Fonterra: a lesson in how to sell your future
Fonterra executives should take heed of the collapse of the largest US seller of milk, because the co-op is heading down the same track, says Rod Oram
In some disconcerting ways Fonterra looks like Dean Foods, the largest US seller of liquid milk which recently went bust after almost 100 years in business.
The co-op and the corporate share a number of strategic, cultural and operational weaknesses. For Dean, those took some 15 years to cause its demise. So far, Fonterra is only half way through a similar cycle but thankfully it has some strengths that could help it break free and save itself.
Here are the top factors that killed off Dean; and how they are playing out in Fonterra:
1. Reliance on a commodity:
Dean pioneered the processing and selling of liquid milk to US consumers. From one small plant in Illinois in 1925, it grew to 60 mega-plants across the country. As its scale grew, so did its efficiency. As the power of its brands and distribution developed, so did its ability to earn a small premium for its products. But they were still commodities. Any increase in the cost of raw milk still makes a disproportionately big hit on its profits. This year’s rise in raw milk price, undermining its cost savings, helped tip it into bankruptcy.
Fonterra is only 18 years old but its precursor co-ops and the Dairy Board that organised their output and marketed their products dated back many decades. Together they pioneered the manufacture and selling of dried milk to consumers abroad. They too became highly efficient yet capable of earning small premiums, yet they were equally vulnerable to commodity cycles.
Fonterra has shifted a good proportion of its milk into slightly more tailored and slightly higher value ingredient powders, but only a much smaller volume into higher value food service and consumer products. So its financial performance and its rewards to farmers are still fundamentally driven by commodity booms and busts.
2. Weak on innovation:
Dean was so focused on selling liquid milk it never innovated widely and effectively in the broader dairy sector.
Fonterra has some 400 scientists who over the years have come up with more than 300 potential products. But they commercialised only a few because the co-op lacked focus. It tried to provide all products to all consumers, it admitted at its year-end results presentation in September.
3. Loss of market, brand and premium:
Dean failed to respond effectively over the past couple of decades to the big shift in the US grocery market to retailers’ own-label products. That failure is compounded now by more major retailers setting up their own processing plants. Walmart, for example, accounted for 15 percent of Dean’s total revenues until the retailer opened its own milk plant in Indiana in 2018.
This dynamic has had deep repercussions back to dairy farmers. Dean buys 20 percent of the milk collected by Dairy Farmers of America, a co-op which is the world’s largest dairy processor. Its output last year was some 15 percent higher than Fonterra’s, the world’s second largest. DFA is negotiating to buy Dean’s plants, which begs two questions: Who does DFA hope to sell the milk to? And are its farmer-shareholders doubling down on a declining commodity model?
In Fonterra’s case, competition has come in a different form. Over the past 15 years or so it has faced much more competition in international markets from major new exporters. Most notable are US, Irish and some continental European farmers and milk processors. Fonterra’s global market share has declined.
Fonterra has also had a large customer turn into a competitor. After the co-op’s false alarm about botulism in whey protein, a key ingredient in infant formula, Danone, the French dairy giant, bought processing, blending and packaging plants here and expanded them.
4. Market growth masks strategic weakness:
In the US, the volume of milk drunk per capita declined some 40 percent over the past 50 years. Over the same time, the US population rose 60 percent to 327 million. Dean rode the market growth and ignored the product decline.
For the NZ dairy sector in general and Fonterra in particular, China has been the co-op's answer to almost everything over the past decade. Chinese consumers’ appetite for dairy products has driven astonishing growth in the market, and thus supply from New Zealand and other countries. Some 25 percent of China’s foreign milk supply comes from New Zealand, as do 50 percent of its cheese imports and 90 per cent of its butter imports.
Fonterra’s farmer-shareholders have invested heavily in expanding their own production and in funding investment in Fonterra’s plants here and operations overseas. But China became a blackhole consuming $1billion of the farmer-shareholders’ capital in ill-conceived and executed ventures such as Beingmate, the Chinese infant formula company, and Fonterra’ Chinese farms. More write-offs on those assets may be necessary.
5. Selling the future:
In the early 2000s, Dean was a US pioneer in soy and organic milks through its subsidiary WhiteWave. But it considered them niche products. When it needed cash to support its mainstream milk it floated a 20 percent stake in the company for US$320 million.
A few months later, it also sold its Morningstar dairy business to Saputo, a Canadian dairy company, for US$1.45b. That unit made cultured dairy products, ice cream mixes, coffee creamers and aerosol whipped toppings. They were all growing segments of the dairy market. But Dean considered them distractions from its core liquid milk operations. Moreover, it needed the funds to support that traditional but declining business and to pay down debt.
