder this was a massive missed opportunity with Kerry Group’s share market value increasing from $146 million on listing to nearly $30 billion today. Fonterra’s equity has been fairly static and is currently $8 billion.


The inescapable conclusion is that it is the ownership structure, not board composition, inhibiting Fonterra from reaching its true potential.


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