Fonterra looks to growth but is its keeping options open

By LIAM DANN

Details are now emerging of the stand-offs between management and directors that were part of the Craig Norgate era at Fonterra.

The issue at stake is how much risk the company should take on to expand its brand business in the world.

Inquiries by the Business Herald show conflicts within the past 18 months over big investment decisions.

New chief executive Andrew Ferrier says those tensions are gone but sceptics believe an aversion to risk is embedded in the company and the problem will return.

The new details are of how management went to the board of directors in early 2003 with a proposal to take over National Foods, Australia's largest listed dairy company.

The takeover never happened.

Control of National Foods would have cemented Fonterra's position as the number one player in the transtasman consumer dairy market.

Fonterra's most senior executives believed they had been given a golden opportunity. In the grip of a crippling drought, the Australian industry was fragmented and underperforming.

Fonterra - sitting on an inherited 18 per cent cornerstone stake in National Foods - was ready to roll. The board rejected the proposal.

In the next 18 months, shares in National Foods rose by nearly 50 per cent.

Fonterra is still talking about developing the business in Australia but a National Foods takeover is off the agenda. Ferrier, who is approaching the end of his first year in the job, says it is too expensive right now.

National Foods, now trading at $4.67 a share, would cost Fonterra much more than $5 a share to take over, compared with management's expectation of less than $4 back then.

Anyone who has ever considered buying shares can understand how easy it is to miss a bargain. Hindsight is cruel.

But critics familiar with Fonterra's inside workings view this as not an isolated bad call.

Instead, they say it is a symptom of a risk aversion holding the company back.

One former high-level insider goes further, claiming Fonterra's co-operative capital structure is fundamentally flawed.

Those in this camp believe that unless consumer foods business New Zealand Milk is spun out of the co-operative, and separated from Fonterra's core ingredients business, it will never be allowed to reach its potential.

Of all the dairy industry's goals, a thriving consumer business is the holy grail.

Inside and outside Fonterra, there is agreement that strong global brands are the key to escaping the commodity trap.

Since he took over, Ferrier has been blessed with one of the strongest commodity markets this country has ever seen.

But it is widely accepted that commodity prices are trending down over time.

New Zealand Milk's growth is supposed to offset the downward trend. However, as this year's annual result showed, New Zealand Milk struggles when commodity prices are high because the cost of its raw ingredients goes up and its margins are squeezed.

In order to maintain those margins Fonterra needs strong brands. Ferrier knows this.

The appointment this week of international brand marketing specialist Sanjay Khosla - taking over the top job at New Zealand Milk from David Pilkington - reflects a commitment to get the consumer business and its brands firing.

All agree that Khosla's appointment is a great step. But there are fears that the relentless focus on farmer payout could restrict his freedom to work the magic he did on tea brand Lipton.

A senior source puts it this way: Fonterra is happy to spend $120 million putting in a big new powder plant but reluctant to invest $120 million in the consumer business. He cites another example of what critics see as the board failing to act.

It was an opportunity last year for New Zealand Milk to invest in "a great brand" - he would not name it - that would have given good returns. The proposal was declined by the board as too big an investment.

The argument here is that the board failed to recognise that investing in, say, a milk powder dryer - subject to commodity prices and foreign exchange moves - was probably more risky than investing in brands. In fact, it may be easier to quantify the risk in a brand.

Everyone knows how many customers go into a Coles supermarket in Australia on a given day to buy a dairy brand. But, this source argues, Fonterra's farmer shareholders - and thus the company - can't think that way.

"Farmers need that powder plant to process their milk but they don't need Fonterra to be making investments on their behalf in Chile or Venezuela or Brazil."

In the short term, farmers can earn more off that capital by converting the back paddock or upgrading the milking.

China gives another example. New Zealand Milk has to be there. A China strategy is vital to Asian expansion plans.

While an appropriate investment there would be seen as positive by shareholders of a listed company, to Fonterra shareholders "its a bloody negative because it has just reduced the monthly milk cheque".

"So to me there is a fundamental flaw."

One solution would be a separate governance board for New Zealand Milk. It would be possible to list the company in a way that secured a cornerstone for Fonterra and New Zealand.

There are existing models like Telecom's Kiwi share or Livestock Improvement's farmer-only share register, the source says. It's a timely thought.

Dairy farmers are about to begin an important debate on Fonterra's capital structure. There is some desire for change but breaking out New Zealand Milk from the ingredients business will almost certainly not be on the agenda.

Shareholder council chairman John Monaghan says farmers are still talking to the board about what the key issues are. He says the council accepts tensions exist within the current structure but any changes will be evolutionary rather than revolutionary.

Ferrier bristles at suggestions that the co-operative structure is fundamentally flawed. "It's an open-and-shut case. The capital structure is not holding us back." That is a view held across management and the board, he says. "There is no crisis."

So why won't Fonterra move on National Foods? Critics believe that even at today's prices Fonterra still needs to move forward in Australia. They argue takeovers are always expensive.

But it's not the first play that determines whether a strategy is a success. Whoever grabs National Foods - and there is speculation that it might be Graeme Hart - grabs the initiative.

That initial play might not make money but it puts the player in a position that can't be touched.

"The real issue with Fonterra is you've got a board that just won't make those decisions," a source says.

But Ferrier says Fonterra will not be rushed. "We certainly have an intention to grow this business significantly but we will take a lower risk profile than certain other public companies might."

He is comfortable with Fonterra's position in Australia. It didn't get National Foods last year but it did double its stake in Bonlac - Australia's fourth biggest dairy company - to 50 per cent.

It also owns West Australian consumer business Peters & Brownes and Melbourne-based Bonland Dairies. Last year, Bonland bought a snack business called Favorite Foods.

The stake in National Foods is big enough to prevent anyone else making a full takeover bid. And Fonterra is not about to budge on that, Ferrier says.

There is always some risk in not moving, he concedes. "In our evaluation it's not an overly high risk. We will have the opportunity to play at a consolidation on our timetable."

Former director Murray Flett, who missed out on re-election to the board last May, says it's time for Fonterra to devote more attention to New Zealand Milk. But it is wrong to say that it has been neglected, he says.

As well as making huge headway in the core ingredients business, some "pretty significant beachheads" have been opened up in the consumer business. The joint-venture deal with Nestle in South America, the opportunities in China and India, that's all consumer business, Flett says.

"What it must do is continue to move at that sort of pace."

Ferrier agrees that the time has come for serious work on developing New Zealand Milk.

Whether he will face less of the frustrating roadblocks than his predecessors remains to be seen.