Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Added value only sensible way to develop

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Dairy industry should study fate of forestry and concentrate less on commodity products

Dairy is in danger of following in the footsteps of forestry, which failed to invest in value-added products. Photo / NZPA
Dairy is in danger of following in the footsteps of forestry, which failed to invest in value-added products. Photo / NZPA

The booming dairy sector is making a big contribution to the country's export surge and the huge upturn in economic confidence.

However, we shouldn't get carried away by this development because the dairy industry and Fonterra have a long, long way to go before they reach their full potential.

The dairy sector should be more focused on added-value products instead of its emphasis on production and commodities, particularly as the latter can experience serious price fluctuations over the medium and longer term.

Our forestry industry, which is now controlled by foreign interests and is heavily reliant on low-value log exports, is an excellent example of what happens when a sector fails to invest in profitable added-value products.

Four decades ago forestry was the country's big hope, just as dairy, Xero and technology are today.

The sharemarket was dominated by a number of large forestry companies, particularly NZ Forest Products, Tasman Pulp & Paper, Carter Holt Harvey and Winstone.

But the industry failed to take advantage of its opportunities and these companies have effectively disappeared with most of their pulp and paper operations now owned by overseas interests.

Our plantation forests are also predominantly overseas owned, many by investment funds.

These investment funds, a number of which are run on behalf of well known North American universities, have no interest in investing in added- value activities in New Zealand.

As a result we have become more reliant on low-value log exports which have risen from 29 per cent of total forestry volume in 1992 to 50 per cent in 2012 and 55 per cent in the 12 months ended September 2013.

The export value figures tell a similar story. Log exports have increased 4.4 times since 1992 and now represent 43 per cent of forestry export value compared with just 23 per cent two decades ago. This is extremely beneficial for Port of Tauranga, which accounts for 40 per cent of the country's total log exports, but has limited value as far as the domestic economy is concerned, particularly compared with the predictions made 30 years ago.

The forestry sector has had little employment growth and relatively low wages.

There have been a number of fatal logging accidents as workers have often been under pressure to fell trees as quickly as possible in order to rush them to Mt Maunganui for shipping to China.

China now takes 67 per cent of our logs compared with just 13 per cent in 1992. Korea accounts for 16 per cent of our log ex ports versus 37 per cent in 1992 and Japan takes only 6 per cent compared with 47 per cent two decades ago.

We are becoming increasingly reliant on China and its demand for forestry and dairy commodity products.

This is great in the short term as China is prepared to pay high prices, but it is not a reliable or sustainable long-term strategy.

Forty years ago New Zealand was seen as the leader in planted radiata pine, with Chile a long way behind but determined to catch up. At one stage Carter Holt Harvey had a substantial shareholding in Chile's largest forest products company.

However, in recent years Chile has shot past us because of a strong strategic focus and the willingness to invest in added-value production.

Chile's share of world forestry trade, in value terms, has gone from just 0.32 per cent in 1970 to 1.04 per cent in 1992 and 1.96 per cent in 2012.

Over the same period New Zealand's world share has gone from 0.56 per cent to 0.96 per cent to 1.40 per cent.

Chile has focused on pulp and paper and has minimal log exports whereas we are becoming increasingly reliant on low-value commodity log exports.

Our dairy industry has also become heavily reliant on commodity products, particularly milk powder. This is positive in the short term - because of Chinese demand - but is not a reliable long-term strategy.

There is considerable confusion over Fonterra's long-term strategy and this confusion has not been cleared up by the stock exchange listing of the Fonterra Shareholders' Fund. The fund is supposed to capture the added-value operations of the dairy co-operative but at Thursday's close it had a market value of only $616 million compared with $609 million for A2 Corporation and $585 million for Synlait Milk.

The fund is totally different to a limited liability company but, nevertheless, it should be worth much more than either A2 Corporation or Synlait Milk.

Last year Synlait Milk delivered total share market returns of 79.1 per cent, A2 Corporation 50.9 per cent while the Fonterra Shareholders' Fund had a negative 13.0 per cent return. The share price performances of Synlait Milk and A2 Corporation have benefited from their excellent and proactive communicators whereas Fonterra is seriously inadequate in this area.

Why is Fonterra such a poor communicator to its non-farmer shareholders?

What are the co-op's long-term strategies and goals?

Do its farmer shareholders want Fonterra to develop its added-value operations or are they only interested in the short-term milk price?

Are farmers willing to contribute more capital for Fonterra to invest in added-value and branded activities and, if not, will they allow outside interests to provide this investment and hold shares in the co-operative?

Where are Fonterra's main focuses in the short, medium and long term?

The problem with Fonterra is that it is more of a production rather than a brand or consumer-oriented organisation. This is the consequence of the Dairy Restructuring Act which gives Fonterra a virtual monopoly over milk supply but essentially requires it to purchase all the milk offered to it by farmers.

With more and more agricultural land being converted to dairy the co-op is under huge pressure to use its limited capital building production facilities rather than investing in branded or value-added products.

This is a dangerous strategy, particularly as farmers are taking on large amounts of debt to convert their farms to dairy and a sharp drop in milk powder prices will have a big impact on the milk price and farmers' incomes.

Fonterra is also taking on more debt as illustrated this week when it raised 1.25 billion Chinese renminbi ($249 million) through a five-year "dim sum" bond issue (Chinese renminbi raised overseas) as part of its ongoing commitment to developing its China business.

Similarities with the forestry sector are obvious.

Three decades ago all the talk was about the increase in forestry production, popularly known as "the wall of wood" at the time. There was huge optimism in the sector and our forestry companies borrowed heavily to buy more and more production facilities in Chile, Canada, United States, United Kingdom and Australia.

When commodity prices declined the forestry sector was devastated because it had too much debt and was far too reliant on commodity products.

The growth prospects of NZ Forest Products (which had been acquired by Carter Holt), Tasman Pulp & Paper (which was included in the Fletcher Challenge merger), Carter Holt Harvey and Winstone disappeared as did the bullish outlook for the local forestry sector.

Fonterra has a bright future but it has to invest more in branded added- value products.

The performance of the co-op's NZX listed Shareholders' Fund indicates that investors don't believe the co-op is making much progress with these branded products.

Disclosure of interests: Brian Gaynor is an executive director of Milford Asset Management which holds A2 Corporation and Synlait Milk shares on behalf of clients.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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