Alex Duncan: Fonterra - never let a good crisis go to waste

When it comes to New Zealand business crises, Fonterra has a humdinger. Photo / File

COMMENT:

"Never let a good crisis go to waste" was Winston Churchill's response to the many historic crises he faced. When it comes to New Zealand business crises, Fonterra has a humdinger, largely of its own making.

Crises provide opportunities for worthwhile change that challenges conventional wisdom while bypassing procrastinators, 'hand-wringers' and those unduly benefiting from the status quo.

Fonterra's current challenges partly stem from commentators eagerly prodding the co-operative to execute a 'grass to glass' strategy that floats the cooperative downstream toward the final customer.

Farmers never really bought the story. We can discern that, not from what they said, but by how they behaved, which is always more revealing. They rejected these innovations at every opportunity. To see this playing out, let's consider the story of how Fonterra arrived at 2019.

From the dairy industry's earliest days, cooperatives were established to ensure that farmers' perishable milk would be processed into a durable form that could be sold at a fair price. Farmers were able to raise debt to help finance their new factories by subordinating their milk cheques to debt claims. This still applies today. Fonterra's shareholders effectively stand behind the co-operative's debt, which is reflected in Fonterra's strong debt rating.

As the industry developed, farms became larger and processing economies of scale caused co-operatives to merge and consolidate. The Dairy Board sat across the top to assist in 'orderly' marketing of dairy products as a single-desk seller. The merits of this function were strongest when single national purchasing agencies shaped export markets in the 20th century.

After the United Kingdom's accession to the (then) EEC in the 1960s, New Zealand's dairy products were exported to many more countries.

However, international dairy trade was still substantially influenced by distorting tariffs and quotas through which the Dairy Board navigated.

If Fonterra messes up, it is shareholders who have to stand behind its debt. Photo / File

By the start of this century, the process of consolidation resulted in the sector being dominated by three major entities – the NZ Dairy Board, Kiwi Co-operative Dairies and NZ Dairy Group.

This made for an awkward and often dysfunctional structure, evidenced by vexed and complex internal processes by which the Dairy Board allocated products to be manufactured by the two large co-operatives.

Moreover, the credibility of New Zealand arguing for international trade liberalisation depended on removing single-desk selling arrangements for its largest export sector. The easiest path to achieving this was combining the three entities into a co-operative. Pragmatism won, but any other course would likely have required substantial effort and time to untangle the complex legacy arrangements between three entities with conflicting goals.

In this consolidation process, the most important regulation imposed on Fonterra obliged it to allow farmers to easily switch between Fonterra and other processors (open entry and exit on the same terms), and to provide milk to smaller processors and Goodman Fielder.

So, the main benefit of Fonterra's formation was clearing the way to deregulate the dairy sector. There were implausible assertions at the time that the merger would result in benefits in the billions.

Subsequent promises of substantial value creation through 'game changing' strategies have likewise invariably disappointed.

There are good reasons why farmers never 'got' the programme. Even now, Fonterra represents about 80 per cent of New Zealand's total processing capacity. The co-operative's ingredients business represents nearly 90 per cent of capital employed (a proportion that has steadily risen largely due to the poor performance of downstream consumer and offshore farm investments).

Fonterra shareholders therefore continue to value control over the facilities on which they rely to process milk into durable products for sale internationally. Their financial exposure to their farms dwarfs their investment in Fonterra.

But if Fonterra messes up, it is shareholders who have to stand behind its debt.

They therefore have a strong motivation for the co-operative to be prudent and excel at the basics of processing milk into stable products.

Consequently, since Fonterra's formation, its shareholders have been reluctant to provide capital to support an expansive downstream strategy.

Caution was doubly necessary because of the lack of transparency in Fonterra's financial performance measurements in the years immediately after its formation.

Prior to 2009, all distributions were treated as 'payout' linked to milk production. Retentions were almost solely the result of gains on the sale of assets.

Until 2009, Fonterra did not have a milk price, a meaningful measure of earnings, or a measure of dividends per share. Photo / File

Until 2009, Fonterra did not have a milk price, a meaningful measure of earnings, or a measure of dividends per share. Greater transparency was also enabled by the advent of GDT in July 2008.

Until 2009, Fonterra largely funded investment through farmers having to purchase additional shares in proportion to the additional milk they produced. The price of shares was set by Fonterra within a range determined by an independent valuer. Share price and milk volumes grew steadily through to 2009, with new shares largely financing additional production capacity.

