Fran O’Sullivan: The Chinese market is too valuable for Fonterra to write off

Major manufacturers like Yili and Mengniu now outrank Fonterra on turnover. Photo / NZME

OPINION

China’s dairy industry is on a tear. Despite current difficulties with oversupply, which have resulted in some 60 per cent of China’s smaller dairy farms operating at a deficit and smaller operators slaughtering cattle to reduce losses, major manufacturers like Yili and Mengniu — which now outrank Fonterra on turnover — have recovered their “Chinese feet” and are once again going hard for domestic dominance.

That reality, combined with the tentative and faltering recovery of the Chinese consumer market — which has again resulted in an oversupply of inventory in China — has depressed prices and given Fonterra’s senior executive and directors one heck of a headache as the dairy co-operative focuses on the long game and tries to stare past a current cashflow squeeze.

You wouldn’t pick it if you wandered the streets of Shanghai and saw many middle-class people drinking “dirty cheese coffees” and the like.

Fonterra still plays very well indeed in the competitive Chinese foodservice business.

But it is at the coalface, selling massive amounts of whole milk powder, where our largest company still makes a great deal of its coin, that the pain is being felt as demand for New Zealand imported powder drops.

Already, farmers have been slammed by Fonterra’s prediction that the farm milk price will be between $6 and $7.50 per kilogram of milk solids — down from an earlier forecast of between $6.25 and $7.75. Synlait has also followed suit.

The upshot is that Dairy NZ is forecasting that some $5 billion-plus of revenue will not come into the New Zealand economy. Clearly this will impact on farmers’ pockets. But they have been there before and are already trimming costs.

The wider question is how much of a shock this will be to the New Zealand economy, and to the heroic tax revenue assumptions that our electioneering politicians are making.

Yesterday, Fonterra CEO Miles Hurrell announced plans to take out $1b of costs over the seven years to 2030. As Hurrell puts it, Fonterra will be sharing the cost with its farmer shareholders. Much of the cost reduction through efficiencies and reducing staff numbers will be frontloaded over the next three years.

That can only take the company so far.

The question is at what point Fonterra’s Chinese customers will use up their milk powder stockpiles and go hard into the market again, paying higher prices for New Zealand product.

Hurrell takes some confidence from the fact that the remaining tariffs on New Zealand dairy products are being removed from January 2024 as part of the NZ-China Free Trade Agreement.

This will give New Zealand dairy exporters a competitive advantage.

Here’s another potential plus.

Reports out of China suggest its raw milk producers are facing a new cost crisis as feed prices start to rise again after the recent milk surplus began to abate, thanks to herds shrinking and dairies stockpiling before the Mid-Autumn Festival at the end of this month. This suggests there will come a point when it is economic for Chinese manufacturers to pay a decent price for New Zealand milk powder again as domestic supplies become more costly.

But there is no turning away from the reality that China’s major players are seeking domestic dominance.

According to Rabobank’s 2023 Global Dairy Top 20 Report, Yili once again retained its spot as the only Asian dairy producer among the top five, securing its top leadership position in the region’s dairy industry for 10 consecutive years.

France’s Lactalis tops the ranking with $US28.6b in dairy turnover in 2022. Interestingly, Dairy Farmers of America has jumped to second place, pushing Nestle down into third. Yili, which is China’s biggest dairy company, retains its No 5 placing with US$18.3b turnover and Mengniu came in eighth with US$14.4b, pushing ahead of Fonterra at ninth with US$14.2b.

Some of this is driven by foreign exchange considerations — but there is no getting away from the fact that confidence has been restored to the Chinese dairy industry some 15 years on from the melamine disaster which resulted in Chinese consumers losing trust in local milk.

This return to confidence was underlined by recent results from the two companies.

The giant Yili Industrial Group Co generated revenue of nearly 66.2 billion yuan (NZ$15.32b)in the first half of 2023, up 4.31 per cent year-on-year, the company said in its half-year financial report. The net profit reached 6.31b yuan, a year-on-year increase of 2.85 per cent.

China’s second dairy giant, Inner Mongolia Mengniu Co, reported an operating profit of 3.27b yuan in the first half of 2023, up 29.9 per cent year-on-year, the company said in its half-year financial report.

It is important that Fonterra does focus on the long game.

The co-op’s board, led by chairman Peter McBride, has recently returned from a visit to China. McBride leads a team of elected directors including Brent Goldsack, Leonie Guiney, Andy Macfarlane, John Nicholls, Cathy Quinn and Alison Watters. They are joined by four appointed directors: Clinton Dines, Bruce Hassall, Holly Kramer and Scott St John.

The Fonterra executive has also been in China, after a long period prompted by the Covid-19 pandemic, which resulted in just McBride and Hurrell visiting their operations in China before the country opened up again this year.

What the directors would have found when they arrived in Hohhot, Inner Mongolia — home to Yili and Mengniu — is that these major players are using intelligent manufacturing, smart pastures and zero-carbon factories to further tap Chinese consumers with green products.

It's important that Fonterra does focus on the long game.

Mengniu has set up China’s first zero-carbon factory in Yunnan province and in May established the world’s first fully intelligent dairy factory in the Ningxia Hui autonomous region in Northwest China.

Compared to traditional companies that require some 3000 employees, this factory needs only 100 workers. These are enormous efficiencies.

Yili has also built 15 innovation centres across the world, which will conduct research on cutting-edge global health issues. This is where the battle lines are being formed.

But where Fonterra can play is in growing its customer relationships with these large players.

It would be trite to write China off as Fonterra’s most significant play at this stage.

Again, focusing on the long run, projections suggest the Chinese middle class will double from 400 million to 800 million people over time. Within that, there will be plenty of consumers for Fonterra to tap.

The co-op is now looking to expand into some of China’s second-tier cities to meet projected future demand for New Zealand product.

The management and directors are sure to find themselves confronting searching questions from farmer shareholders when they do the rounds at the annual results roadshow meetings at the end of this month following the AGM.

The challenge will be to persuade them to look through the current pain to the long-run prospects.