When bigger is better

By BRUCE ANDERSON

The recent New Zealand dairy merger resulting in Fonterra is a positive and significant example for agricultural cooperatives globally.

Certainly it was not accomplished easily, and the New Zealand dairy industry is to be congratulated for its foresight and fortitude in making Fonterra a reality.

However, the very nature of the food industry poses some major challenges.

World food consumption increases by approximately the rate of population growth, which varies by region from 1 to 4 per cent. This implies that growth in the demand for food is low but very stable.

Investors in food companies generally expect a 10 to 17 per cent return on their equity. Given the slow growth in food consumption, there are only two ways to achieve that return: by internal expansion (new stores and products) or by external expansion (mergers and acquisitions).

Probably the most significant trend in the food industry is the consolidation in the global retail food sector.

Today US chain Wal-Mart is the largest retailer of food in the world. This year its total sales were $US191 billion with over 3000 stores.

Carrefour, the major food retailer in Europe, with significant operations in Southeast Asia and South America, had sales last year of about $US59 billion and 9000 stores.

Both Wal-Mart and Carrefour are actively building and buying stores.

There are still few transcontinental food retailers anywhere in the world. This implies significant room for further expansion and acquisition.

Think about the economic power giant retailers can exert against smaller sellers, like the New Zealand dairy industry.

Many food manufacturers have thought about it and they are pursuing acquisitions and mergers as their primary means of growth. About two years ago Heinz and Best Foods, two US food manufacturers, announced a merger. They felt they were too small to individually deal with the large food retailers. At the time each had about $US10 billion in sales. The merger fell through and Best Foods was acquired by Unilever with approximately $US43 billion in sales.

Expect these trends to continue.

One of the key reasons for growth in the food industry is the need to cover rising costs.

A few preliminary studies suggest food companies do a good job of managing variable costs, which do not increase very much, if at all, in proportion to sales.

The main problem is fixed costs. Some fixed costs are uncontrollable, such as utilities, insurance, taxes and salaries.

But the largest component of fixed costs is depreciation. When a new plant is built or equipment replaced it usually costs significantly more than the original plant or equipment. Thus the increase in fixed costs.

Without growth, increasing fixed costs will erode profits and turn them into a loss.

The primary strategy is to spread increasing fixed costs over a greater volume of sales.

There are only two ways to increase sales: through internal growth such as developing new products and processes or through external growth via mergers and acquisitions. Each has its advantages and disadvantages.

New products and processes are expensive and risky. I usually use 30 per cent as the probability of a new product or process succeeding.

In addition, if you find something new, the chances are that your competitors will copy it.

Despite these drawbacks, good companies have learned that to be successful they must continually innovate. Certainly New Zealand is recognised as being at the leading edge of product and process innovation in the global dairy industry and this needs to continue.

The primary disadvantage of acquisitions is that they require capital. Because most cooperatives do not have access to equity markets it is more difficult for them to raise large sums of capital, which limits the size of the acquisitions they can make.

Cooperative mergers, as opposed to acquisitions, generally do not require significant capital. On the other hand, it is always difficult to merge different corporate cultures.

In addition, mergers are disruptive, and members feel they have less influence in a larger cooperative.

Worldwide, the role of cooperatives in the food industry will probably continue to increase. This is because public corporations do not like the economics of the food business. Public corporations would prefer to be in industries which have high growth, low capital investment needs and little competition.

Some are even getting out of the food business, while in the US some food companies have expressed a desire to pursue a Nike strategy. Nike designs and markets athletic shoes but does not manufacture a single shoe. With this strategy few fixed assets are needed so the return on equity and assets can be increased significantly while the risk of obsolete fixed assets is reduced.

In some cases cooperatives have agreed to own and operate the fixed assets. Their aim is to provide an assured outlet for their members' commodities. In addition, cooperative members will often accept a lower return on their investment in the cooperative than public shareholders demand, to preserve a return on their farm operations.

There is every reason to believe this trend will continue. Cooperatives will fill the void in the food industry left by departing companies.

Many long for the good old days when the milk plant was just down the road, cooperative headquarters was in a nearby city, we knew all the directors and many employees by first name, and management knew us. But for many cooperative members those days are gone forever.

Members must now exert more effort to keep informed about the ever more complex operations of their cooperatives.

Cooperatives are democratic organisations. Democracy has three major components: voice, voting and exit. Voice means expressing your opinion. But the most important element of voice is asking the right questions.

The second element of democracy is voting. If members do not feel their elected officials are doing the best job they have the power to replace them.

With only one cooperative the ability for farmers to exit by moving to alternative markets is extremely limited. As a result, members have an increased responsibility to exercise their power of voice and voting.

The cooperative also has increased responsibilities. Experience from Europe indicates that when members have no market alternative to their cooperative they become more critical of their organisation.

The cooperative must make a greater effort to communicate and exchange views with members.

Members truly want to know what their organisation is thinking and doing. Often only a small fraction of an organisation's strategic plan is proprietary and needs to be held confidential. To the extent possible the cooperative should share its strategic plan with members.

Because the dairy industry has consolidated as far as it can within the borders of New Zealand, the next step is increased consolidation internationally.

Certainly, the New Zealand industry is already active in many countries, but the continued need to spread future increased fixed costs will mean more foreign joint ventures, strategic alliances and acquisitions as well as possibly mergers with foreign cooperatives.

Cooperatives cannot buck market trends in the food industry or anywhere else. With the creation of Fonterra the New Zealand dairy industry seems well positioned to be competitive and efficient for the near future. However, the new organisation requires an increased understanding and effort on the part of cooperative members, elected representatives and management to prosper, keep ahead of the curve and rise to the next challenge.

Cooperative organisations rarely engage in self-congratulation. However, all members of the New Zealand dairy industry should take a moment to appreciate what you have accomplished.

But just a moment - because if you stand still too long, the trends and economics of the food industry are working against you 24 hours a day 7 days a week.

* Bruce Anderson is Associate Professor in the Department of Applied Economics and Management at Cornell University, New York, and director of the Cornell Cooperative Enterprise Program. He advised the New Zealand dairy industry on the establishment of Fonterra.