The dilemma for Fonterra is that its business plans are based on a belief that it needs to grow its milk supply by more than 30 per cent over the next seven years. This was a key message Fonterra presented to its non-farmer investors in December 2017, with chief executive Theo Spierings referring repeatedly to “çost leadership through scale efficiency” and concluding with the message “Fonterra presents a strong investment opportunity”.
It is notable that Fonterra sees the future world very differently than does the current New Zealand Government. The Government says that the future lies in earning more from less through more value-add activities. Fonterra’s perspective is to agree with the value-add part of that story but not from less production. It wants more production.
To find the specifics of what Fonterra has been thinking about the future, one has to look in detail at what it has been saying in the presentations to its non-farmer investors. These professional investors are the institutions and retail investors who drive the share price through purchase and sale of investor units. They are also the main potential source of additional capital.
These professional investors do not get a vote at the annual meeting. Indeed, these investors don’t even bother to turn up at the AGM. This event is for the farmer owners, and the messaging of that day reflects that situation.
Fonterra’s most recent professional investor presentation was on December 7, 2017, comprising six hours of presentations and one hour for lunch. All of the Fonterra management heavies were there, led by Spierings.
Compared to farmer shareholder meetings, there is more substance and less spin at the professional investor meetings. These professionals expect and get the real oil as Fonterra sees it, despite it still being loaded with plenty of puffery.
Fonterra’s leaders told the professional investors that Fonterra holds an admirable position but that it would need to grow much bigger. The target for 2025 is 30 billion LMEs (liquid milk equivalents), up from a 2017 global Fonterra supply of 22.4 billion.
This term ‘LME’ will not be familiar to most New Zealanders, but it is becoming a standard international unit to compare milks of different composition. One New Zealand litre equals approximately 1.15 LME, with some variation between seasons of the year, and 1kg of milksolids (fat plus protein) is about 13 LME. So, Fonterra wants another 570 million kg of milksolids each year from all around the world.
Fonterra was estimating it could grow its New Zealand milk supply by 1.5 per cent a year, which would provide about 170 million additional kilograms of milksolids a year by 2025. However, this would seem highly optimistic. Some might say it is unrealistic.
Looking ahead, there are strong headwinds relating to New Zealand’s dairy production. First, there is the issue of Fonterra’s forthcoming farmer penalties for milk produced by high feeding of PKE. Those penalties start next spring. Second, some 23,000ha of land has been retired from dairying in the last two years. More land retirement from dairying seems likely as small farms on marginal dairy country shift to beef. Third, there are increasing pressures to de-intensify as a response to nutrient compliance issues. Fourth, the political winds on greenhouse gas emissions do not give farmers confidence. And fifth, everyone is worried about Mycoplasma.
Fonterra has an additional worry that it has been steadily losing market share to other companies, down from 96 per cent at company formation in year 2000 to about 82 per cent this year, and almost certainly lower over the next two years with competitors having additional processing capacity coming onstream.
Regardless of whether or not Fonterra gets some growth in New Zealand, or indeed more likely suffers significant declines, it is clear that the volumes Fonterra is talking about can only come from major overseas processing investments.
Fonterra’s recent purchase discussions with Samcor in Argentina are part of this global strategy. However, in recent weeks Fonterra has missed out there, with a local buyer being the winner. Fonterra was also interested in buying Murray Goulburn in Australia. Once again, Fonterra’s discussions went nowhere, with Saputo from Canada about to become the purchaser.
An alternative perspective would be that Fonterra will need to work hard simply to maintain its current overseas supply of milk. In Australia, Fonterra has benefitted greatly in the last two years from Murray Goulburn’s self-destructive behaviour. However, with Saputo in control at Murray Goulburn, there will be a lot more farmgate competition for Australian milk supply.
The reason that Fonterra thinks it needs more milk is primarily but not only because of China. The way Fonterra sees it is that China has minimal capacity to grow its own supply, whereas Chinese consumer demand will increase by 8 billion LME by 2025. Filling the gap, if it does occur, will require Chinese imports to increase by more than 75 per cent over that time period.
Fonterra sees many opportunities in China, with butter and cream likely to be at the forefront, but these are not the only ones. Apart from the butter category, where Fonterra is clearly No 1, the unstated challenge is whether or not Fonterra has the systems and capability to take advantage of the emerging value-add opportunities. The track record suggests that it does not.
What was obvious to all attendees at the professional investor seminar, but left unsaid, was that Fonterra does not have the balance sheet to fund its own transformation. A combination of big growth in volumes combined with transformation to value-add implies a great deal of capital.
Companies have three ways to fund growth. The first is by retained profits. However, Fonterra is under considerable pressure from its farmers that most of the profits should be returned to them, and that is the current practice. Indeed, this year it looks like there will be no profits to distribute and the promised dividends will come from the balance sheet.
The second funding option is to take on more debt. However, Fonterra is in no position to take on a lot more debt if it wishes to retain its current financial ratings (which determine interest rates).
The third option is to take on more equity. The challenge for Fonterra is that only farmers who produce milk can be shareholders.
One way of getting around this would be for Fonterra to take on more farmer shareholders by opening up membership to Australian farmers. There is talk of that, but I see it as a bridge too far.
The other way is that Fonterra could sell units into the so-called Fonterra Shareholders’ Fund. In reality, that means selling units to professional investors, who share in the profits despite not having a formal vote in regard to company policy.
The downside is that further substantial investment by these outside investors would cause considerable grumbling amongst farmer shareholders. Their concern will be that it is yet another step away from co-operative principles and a de facto loss of control.
Perhaps the first step is for Fonterra to scale back its ambitions and focus on working with the New Zealand milk that it already has. It would still be the largest cross-border dairy marketer. Setting up systems to maximise profits from that milk, and finding the necessary capital to fund that transformation, should be more than enough to keep it busy.
Whatever way one looks at it, Fonterra is caught between a rock and a hard place. It cannot really blame anyone but itself.
Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington. His articles are archived at https://keithwoodford.wordpress.com
By: KEITH WOODFORD