David Hargreaves expresses reservations about Fonterra's efforts to turn itself around

By David Hargreaves

It's an unfortunate truism that whenever a company strikes problems and decides to undertake a 'review' then so the extent of the problems will turn out to be so much worse than first thought at the time the review is announced.

When you start digging, you dig up dirt.

This is what's appearing to be happening with giant dairy co-operative Fonterra, which commenced its own 'review' last year. In the run-up to last week's announcement of half-year results Fonterra had already signposted there would be no interim dividend paid.

And while the company's being clear at this stage it won't make any formal decisions on whether there will be full-year dividend until after the end of its July financial year, it seems apparent to me even at this stage that there won't be.

Not performing

While problems such as its troublesome investment in China's Beingmate have attracted a lot of attention, the half-year result painted a picture of a company just simply not performing well at a basic operational level. And you have to feel the extent of the malaise within the company is worse than it might have first appeared, and things will take some time to  turn around. And I don't think it is a given at all that the performance of the company CAN necessarily be turned around. The leadership is going to have to be very good from this point on.

In a way, Fonterra's getting a get out of jail free card with the way global milk prices have risen. Although this does, contrarily, put pressure on Fonterra's operating margins (because the price it pays for its milk is a key input cost), the rising global prices will see a higher 'farmgate milk price' paid to farmers - which should compensate for the absence of a dividend.

Therefore, a decision not to pay a dividend this year is likely to be much easier for the new chairman John Monaghan and new CEO Miles Hurrell to justify than it might be in a year of falling milk prices.

So, Monaghan, Hurrell and the team have effectively bought some time while they try to right the ship, starting with asset sales and a planned $800 million reduction in debt.

It's about more than getting into shape

But as I've indicated before, the Fonterra review will have to ultimately be about a lot more than just getting the finances back into shape.

FNZC managing director, head of institutional research, Arie Dekker has been an articulate and constructive critic of Fonterra in recent times and he put it nicely in a research note after the release of the Fonterra interim results, when he said that the company must be realistic about its capability and “DNA” through the review process, "having seen significant value destruction as it has invested away from its core business without the capital structure to necessarily withstand bumps along the way". 

In looking back through some of Fonterra's annual reports, I found this interesting passage from the 2014 report:

Post balance date we announced that we are establishing a global partnership with Beingmate, a leading infant food manufacturer in China and a longstanding customer. Our partnership represents a major step forward in terms of our strategy and will increase the volume and value of our ingredients and branded products exported to China. Together we will create a fully integrated global supply chain from the farmgate to China’s consumers, using Fonterra’s milk pools and manufacturing sites in New Zealand, Australia and Europe. This global, integrated supply chain will see more of our high-quality Anmum™ infant formula exported from here in New Zealand. It will see more highvalue infant formula products made in Australia for China at our Darnum plant – a second milk pool. And it includes a third milk pool in Europe, where ingredients will be manufactured at our new plant in the Netherlands in a joint venture with A-Ware, and through an alliance with Dairy Crest in the United Kingdom. We will ultimately work with Beingmate to evaluate mutual investments in dairy farms in China. 

Somehow, the nub of all Fonterra's current woes can be seen in those words. To read that passage in the cold light of 2019 is to realise the extent of the mistakes that Fonterra has made in terms of its approach and attempting to be a global dairy leader without the necessary capital behind it. And it is also to realise that Fonterra will now likely U-turn on much of what has been done in recent years. 

At this point I quote FNZC's Dekker again:  

"It is important [Fonterra] follows through on the intent to be open and transparent on unallocated costs and on investment requirements, and the outcomes expected from future meaningful investment. We think a lack of clarity and openness on that has contributed to the value destruction FSF has seen in the last five years. We also need to see FSF provide confidence on longer-term capital structure, to the extent that is required to address its sustainable competitive positioning for NZ milk."

Very sage words, I believe and I hope Fonterra has read that research report.

Effectively now what's being suggested from Fonterra is a kind of 'back to basics' approach, stripping back the overseas investments and focusing on maximising returns from New Zealand milk.

It sounds good, but...

The language around this new approach in the half-year results announcement was sufficiently vague to be, I think, fairly discouraging.

Comments like this one from Monaghan: "We believe there’s a premium to be earned from products backed by our co-operative heritage and provenance", sound good. But what's actually meant by that? And what is actually involved in achieving that?

As said further up this article, the rising global milk prices have probably bought the new Fonterra team some time. But not much.

Clearly the recently burgeoning debt levels at the company must be brought under some control first. 

But I think seriously tackling the company's need for access to fresh capital has to follow through very quickly as an urgent priority.

It's an issue Fonterra has avoided. As we can now more clearly see the company went ahead without a strong capital backstop and endeavoured to make itself a global player.

No assumptions

Stripping the company back now makes sense. 

I don't think, however, that we can assume that the world will just come running for our 'heritage and provenance' milk without some genuine innovation and brand development applied. 

Once Fonterra has sorted out its financial situation now, it will have to come up with a real plan to promote and market its products. And that is going to require capital.

Until it finds a solution to the capital conundrum I don't think Fonterra can assume a safe future. Developments such as the looming takeover of Westland Milk by China's largest dairy producer Yili show that the world is moving quickly. 

By the end of this financial year Fonterra does need to be laying out some firm plans for how it will be re-establishing itself. A convincing strategy needs to be forthcoming. Based on what I could see from the half-year presentation I'm far from certain we are going to see that.