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Rod Oram: Should Fonterra be broken up?

Rod Oram asks whether Fonterra should be broken up and why it needs a new chairman and strategy

Should Fonterra be broken up into two businesses – one processing commodities and the other making value-added products?

The discussion has started within Fonterra and among some of its shareholders. It is on the mind of the Government too.

In the recent Cabinet paper launching the dairy industry review, the fourth of five main focus areas for the review was “Fonterra’s co-operative structure and its impact on Fonterra’s ability to raise capital to invest in innovation and value creation.”

It’s an urgent question. As a co-op, it can only raise more equity capital when farmers want it to process more milk. But gone are the days when booming dairy production allowed Fonterra to raise lots more capital to make itself more sophisticated.

New Zealand’s total milk volume will at best rise very slowly because dairy farming has hit its environmental limits. Only less pollution and/or more productivity will allow growth; and Fonterra’s share of the milk available is falling because of increasing competition from other processors.

Worse, Fonterra has made life harder for itself in two ways. First, it has failed to develop its value-add business as an adequate counter-balance to vicious cycles in commodity prices. When the milk payout is high, the higher raw material cost of milk in value-add products hits their profits and thus dividends to shareholders.

With its latest forecasts, Fonterra once again showed how hamstrung it is. It raised its estimate for this season’s payout and forecast $7 per kg of milk solids for next season, which would be one of the highest yet in Fonterra’s 17-year history to date. But it almost halved the dividend forecast it made only two months ago at its interim results.

Second, it has squandered about $1.5 billion of its scarce capital on three major investments in China over the past 13 years. These were meant to significantly advance its value-add businesses in a fast-growing market that now accounts for a quarter of the co-op’s business.

It lost its $200m investment in Sanlu when the Chinese company was bankrupted by its melamine poisoning scandal; it has written off $506m of its $750m stake in Beingmate Baby & Child Food, and the real value of the remaining $244m is highly uncertain; and its heavy investment in China Farms has accumulated large losses and has yet to prove its worth.

Through all this, Fonterra has remained as dominated by commodities as ever. It is the second largest milk processor in the world after Dairy Farmers of America. But it ranks 18th out of the top 20 processors for revenue per kg of milk, according to IFCN, a leading global dairy analyst. Fonterra’s revenue was only 60c US per kg of milk in 2016, 40 percent below the average for the top 20, and only one-quarter of the revenue per kg of Danone, the world leader.

No wonder some farmers are asking themselves whether they’d be better off owning shares in a pure commodity play or selling their milk to a processor such as Open Country which doesn’t require them to invest in it. Conversely, other farmers are keen to invest in a processor such as Synlait Milk. It is moving faster away from commodities than Fonterra or Tatua, which is the most advanced local dairy company in value-add products. All three have a better return on capital than Fonterra.

A rationale reversal

A break up of Fonterra would reverse the rationale that underpinned its creation in 2001. An integrated co-op processing most of New Zealand’s milk was the best way for the country to be big in commodities while also growing fast in value-added products, industry leaders convinced the government of the day.

Clearly that hasn’t worked. Responsibility for the failure of strategy and execution rests with many people in Fonterra, particularly its first two CEOs and chairmen. But the departure of Theo Spierings, its third CEO, later this year leaves one man standing - John Wilson , a director since 2003 and, since 2012, its third chairman.

To finally fulfil its potential Fonterra urgently needs a new strategy. For that it needs a new chair, a diversified and revitalised board, a new CEO, a new auditor and a Shareholders’ Council that retrains itself from lapdog to watchdog.

In his 15 years on the board he has been involved in every decision about strategy and execution the board has made. Through those, though, he has shown too little of the talent and track record required to lead a massive shift in the co-op’s strategy and culture, which may or may not eventuate in a breakup. If he hangs on long enough to lead the choosing of the co-op’s fourth CEO he would only prolong his compromised legacy.

The calls for his resignation are rising. The latest is from Harry Bayliss , a founding director of Fonterra, a Taranaki farmer, and the most senior industry leader yet to call on Wilson to quit.

“I think the fundamental issue is the board leadership. I would like to think if there is a change of leadership there will be a significant change in the way the board operates and within 12 months the company will significantly lift its profile among shareholders and the wider business community.”

Bayliss went on to say in the interview with NBR: “I would like to think he is man enough to accept his role and accountability for the performance of the company.”

