No Minister

Fonterra’s cows did a double backward somersault while mooing the "Star Spangled Banner"

Translated that meant, So long, and thanks for all the payouts.

It was around 2011 that I concluded that Fonterra was never going to be able to successfuly execute all those grand strategic plans from the turn of the century.
I looked at it pretty simply: the idea of having a dividend from shares as a supplement to the actual milk-solids income sounded good; it meant the company would be focused on all that “value-added” stuff that’s been a mantra in NZ at least since the 1980’s. As that factor improved over time the dividend would steadily increase, which would also increase the value of the shares, thereby making it easier for Fonterra to raise capital and borrow. In effect, each Fonterra farmer would be a microcosm of the company itself; a declining proportion of basic commodity business and income, with a rising share of “value-added” product business and income.

As Agricultural professor Keith Woodford describes:

By chance, today I was looking at a 2007 document from Fonterra which set out how in the 2006/07 year Fonterra paid a milk price of $3.87 plus a value add component of 59c. Back then the value-add component was significant. The fair value share was valued at $6.79. Fonterra had 12 billion of assets and equity of around 8.46 billion (6.79 X 1.246 billion kgMS). The particular document I was looking at was Fonterra’s first document to farmers proposing bringing in non-farmer investors

So to be fair, it looked like it was working – for a while.

But by 2013 I was really done, and the following two seasons, with a terrible global commodity market and resulting record low payout, was simply a confirmation of Fonterra’s strategic failures. Sure, the zero-interest emergency loan was nice, but such should not have been needed if the original strategies had worked.
My only regret is that I did not move fast enough. I did escape in 2018, after the share price had dropped to around $5.46, down from $6.50 in January 2018, and certainly I escaped ahead of the looming disaster of $3.17. But it was still a hit to debt-reduction plans and as I’ve been saying to people, while I’ve managed to escape a bomb-laden building to stand perhaps 100m away, and will not get killed in any explosion and collapse, the question is whether I’m far enough away to escape the resulting shrapnel and debris?

For example, while private companies have long said they will pay prices for milk that are competitive with Fonterra, the thinking was only on the upside. If Fonterra starts going down will “a competitive milk price” be interpreted by those companies as following Fonterra’s down? Why would they not drop their prices when they’re operating in the same commodity world (obviously not talking about the likes of Tatua). What proportion of their suppliers would they be willing to allow to go to the wall if the result is simply a stronger base of suppliers who’ve managed to buy up the dying ones cheap? Same volume of supply for less cost! What would be the problem from their perspective?
And of course none of this will change the long-term trajectory of NZ dairy farms becoming fewer, larger and more corporate , as they have in the USA:

The number of farms selling milk has decreased from around 50,000 in 2012 down to 39,000 at the end of 2017. Another 1800 farms have dropped out in the 15 months through to March 2019. Go back some 20 years and there were 100,000 dairy farms.

The average American dairy farm now has about 250 cows but averages can mislead. Sixty-five percent of farms in 2017 had less than 100 cows and produced only 11 percent of the nation’s milk.  Fifty-seven percent of the nation’s milk was produced on less than 2000 farms, with each of these having more than 1000 cows. The biggest American farm owner that I know has 60,000 cows on multiple farms.

The trajectory here in NZ has not been quite as steep, with numbers of dairy farmers dropping from around 20,000 twenty years ago to between 12-14,000. That’s mainly because NZ company farms don’t have the immigration labour advantages of the US:

On the big farms, often with several thousand cows, all the workers are likely to be Hispanic. The language in the milking parlour is always Spanish.

Many of the immigrant workers lack documentation.  However, that is just a hindrance rather than a defining problem. The system works because agriculture has a dispensation from online registration of workers. False documents are easily obtained, and with a paper system it takes many months for the Government to catch up with things. The next day the worker produces a new set of documents under another name.

Sharemilking and contract milking in NZ still have flexibility advantages over the NZ corporate model even as the numbers of traditional family owned and run dairy farms continues to fall away.

