Fighting talk over the farm gate

Gary Romano, Fonterra managing director. Photo / Supplied

"These people are getting on this bandwagon and suggesting the price at retail is being manipulated by us at a corporate level manipulating this farmgate price," says Fonterra Trade and Operations managing director Gary Romano, clearly annoyed by the Commerce Commission complaints.

To show why the complaints are without foundation, Romano and Fonterra Brands managing director Peter McClure take the Herald through some of the intricacies of the Fonterra organisation and how farmers get paid: how farmers belonging to the co-operative buy shares - one for every kilogram of milk solids sold. And how the payout they receive is made up of two components - the milk price and a dividend comprising the combined profit Fonterra makes across its divisions.

The milk price is currently $7.50 a kilo of milk solids and the profit around 40c-50c a kilo, giving a total payout of $7.90-$8 per kilo. Per litre, that works out to 63c a litre farmgate milk price and 3c-4c a litre profit.

Romano says the complainants are suggesting some profit is "leaking into" the farmgate price to make it too high. "The farmgate price is their cost of goods so they have a vested interest to have this as low as possible. These guys are saying we are bleeding some of this profit into their milk price. One, that's laughable to make any material difference and two, why would we do that?" he says.

"For what purpose? If I do that I inflate this farmgate price with all the firepower of 3c and what do I do with my shares? I'm undermining it. Why would I do that?"

The complainants say it's in Fonterra's interests to have the share price as low as possible because it encourages entry into the co-operative and discourages exit. They say the co-operative does have the ability to unilaterally apportion their total return to shareholders as it sees fit between dividend and farmgate milk price. They point out the practice is cost-neutral - the total payout is the same for the shareholders, just apportioned differently. But it's not cost-neutral to competitors because it forces them to match an artificial, uneconomic market price.

The Herald asked Wellington dairy industry consultant Peter Fraser if he could shed light on the issue.

"The argument is they are robbing the dividend to crank up the milk price," says Fraser. "If they are, and I'm not saying they are, there would be an asymmetric effect between domestic consumers and independent processors."

He says it would show the Raw Milk regulations as being problematic. "The old regulated price formula was replaced with Fonterra's farmgate milk price in 2009 as we had good evidence that it was setting the price too low relative to the Fonterra price. If the allegation that the Fonterra price is being manipulated upwards is correct, then it suggests that we should have stuck with the formula after all."

Fraser says that the only way such a mechanism would work would be if the share price was significantly discounted, producing a lower dividend but still leaving "free money" in the system which could, in theory, be added to the milk price. "This is precisely what has happened, as part of Fonterra's 2009 capital structure proposal involving the revaluation of Fonterra's shares - this reduced their value by around 25 per cent."

Romano maintains Fonterra's competitors and are actually getting milk from Fonterra at a significant discount. "All they are doing is gaming the system because DIRA [the raw milk regulations] requires Fonterra to provide up to 50 million litres per operator."

Fonterra Brands managing director Peter McClure says it's possible to find a two-litre bottle of milk priced between $3.50 and $5.20. The $5.20 price tends to be in the "route trade" such as corner dairies whereas the $3.50 price is house brands in supermarkets or in "oil channels" where consumers can find two 2L bottles for $7.

McClure says after buying milk at the farmgate milk price, adding processing, packaging, distribution and merchandising costs plus general administration overheads, Fonterra's margin is around 12 per cent. "Are we making excessive profits? Absolutely not. We are making standard profits at the lower end of the bracket." He does acknowledge that local competition makes a difference and that there have been "blips" when the retail price doesn't mirror raw milk price. "One was when Woolworths first came to New Zealand [2007-8] - they crashed milk pricing for a little while."

Not so easily explained is why when international prices fall, retail prices are slow to respond. Figures in the Ministry of Agriculture and Forestry March report on the domestic milk market show that between 2007/8 and 2008/9 the cost of milk fell almost 40 per cent from 62c to 40c per litre yet the retail price climbed 13c per litre (8.5 per cent). The Herald also asked how the margins between international prices and local retail prices for cheese and butter appear to be increasing since 2004 - by 67 per cent for cheese and 65 per cent for butter according to the MAF report.

Surely these margins - which are after the cost of milk - should be relatively flat rather than increasing? McClure said the MAF figures didn't tally with Fonterra's prices and provided the Herald with a different set of numbers stating: "Our gross margins for cheese and butter are in the order of 18 per cent and 7 per cent, respectively. Down on last year by 4 per cent and 7 per cent and very low returns relative to average fast moving consumer goods product returns."

McClure maintains there is plenty of independent competition in the local market - Fresha Valley, Marphona Farms, Al and Son and Klondyke. "If little guys like this can compete and make money and effectively drive the pricing expectations in the route trade, don't tell me that Open Country or any of those others can't compete." He argues they don't compete locally is because they are getting better returns offshore.

McClure also points out that Fonterra's Anchor brand is just 16 per cent of the market and that the supermarket house brands - Pams, and Budget (packed by Fonterra) and Home Brand and Signature (packed by Goodman Fielder) dominate. "The biggest player in retail milk is Foodstuffs with their Pams and Budget brands, not us."