Fonterra, the country's largest exporter by a wide margin, has had another dreadful week.
The co-operative's massive write-offs were announced just four days after Kerry Group, Ireland's largest dairy group, hit an all-time sharemarket value high of €19.7 billion ($34.1b). This compares with Fonterra's inferred sharemarket value of only $5.6b, based on its NZX-listed Shareholders' Fund.
How can Kerry Group, which has annual revenue of €6.6b ($11.4b), have a sharemarket value of $34.1b while Fonterra, which has revenue of $20.4b, has a market value of only $5.6b?
The sorry Fonterra saga goes back to the late 1990s, when a merger between the Wellington-based New Zealand Dairy Board and the country's two largest dairy co-ops — Hamilton-based New Zealand Dairy Group and Hawera-based Kiwi Cooperative Dairies — was first proposed.
Dairy farmers debated the proposed merger with even more passion than they showed for their local rugby team, with a clear majority supporting amalgamation.
However, a vocal minority were against the proposal, with one North Waikato farmer sending this column 10- to 20-page handwritten letters on a regular basis pointing out the madness of the Dairy Board/Dairy Group/Kiwi deal.
His passionate opposition was based on the belief that Fonterra's domestic monopoly would encourage it to become heavily reliant on debt because of farmers' unwillingness to contribute new equity. He believed that his fellow dairy farmers, who would have a majority on the Fonterra board, had little global expertise and would make naive, debt-funded, acquisitions.
He was concerned about the new company's cost structure, particularly plans to move the head office to Auckland from Wellington, Hawera and Hamilton. This would result in much higher costs, particularly as far as salaries were concerned.
The Commerce Commission, which rejected the proposed merger, was also concerned about cost pressures. In its negative draft determination, issued on August 27, 1999, the Commission outlined the following potential detriments:
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• The new company would be under less pressure to keep costs down
• It would be under less pressure to respond quickly to changes in the industry
• It could reduce payouts and quality of service to farmers
• It could increase prices and reduce quality of service to domestic consumers.
The commission, which looked at the proposal from a domestic market view only, determined that the positive benefits from the merger could be in the $26 million to $92m range a year while the negatives could be between $138m and $527m on an annual basis.
The proposal looked dead and buried because the National Government was unwilling to contest the Commerce Commission's decision.
However, everything changed three months later when a Labour/Alliance coalition won the November 1999 general election and Helen Clark became Prime Minister. Clark, a farmer's daughter, promoted new legislation that allowed the proposed amalgamation to proceed without being subject to Commerce Commission scrutiny.
Nevertheless, a vocal minority continued to speak out against the proposal. Former non-farmer Dairy Group directors Brian Allison and John Fernyhough wrote that the new company was seriously flawed in relation to process, strategy and design and would seriously harm farmers.
Their letter to Government ministers, quoted in the media, argued that "dairy farmers and New Zealand as a whole would be better off with less reliance on a single co-operative structure along with the recognition that other people's capital and ideas are essential for baking a bigger cake".
They argued that governance of the country's largest company would rely on people with "very limited commercial experience and expertise".
Farmers paid little attention to these concerns: 85 per cent of Dairy Group and 83 per cent of Kiwi shareholders voted in support of the merger.
The deal was finally completed on October 16, 2001, with Fonterra having an assessed merger value of $7.5b. That day, Kerry Group had a sharemarket value of €2.7b, or $5.6b at the prevailing exchange rate.
The rest is history with the recent revenue, Ebitda margins and sharemarket values of Fonterra and Kerry outlined in the accompanying table.
Fonterra's revenue has declined over the past five years and its earnings before interest, tax, depreciation and amortisation has gone from just 4.7 per cent in 2014 to 11.2 per cent in 2016 and only 7.1 per cent last year. These Ebitda figures exclude the large number of impairments the co-op incurred because of poor investment decisions. Its sharemarket value has fallen from $11.0b at the end of 2012 to $7.6b at the end of last year and only $5.6b this week.
Meanwhile, a2 Milk's sharemarket value has surged from just $0.3b at the end of 2012 to $11.6b this week. Fonterra has made many mistakes but, arguably, its biggest blunder was its failure to recognise a2's huge potential and make a bid for the infant formula company when it was extremely cheap.
A2's registered office was only 150 metres from Fonterra's Auckland head office on Princes St, yet the dairy giant didn't spot this fantastic opportunity as it was looking thousands of kilometres away at high-risk, debt-fuelled investments in Asia and South America.
A2 would have been a huge boost to Fonterra as it has marketing expertise, an Ebitda margin in excess of 34 per cent and a low cost structure.
The infant formula company has a sharemarket value more than double Fonterra's, yet it has fewer than 200 employees according to its 2018 annual report compared with the dairy giant's 21,500 staff — 11,900 in New Zealand and 9600 overseas.
The failure to identify a2 is consistent with the Commerce Commission's belief that Fonterra "would be under less pressure to respond quickly to changes in the industry".
Fonterra's problems — a lack of global commercial expertise, too much debt, a flawed investment strategy and a bloated cost structure — were clearly identified by the commission, this column's North Waikato correspondent and Allison and Fernyhough almost two decades ago.
The following announcements early this week confirmed Fonterra's poor decision making:
• The co-op's investment in DPA Brazil will be written down by $200m
• The sale and closure of two Venezuelan businesses will result in impairments of approximately $135m
• Its Chinese farms will be written down by $200m following a write-down of $405m on its Chinese listed Beingmate investment last year
• Assets in Australia and New Zealand will be written down by $70m and $200m respectively.
Where is the Fonterra Shareholders' Council, whose main role is to monitor the direction, operations and performance of the dairy giant?
Why aren't dairy farmers marching through the streets in protest at the poor performance of their company or at least showing some support for their 2001 decision by buying shares in the co-op?
The new chairman and chief executive have adopted a more realistic attitude towards Fonterra's businesses, but the co-op's main flaw remains the same as identified by Allison and Fernyhough 18 years ago. That is "that other people's capital and ideas are essential for baking a bigger cake".
Kerry Group started down its road to success in 1986 when the co-op transformed itself into a limited liability company and listed on the Dublin Stock Exchange. This allowed it to attract "other people's capital" and a wider range of skills at the board table.
It has also aligned the interests of management and farmers as Kerry Group's senior management team has been successfully incentivised through the company's numerous share schemes.
Fonterra will only pull itself out of its huge rut when it is willing to accept "other people's capital and ideas".
This involves transforming itself into a limited liability company and appointing directors with significant consumer foods expertise, rather than relying almost totally on farmer directors.
- Brian Gaynor is a director of Milford Asset Management.