But the economic pressures driving all this are similar globally. Basic food commodities continue their centuries long trend of becoming ever cheaper, while costs steadily increase, usually in the form of new burdens, even as old costs drop in areas such as equipment. What these two trendlines mean is that for any given dairy farm, a point is reached where it is no longer an economic unit.

This is nothing new. Our farm was an economic unit with sheep only up until the mid-1950’s. Then it was ok with mixed sheep and an Angus stud. Then with additional land and mixed sheep, stud and non-stud cattle. But by 1980 the writing was on the wall for this model as well, unless you doubled in size, which meant shifting elsewhere. So dairy farming it was, in which our neighbouring farms of just 50Ha were doing perfectly well.

Interesting note on that last: in 1974, one of the worst rural recessions saw two neighbours sell their drystock farms of some 150-200Ha to the Labour government, who split them up into these small dairy units – that have now recombined almost exactly along the old boundaries, to be three times the size of their government-established 1970’s ancestors.

Just another example of how you can’t fight such basic economics on commodities where it’s close to the Free Market model of many producers pumping out much the same stuff, with minimal profits, as the American dairy giant Dean Foods has been the latest to discover:

Wrestling with debt and struggling to adjust to consumer demands, ​America’s largest dairy producer filed for Chapter 11 bankruptcy protection [in mid-November 2019].

Dean’s business is largely fluid milk and ice cream — two categories that have declined. Fluid milk per capita consumption has dropped from 247 pounds in 1975 to 146 pounds in 2018, and regular ice cream consumption dropped from 18.2 pounds in 1975 to 11.8 pounds in 2018, according to USDA.

Plant-based dairy is in demand, with oat, almond, soy and other beverages gaining popularity.

Think about that while noting how much Fonterra still relies on a product even lower on the commodity chain than fluid milk – Whole Milk Powder (WMP)!

One of the standard economic results of such a situation is that producers desperately increase production to try and stay ahead. Another tell of Fonterra’s problems was that they pushed their farmers hard to do exactly that, which would not have been such a bad idea if the basic commodity was being turned into products of ever-higher profitability. After all, as the first report about big US farms notes:

Despite this decline, milk production keeps going up.  This is in part because it only takes one big farm to replace many small farms. Also, milk produced per cow continues to rise by around 1.3 percent each year.

Which is linked to the Dean Foods report:

According to USDA data, per capita dairy consumption in pounds per person has increased from 539 pounds in 1975 to 646 pounds in 2018, with more consumption of yogurt and cheese.

In other words, even with plant-based milks on the rise the real problem is not dairy products as a whole but unprocessed dairy. Obviously Fonterra has long known this, with talk of cheese, yoghurt and so forth: equally obviously it’s a problem they haven’t cracked. I can’t think of one product they make, let alone a new product, that could equal, let alone replace their revenue streams from WMP.

While the problems of Dean Foods had some unique aspects, there’s enough commonality there to worry Fonterra. Even aside from the markets, the following aspect of Dean’s growth sounds awfully familiar as they started in 1925 and slowly grew by taking over small, local operations and focusing on operations and finance – until they were taken over by Suiza Foods Corp in 2001:

[Suiza’s] leadership was primarily marketing professionals who were all about growing, buying and acquiring market share. They were not as focused on operational or financial management.

Witness Fonterra’s aggressive expansion into Australia, China and South America, all of which now seem to be stranded assets that are proving tough to reform or get rid of. The Fonterra-owned Aussie outfit did gain farmers, but only because a huge competitor, Murray Goulburn, ran into its own problems. The Chinese Beingmate and China Farms operations have huge writedowns but have not yet been sold after almost two years of Fonterra shopping them.

Chile is another problem – but has not yet caught the public eye. Chilean farmers and shareholders have accused Fonterra of overmilking the Chilean cash cow.

This was likely done to boost things for the NZ supplier-shareholders, but given that suppliers and market share are being lost in Chile this was short-term thinking:

“…whereas some Chileans still admire Kiwi dairy farmers, we never found one farmer who had a good word for Fonterra. Fonterra is strongly disliked as a consequence of the way it has treated its suppliers. Farmers say that never again can Fonterra be trusted.”

