Comment

‘Fonterra’s selective and unrealistic view’

Rod Oram is unconvinced by Fonterra's confidence it can turn around Beingmate and thinks the cooperative needs a change of chairman and culture.

Comment: Fonterra’s strategy in China is a great success, according to John Wilson and Theo Spierings, the co-op’s chairman and chief executive, in their presentation of its interim results on Wednesday.

How come, then, on their watch the co-op has splashed out some $1.5 billion of capital investment in China with only hefty losses to show for it? And how come Spierings, the main architect of the strategy, is quitting as chief executive?

The answer: Fonterra is being highly selective with its evidence, and unrealistic about its prospects in China, which accounts for about one-quarter of its global business.

Yes, as the co-op argues, its sales in China rose 45 percent in volume terms over the past three years; its gross margin, measured in millions of dollars, rose 57 percent; and the enterprise value of its Chinese operations rose by $1bn to $4.7bn.

But the vast bulk of those gains have come from three businesses that require very little capital investment in China: ingredients, consumer and food service. The other two parts of its China strategy – Beingmate in infant formula and China Farms in local milk supply -- have consumed the best part of $1.5bn of capital and are in deep trouble.

Despite these glaring failures, Spierings and Wilson said they remained fully supportive of all elements of the strategy. “You can’t unpick it,” said Spierings. But he is quitting rather than seeing it through.

Wilson said he and the rest of the board fully support the strategy. However, he says they will be open to other ideas a new CEO might bring.

The announcement Spierings was leaving came near the end of the results briefing, and monopolised the rest of the hour-long session. Up until then, the big news was the co-op’s write down of its 18.8 percent stake in Beingmate Baby and Child Food.

Having paid $756m for the stake just three years ago, it first wrote off just $35m of value six months ago, despite a steep plunge in Beingmate’s share price. Now, it has written off a further $408m and taken a $28m hit on its share of Beingmate’s losses.

The residual value of the stake is now $244m. Fonterra based this on the recent share price, plus an estimated premium for what it believes a trade investor like Fonterra might pay for a similar sized stake in Beingmate. That premium was 2.45 yuan per share six months ago; and is now judged to be only 0.52 yuan.

While Beingmate has clearly deteriorated significantly in the past six months, the original premium looks wildly flattering in retrospect. Is the current premium more realistic? Nothing Spierings or Wilson said in the briefing or subsequent interview with Newsroom gave any confidence it is.

They said there was no China Inc. strategy to turn around Beingmate. The work would be done by its three largest shareholders: Xie Hong, its founder, with a stake of 34 percent, Fonterra with 18.8 percent, and He Xiaohua, a long-time business associate of Xie’s who has a 1.9 percent stake in Beingmate through her company JVR International. Spierings refers to them by their English names, Sam and Jennifer.

'New leadership is the trick'

Beingmate has suffered a rapid turnover of CEOs and senior executives in its short life. Contrary to recent media reports that Xie has become CEO of Beingmate Baby and Child Food, Fonterra has confirmed he has resumed instead the role of CEO of Beingmate Group, his private company which has the stake in Beingmate Baby and Child Food. Spierings said all three investors had agreed it was time for a new CEO to transform the latter business, and they were searching for one. “The right leadership is all you need.”

However, Fonterra also said it would “continue utilising [the] existing governance structure” in the troubled company. Given Fonterra has publicly expressed great dissatisfaction with the way that’s worked, that sounds deeply unpromising. With only an 18.8 percent stake, Fonterra’s minimal leverage over the business looks likely to continue.

When Wilson was asked yesterday if there were any parallels with Fonterra’s debacle with Sanlu in 2008, he replied none at all. That incident was all about melamine poisoning, which ultimately caused Fonterra to lose its entire $250m investment in its 42 percent stake.

But Fonterra lost the capital because it invested in a company it didn’t understand and couldn’t exert any influence over. If it had been an effective investor it would never have been involved in such a disaster of a company.

When Spierings was asked yesterday if Fonterra had learnt anything in Beingmate, he replied: “Yes, we have. China evolves very quickly. To have an 18.8 percent stake in a Chinese company with regulations increasing very quickly is not the easiest to say it mildly.”