After Fonterra shareholders voted to change its capital structure in 2010, the share price was set at $4.50 per share in the lead-up to listing. Milk volumes grew significantly from then until 2015, driven by higher farm-gate prices. This had little to do with Fonterra, but instead reflected increasing demand from China and the dismantling of European agriculture supports. From around 2010 onwards, and for the first time in history, farmers in New Zealand received farm gate prices that matched those of their counterparts in the US and Europe.

When the capital structure changed in 2012, shareholders once again put the Board and management on tight rations. Capital raised from the issuance of FSF units was returned to farmers, not retained for investment. Retentions after 2012 were meagre.

Advent of Fonterra's capital structure in 2012 coincided with new senior management intent on implementing an expansive downstream strategy. Tension therefore existed between the aspirations of management and the observed collective reluctance of Fonterra's shareholders to invest beyond what was needed to process their milk.

The ramping up of downstream investments was therefore largely debt-funded and almost all have resulted in impairments. Share and unit holders ended up carrying the can, while ex-senior management flew home with rock-star bonuses.

The only benefit of dwelling on the past is to learn lessons for the future. The current crisis provides a useful opportunity for a reset. Since Fonterra's formation, its shareholders have revealed by their

actions that the co-operative is not suited (or trusted) to make large investments downstream in consumer or specialty products due to farmers' collective desire to retain control of facilities they heavily rely on to process their milk.

Moreover, milk production is highly seasonal with only 5 per cent of milk sold domestically, unlike other major dairy-producing country.

This makes manufacture of specialist dairy ingredients costly if it is to draw on milk throughout the year, because production capacity must be sized to the seasonal peak.

Much more value arises from New Zealand's low-input farming systems that make Fonterra an ideal global source of dairy ingredients.

Fonterra's ingredients business will maintain its pre-eminent position within the cooperative, even if in the future the nature of ingredients changes.

Fonterra CEO Miles Hurrell. Hurrell, along with his new senior management team, will be tasked with cleaning up the company's mess. Photo / File

The irony is that Fonterra's overlooked ingredients business is a source of unrealised and substantial value. In other soft commodity markets, investors have moved upstream to control processing and logistics – not downstream. Fonterra already owns these assets.

The billions of dollars invested in Fonterra's diverse range of ingredients assets represent potentially valuable 'Real Options' that have been largely overlooked. Fonterra's mix flexibility is a latent means of reaping rewards from market volatility. Fonterra's plants become a portfolio of traded instruments across all the supply chain - from access to milk, processing, and logistics.

Fonterra's strategy is therefore better aligned with companies like Cargill or Glencore, while being a responsive and reliable supplier to Nestle, A2 Milk and other downstream customers.

With such a clear, straightforward strategy, Farmers would continue to retain control of the co-operative's core processing assets. Fonterra's current capital structure would continue to provide a useful basis for valuing an ingredients-dominated business.

Unit holders would hold a stake in a much simpler infrastructure-focused business that generates a more stable dividend and earnings streams.

Such an outcome would serve Fonterra's goal of achieving better forecasting. The co-operative would also have enough strength to pay a competitive milk price.

Achieving these outcomes requires greater bidding depth in both GDT and financial markets for dairy derivatives. This would be achieved by establishing a linkage between these markets that does not yet exist. But the prize is sufficiently high to motivate smart minds in Fonterra and NZX to work this through.

The residual downstream and consumer business assets should be sold in a contestable process. A contractual link may remain for Fonterra to supply dairy products to the spun-out entities.

Fonterra would also partner with other New Zealand downstream dairy players, rather than competing with them. Offshore ingredients assets would be retained only if they serve the refreshed upstream strategy of the business.

Fonterra shareholders who wish to invest downstream could continue to do so by holding a stake in the spun-off businesses. But no one will be forced to do so, as they are currently.

The new senior management team at Fonterra exudes a measured approach that is absent of hubris. The new team did not create this crisis, but they have to clean it up. Fonterra has the human resources and high-quality core assets to do so. Fonterra's disclosures to be released next month will be an interesting read.

- Alex Duncan is a Principal of Finology, a Seattle-based financial advisory firm. Previously he held senior corporate finance roles at Fonterra for 12 years until mid-2015.