Comment

Oram: A big loss and a strategy vacuum

Fonterra posted its first ever annual loss and announced a wide-ranging strategic review. Rod Oram looks through the wreckage and finds a disturbing lack of detail or strategy.

Fonterra offered new faces and fresh promises as it reported a net loss of $196 million for the year.

But farmer-shareholders will have to wait some months before they get a clearer steer on strategy from the new top team of John Monaghan, Miles Hurrell and Marc Rivers – respectively chairman, interim chief executive and chief financial officer. Then they’ll have to wait a few years or so to find out if the trio can deliver.

The year had started much better, or so it seemed just six months ago when John Wilson and Theo Spierings, then the chairman and chief executive, presented the interim results. Both have now left, leaving the new team to explain what went wrong and how they will fix it.

They said high milk and fat prices had generated a good milk payout to farmers. But those had squeezed the profits in value-added products, which strained finances, the balance sheet and the ability to pay a full dividend.

Those factors accounted for the 22 percent drop in Fonterra's operating profits. But one-off items such as the $439 million write-down on its investment in Beingmate in China and its payment to Danone of $232 million (a net $160 million after tax benefits) for the damages the French dairy company had suffered during Fonterra’s false botulism scare had delivered the net loss.

“The entire business needs to take responsibility for the loss,” Hurrell said.

The financial data tell the sorry story: the co-op’s total equity fell 12 percent to $6.3 billion, its net debt rose 11 percent to $6.2 billion, its debt rose from 3.5 times earnings to 4.5 times earnings and its return on capital fell from 8.3 percent to 6.3 percent.

The new team promised to forecast better and more transparently, to lift performance, to improve financial discipline, to review all major assets and partnerships for their strategic worth, and to take a “disciplined approach” to paying dividends.

They didn’t criticise their predecessors. If they had, they might have been more forthcoming about their own roles in the co-op’s very disappointing performance over recent years. They each played their part to varying degrees depending on their roles and length of service.

15 minutes to explain $196 million loss

So as corporate mea culpas go, Fonterra’s was very perfunctory indeed, lacking insight or self-evaluation. The new trio spent only 15 minutes explaining the $196 million loss and the remedies for it. Journalists worked hard for the following 45 minutes trying to squeeze a little more information out of them.

For example, the trio initially said nothing about Beingmate other than it was the first subject of their strategic review. They refused to give any operational details on whether the co-op was getting more or less out of the relationship.

So, they were asked why was Fonterra’s Anmum infant formula brand now listed under the co-op’s advanced nutrition business in China and not under Beingmate? After all, selling Anmum through Beingmate was the key strategic imperative for the co-op’s $755 million investment in the Chinese company just two and a half years ago.

Beingmate no longer has exclusive rights to Anmum, was the answer.

When did that happen?

Recently, was the reply.

Another writedown to come?

The answer suggests that Fonterra’s short, troubled and unproductive relationship with Beingmate could get even more costly for the co-op’s shareholders in the form of a further large write-down in their investment.

Likewise, the trio were asked about the performance of Fonterra's investment in a joint venture with Royal A-ware Food Group in the Netherlands. Fonterra borrowed some 130 million euros to build a plant there in 2015 to process waste whey and lactose from A-ware’s cheese-making into potentially high value products.

Was the plant meeting the high product price premiums on which the investment was predicated, and thus achieving a return on capital?

In reply, Rivers, Fonterra’s chief financial officer, expressed satisfaction with the operating performance of the plant, reading out some data as evidence. But he failed to address the far more crucial question of whether the plant is profitable.

Both these examples go right to the heart of a key failure of Fonterra’s governance and management of major strategic investments under John Wilson and Theo Spierings, and to some extent some of their predecessors.

'It'll take time'

Thus, in the results briefing Monaghan, who has been on the board for a decade, was asked what steps he had taken, or was planning, since he took over as chairman seven weeks ago to change board culture and practices. He replied that change “takes time”.

Were there any specific actions so far? “We’ve done away with a number of board working groups.”

Such as?

“We had a Beingmate committee.”

If shareholders were looking for a crumb of comfort in the results, that might be one. Since the board’s Beingmate committee had apparently failed to prevent the disastrous relationship with the Chinese company, or to repair it once it was evidently so, the committee’s demise might be progress of sorts.

$100m for McKinsey...

Another of the unexplained mysteries of Fonterra’s performance involves its operating costs. In 2015, the co-op hired McKinsey, the global management consultants, to advise it on restructuring operations to improve performance and cut costs.

The programme was called Velocity, with a percentage of the cost savings generated being awarded as bonuses to those employees most heavily involved and to McKinsey as performance-based fees.

In its 2017 financial year, Fonterra temporarily changed Spierings’ bonus structure so an unspecified part of his total remuneration came from the pool of Velocity savings. Informed insider speculation suggests McKinsey’s reward could have been as much as $100 million a year.

When asked about this at the results briefing, Monaghan replied that such commercial terms were confidential. Hurrell added that McKinsey was no longer involved but it had instilled, for example, “strong discipline around the delivery of projects”. One example was the “removal of costs in milk collection”.

Short term discipline

Indeed, the Velocity programme did help the co-op cut its operating costs by 13 percent in fiscal years 2016 and 2017. But they rose by 7 percent in the year just ended, suggesting some of the discipline McKinsey expensively dispensed is losing some of its effectiveness.

Above all, though, the co-op has some fundamental strategic failures to fix. The biggest is how a high milk price is so damaging to the profitability and market share of its downstream, value-added businesses globally.

The next biggest is how to make China, which now accounts for a quarter of the co-op’s business, more profitable. In the past financial year, Fonterra increased the milk volume it pushed through its consumer and food service businesses there by 11 percent, but its normalised operating profits from them fell by 20 per cent.

Loss-making farms

Likewise, milk production at its China Farms fell 19 percent because the business is changing the profile of its herds. If Fonterra’s ingredients business had not taken a $30m hit from subsidising the price it paid for the milk, China Farms would have lost 14.6 US cents on every litre of milk it produced.

Given all these issues and many more, Fonterra’s new chairman, CEO and CFO failed in their 15-minute results presentation and 45 minutes of subsequent Q&A to demonstrate that they have an adequate grip yet on the co-op’s weaknesses or solutions to them.

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