That was the closest Spierings and Wilson came to admitting they had made a mistake investing in Beingmate, or apologizing to shareholders for doing so.

If there is ultimately no residual value in Beingmate, Fonterra will have wasted more than $1bn of shareholders’ money on Sanlu and Beingmate. No doubt shareholders will want rock solid assurances from Spierings’ and Wilson’s successors that their co-op’s management and board have finally learnt the lesson.

When Fonterra first announced its intention to invest in Beingmate in 2014, it offered a sweeping panorama of seven strategic benefits to the co-op. The deal was a “game changer” in China, Spierings said at the time.

But the only two to eventuate are the companies’ joint ownership of Fonterra’s Darnum powder plant in Australia and some meager sales of Fonterra branded infant formula in China. Spierings still hopes that Fonterra will hit its target of $100m of sales through Beingmate over the first three years, but that’s still only a miniscule sum in terms of Fonterra’s total sales in China.

For analysis of what’s gone massively wrong with Beingmate, Fonterra’s relationship with it, and the towering challenge of turning it around, please read these two previous columns of mine in February and March.

A new CEO will have to clean up

Should Fonterra and its co-investors fail to revive Beingmate, the co-op’s new CEO will have two problems to clean up: writing off most or all of the residual $244m of value of the stake; and finding a new partner on infant formula in China, a market in which Fonterra lags far behind its international competitors.

Wilson said the Beingmate saga greatly pained him and his colleagues. But he said there’s much more to the co-op’s China strategy. Moreover, while the write off was big it was manageable in the context of the co-op’s diverse global business. And anyway, in a business as big as Fonterra inevitably one of its many parts will be struggling at any one time given the nature of the risky and challenging markets it was in.

This view from Wilson sounds as though Fonterra is starting to shuffle Beingmate out of the picture. So, if there’s another write down, it will come after Spierings’ departure and will be billed as just part of his legacy. The upbeat message will be: “Just look how great the rest of China’s doing!”

But its China Farms are clearly not. Over the past three years its milk production has risen from 0.10bn litres in the first half of 2015 to 0.13bn litres in the latest half year. But its gross margin loss worsened from $3m to $8m, and its normalized EBIT loss was $12m in the latest half year. It would have been much higher but for the fact that Fonterra’s downstream ingredients business buys the farms’ milk at a premium to market prices.

Shareholders should be most worried, though, by what Spierings and Wilson are most proud of in China: Fonterra has the “largest share of stomach”, as Spierings terms it, among dairy companies. In other words, it is the largest supplier of dairy products by volume, ahead of China’s major home-grown companies such as Mengniu, Yili and Yashili.

But two great problems arise. First, Fonterra is well behind them in value terms, given the dominance of commodities and ingredients in its Chinese sales mix. The Beingmate debacle has only worsened that. This is the classic volume versus value trap that Fonterra is struggling to escape worldwide.

Second, and far more concerning, Fonterra seems oblivious to the political risk it is running in China. It is inconceivable the Chinese government will allow a foreign company long term tenure as the biggest company in any sector, particularly a major food category; and particularly a foreign company that has screwed up two major investments, and has caused two food scares, in just over a decade.

So, it’s abundantly clear that Fonterra’s board is failing to deliver the rigour and reality the co-op urgently needs. It needs a change of chair and culture, so the co-op can begin to learn how to stop making very expensive mistakes and start to learn how to really shift from volume to value. Pledging to catch up with the powerful profit and share value growth of Synlait and a2 Milk would be a good start.

In all this, the Shareholders Council was designed to be the farmers’ watchdog. But after the co-op’s half-a-billion loss on Beingmate and the Danone settlement, its message yesterday was as supine as ever.

“I encourage Fonterra Farmers to attend next week’s roadshow meetings with an expectation that their Board will provide full, frank and transparent conversation on its learnings to date and most importantly what actions will be undertaken to rectify matters,” Duncan Coull, the council’s chairman, said in a message.

The 13 meetings with directors run Monday to Thursday next week down the length of the country. Should any shareholders feel like sharing their thoughts post-meetings, I’m readily available on 021 444 839 or Rod.Oram@NZ2050.com

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