To be fair, Fonterra is not the only dairy company that talked big and failed to deliver, as this Australian report discusses.

But even in being fair, all that those other dairy company problems show is that Fonterra has got a very steep uphill climb even if it successfully dumps its failures. While it’s good that Fonterra has finally recognised all these problems – having given up on the idea of becoming another Nestle and setting a strategy of focusing on being an efficient commodity producer – you still have to wonder whether Westland Dairy, who decided to go it alone in 2001, is where Fonterra is headed, and for much the same reasons on a smaller scale:

  • Big plans for expansions that did not work out.
  • Not funded by sufficient capital contributions from farmers.
  • Large-scale borrowing instead.
  • Ignoring the A2 milk revolution.

That last issue was for me, the crowning glory of Fonterra’s strategic stupidity, as it was for Westland, who by now could have been producing more than 50 million kg A2 Milksolids per year. The a2 Milk Company is making a profit well in excess of $300 million from about 20 million kg A2 per year.

Now that’s value-added thinking.

Fonterra’s share price has recovered somewhat, to $4.02 as of today. But while that might mean that its new strategy is working its far too early to say, given all those overhanging problems from the past – and it also has the best global dairy prices seen in a decade. We went through this in 2013/14 with $8.40/kg payout, during which some moronic corporate dairy conversions ran their business model on $8/kg payout well into the future – while their moron banks gave them the credit to do so, which leads to:

When Fonterra states its debt ratio it uses a formula of interest-paying debt divided by this same debt plus equity. What gets left out of the equation is some billions of liabilities to famers and trade creditors, which at any time total some billions. An alternative metric which I have never seen Fonterra use is net assets divided by total assets. That ratio at the end of 2017/18 was only 35 percent.  Conversely, total liabilities were 65 percent of total assets.

Fonterra may not use such metrics publicly but you can bet the banks and agencies that rate Fonterra’s risk do. Not to mention non-farm shareholders: the little guys have likely hung on but the institutional ones are gone for good. A possible silver lining here is that this may present an opportunity to re-visit the unique and strange mechanism that forces the farmer and non-farmer shares to have the same price.

The drop in share prices and other factors such as Orr’s ideas in the Reserve Bank, have led to increased pressure on farmers to reduce their debt levels, with capital re-payments in addition to monthly interest. Fonterra thus has to worry about the viability of those debtors as well as itself: yet another tough balancing act.

Fonterra may survive with its new strategy, but even if it does, for all the talk and the billions of dollars spent over two decades, it will be as something little more than what we had before Fonterra.

Addendum (because this story really needs more coverage)

Fonterra’s Company Culture is the heart of the problem:

A few months later, the Global Financial Crisis (GFC) had struck and I suspected that Fonterra might   be facing a liquidity crisis. I decided to do some analysis on Fonterra’s finances, using public documents. My calculations quickly showed that Fonterra was highly indebted, with inventories apparently overvalued, and almost certainly running up against its bank covenants.

Rather than putting the analyses into the public arena, on 23 December 2008 I sent my document to Fonterra’s Chair Henry van der Heyden, to Fonterra’s CEO Andrew Ferrier, and to Blue Read as Chair of the Shareholder Council. I asked them if they agreed with what I was seeing.

Within 24 hours, Henry van der Heyden came back to me and said that I must come up to Auckland to talk to their financial team. That meeting happened in the first few days of 2009. I spent a day with CFO Guy Cowan, who called in various other people to assist with information. Andrew Ferrier rang in several times during the day to see how we were going.

Guy Cowan was very frank. Yes, Fonterra was in a cash crisis. Later I learned that they had been at risk of not being able to pay farmers the previous month. The details are a story for another time.

If I’d known that story at the time or soon after I’d have bailed as soon as the shares became tradable in 2013 rather than even waiting until 2017.

Written by Tom Hunter

January 1, 2020 at 6:00 pm

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