Given its freedom, WhiteWave expanded very rapidly in plant-based milks and in organic foods. Just five years later, Danone paid US$12.5b for WhiteWave. The acquisition gave it a fully developed organic food supply chain while major food competitors were still trying to build their own to catch the rapid market shift; and it doubled the US’s share of Danone’s global revenues to 22 percent.
Over the past 15 years, Fonterra has tried organic milk supply, largely abandoned it, and is now belatedly trying to rebuild it. Far worse, it was so sure of its own products it was long dismissive of and hostile to A2 milk (the technology). Yet, since its inception 19 years ago, a2 Milk (the company) has grown to a vastly profitable marketer of the milk, generating a market cap of $10.4b. Belatedly, Fonterra has had to swallow its pride and become a licensed producer, distributor, seller and marketer of a2 Milk.
Fonterra seems to have no strategy to meet the fast growing desire of some consumers for alternative, and often premium, milks. In its skeletal presentation of its new strategy with its results in September, it had one line on one slide: “Supplement with non-dairy where makes sense.”
When asked to elucidate the point, Miles Hurrell, Fonterra’s chief executive, said the co-op already had some experience in adding plant ingredients into some of its products. On later prompting, the co-op’s PR department offered one example: “Fat filled milk powder is the best example – using vegetable oil in skim milk powder produces an affordable nutritious product for developing markets at a price point consumers can afford.” Hardly a premium product for discerning consumers.
Worse, Fonterra has sold its future in a far more fundamental way. Its write-down over the last two years totalling more than $1b on assets in China, Australia, New Zealand and South America has left it critically capital constrained. Unless it has a major restructuring of its capital to bring in outside investors, it remains entirely dependent on its farmer-shareholders.
But in many parts of the country, those farmer-shareholders are enjoying increased competition for their milk from other processors. The Chinese ones in particular can afford to pay more than Fonterra because their value chains run right through to Chinese consumers.
If Fonterra fails over the next few years to significantly improve its performance and thus its rewards to its farmer-shareholders, it will lose more shareholders and suppliers to its domestic competitors. Moreover, those who switch will be able to take their capital out of the co-op. Even small decreases in milk supply in some parts of the country would adversely affect its efficiency and its ability to invest in a more profitable and sustainable future.
6. Poor strategic foresight:
Dean and Fonterra have suffered from their inability to devise insightful strategies, and to execute them well. Now Fonterra is promising its new strategy will put it on the road to recovery and to value generation for its farmer-shareholders and wider stakeholders. It presented the strategy at its year-end results briefing in September. This document is the 48-slide deck accompanying the briefing. But only nine slides cover strategy, 9-11 and 17-22. Of those, three get to the heart of the strategy. The first covers the overview, the second "opportunities and growing risks", and the third "strengths and our realities.”
But these few slides consist only of broad statements, accompanied by some very thin and generic comments from John Monaghan, chairman, Miles Hurrell, chief executive, and Marc Rivers, chief financial officer. Chris Greenough, Fonterra’s Director of Portfolio Management, who was apparently central to the strategy development, was not present. An earlier media briefing shed little additional light.
My subsequent requests for interviews with Hurrell, Rivers and Greenough to learn more about the strategy have yet to bear fruit. The message back was that the briefings had adequately covered it. They didn’t. They gave no indication of Fonterra’s understanding of the world or its opportunities and risks in it such as accelerating climate and environmental pressures, changing human diets, the rise of new foods and the increasing sophistication of competitors.
Worse, there are no apparent links between those slides and this one below on Fonterra’s goals for its five-year financial performance. Fonterra is expecting flat volume and barely rising sales, so this is a discouraging slide. Gross margins remain flat while earnings before interest and tax rise modestly, both a sign of lack of innovation. The impressive uplift in net profits and return on capital hinges largely on paying down some of Fonterra’s high debt, Rivers said in the results/strategy briefing.
Thus, it seems Fonterra will be so pre-occupied cutting costs, reducing capital expenditure and paying down debt that it won’t be investing in its future. Nor, apparently, is it prepared to invest much in new products. Instead it will rely on bringing its existing intellectual property into “partnerships” to do so. Well, good luck finding amenable partners willing to give Fonterra a handsome return on that minimal investment.
At best Fonterra has five years to understand and articulate its view of the world, devise a strategy to thrive from it, create an innovative culture and capital and ownership structure to support it, begin executing all the elements and start showing a step-change in its performance. If it doesn’t it will continue to follow the road to its demise, a road that looks like Dean’s.
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