Repeated mistakes in China

Analysis of Fonterra’s performance since it was created in 2001 shows it remains good at commodities, but poor at generating greater value from its milk. Its greatest weakness – at board and management levels - is in allocating capital to value-add investments then monitoring their performance against their promised outcomes.

By far its greatest and most expensive disasters to date have been in China, a subject I explored on Tuesday in a lecture to the North Asia Centre of Asia-Pacific Excellence at the University of Auckland. A PDF of my presentation is available on the Centre’s website; and a video of it will follow soon.

In essence, Fonterra failed in Sanlu because:

- Sanlu’s ownership structure was highly complex and conflicted - its management structure was opaque, it was dependent on myriad small suppliers of milk, and its operating systems and culture were highly deficient; and

- Fonterra had three appointees to Sanlu’s board but only one spoke Mandarin, it had extremely limited knowledge of Sanlu’s operations, it seconded only one or two technicians at a time to Sanlu to work on quality control and none spoke Mandarin; and

- Fonterra exerted very limited, if any, influence on Sanlu.

As a result, Fonterra was totally blind-sided: Chairman Henry van der Heyden and CEO Andrew Ferrier were clearly astounded by the revelations as the scandal unfolded.

Fonterra should have learnt those lessons, at the cost of its lost $200m investment. But it has made them all over again in spades at Beingmate:

- Fonterra felt under great pressure to make a big strategic investment in China to rectify its own failures in the market, and to assuage what it believed were the desires of the Chinese government;

- Beingmate took advantage of Fonterra’s weak position to drive a hard bargain;

- Beingmate has utterly failed to deliver on the prospects promised, through a combination of its own internal failures and turbulent market conditions; and

- Fonterra has doggedly stuck with Beingmate, arguing it is an integral part of its China strategy and it will eventually come right.

“Beingmate was outside our capability. We’ve denied for three years that there was an issue; the only issues were 'external and short-term' ones rather than anything to do with Beingmate,” says a former Fonterra senior executive who was there when the deal was done.

For more analysis of this please see two of my previous columns on the company in February and in March.

Fonterra seems just as surprised by its failure with Beingmate as it was by Sanlu. Yet, Beingmate was already showing weaknesses when Fonterra started taking an interest in it. These became more obvious in the months between signing its memorandum of understanding with Beingmate in August 2014 and buying its stake in the company in March 2015. Its business model and performance suffered a huge setback because of its inability to respond to the fast growth of e-commerce in the Chinese infant formula market.

Yet, in that very same period all the warning signs were there. For example, the Shanghai office of McKinsey, the global management consultant which was the architect of the strategy that led to the creation of Fonterra and remains to this day one of the co-op’s key strategic advisers, was giving for free public dissemination advice to foreign companies investing in China.

Its October 2014 Pocket Guide to doing business in China gave chapter and verse on the rapid rise of e-commerce, on best practice investing in Chinese companies and on how to protect your reputation. Fonterra seemed to ignore all that advice too.

So far, the cost of the Beingmate debacle to Fonterra is an estimated $702m. There is the $506m of write down of the investment, plus approximately $120m in debt costs, plus $28m in its share of Beingmate’s losses, plus an estimate $48m in dividends Fonterra expected but Beingmate has not paid because it is loss-making.

The residual value of the stake is now $244m. Fonterra and its auditor PwC based this on the Beingmate share price when they prepared the co-op’s interim results earlier this year, plus an estimated premium for what PwC believes a trade investor like Fonterra might pay for a similar sized stake in Beingmate.

That premium was 2.45 yuan per share at the time of the first small write-down in the stake for the FY 2017 results last September, but with the big write-down in the latest interim results in March it was 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 and the current one looks unrealistic given Beingmate’s continuing losses and travails.

A governance failure

All of the above is evidence that Fonterra’s governance is deficient in talent, culture and practices in such areas as:

- lack of diversity and independence of views among directors;

- insufficient investment rigour before and after committing capital;

- insufficient performance monitoring;

- insufficient development of senior executives and CEO candidates;

- retention of a long-standing auditor (PwC’s tenure is 14 years to date, and Bruce Hassall, PwC’s chief executive until September 2016, is now a Fonterra director and chairs its audit and risk committee while, in contrast, mandatory rotation of auditors is the law in the EU and some other jurisdictions);

- its chief executive is not a director; and

- its chairman is in effect an executive chairman.

To finally fulfil its potential Fonterra urgently needs a new strategy. For that it needs a new chair, a diversified and revitalised board, a new CEO, a new auditor and a Shareholders’ Council that retrains itself from lapdog to watchdog.

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