Fonterra has stabilised its finances with more asset sales forthcoming. It now operates a conservative model supported by its farmer members. But the model will not create the ‘national champion’ that the Labour Government has always hoped for

Fonterra’s annual results announced on 18 September for the year ending 31 July 2020 indicate that Fonterra has made good progress in stabilising its financial position. A key outcome is a reduction in interest-bearing debt by $1.1 billion, now down to $4.7 billion. This has been brought about through asset sales and retained profits.

Chief Financial Officer Marc Rivers told a media conference immediately after release of the results that further debt reductions were desired.  The key measure that Fonterra is now using for debt is the multiple of debt to EBITDA, which now stands at 3.4. The desired level in the newly conservative Fonterra is between 2.5 and 3.

It is the perceived need to pay down debt that has caused the dividend – the first for 2.5 years – to be limited to 5c per share. This will be tax assessable in the hands of farmers and unit holders. The cost to Fonterra is about $80 million.

Fonterra has now reduced its stake in Beingmate from 18.8% to 9%. It expects to sell the remaining shares during the coming year. Based on the current market price of 7.4 yuan, then this would bring in about $NZ150 million   However, the rules of the Shenzhen exchange say that Fonterra can only dribble these on to the market, so Fonterra’s members and unit holders will have to be patient.

Beingmate’s shares are now about 35% higher than a year ago but still well less than half the price of 18 yuan per share that Fonterra paid back in 2015.

Fonterra’s China Farms are still on the market and the value was marked down a further $63 million earlier in the year. It seems that these farms are now performing better than in recent years but operational matters remain challenging.  Livestock numbers decreased by 10% (6600 animals) during the year, which seems to be part of an untold story.

Fonterra has referred on occasions to ‘animal husbandry’ matters on these farms but has never been explicit that this is a euphemism for ‘animal health’.  Nor has it been explicit as to the key health condition which has affected both animals and staff to whom it transferred. Other Chinese dairy farms have had similar problems, largely kept away from the media.

The overall Chinese dairy industry is in expansion mode again, and this is illustrated by the substantial imports of live animals over the last year. In this environment, it might seem surprising that no-one has put up their hand to buy the Fonterra farms.

Fonterra’s other big business that is on the market is the Fonterra interest in DPA Brazil. That business appears to have improved somewhat over the last year, so perhaps that is a promising sign for a sale.

Fonterra’s two remaining big overseas businesses are in Chile and Australia. Their long-term role in the new Fonterra must surely be a matter of interest and conjecture.

Chile has been very hard hit over the last 12 months, first from civil unrest that erupted last October. I was there at the time, and the fires still burning across Santiago as we finally flew out were disturbing. The unrest has been tragic for a country that had made huge progress under 30 years of democracy.

Chile, like most of South America has also been very hard hit by COVID-19. It would not be surprising if Fonterra decided this was not a good time to sell, as buyers will be scarce.

The situation in Australia is similarly intriguing but for other reasons. Australia’s milk production is now on the rebound as Australia itself rebounds from drought. However, Fonterra’s own milk supply is not increasing and appears to even be drifting downwards.

CEO Miles Hurrell was asked about Australia at the media conference and he replied that they were ‘very comfortable’ with the milk supply situation. That suggests that the current declining market share is planned rather than unplanned. Fonterra has acknowledged that it is no longer purchasing milk from third parties on account of the difficulty of marketing that milk profitably. This situation contrasts with last year when Fonterra was desperately trying to purchase milk during the drought.

I cannot find any mention in the annual report as to whether active consideration was given to the value of Fonterra’s Australian assets. My own suspicion is that if these assets were offered for sale they would not sell for the current values in Fonterra’s books. Over the last year, when Fonterra’s directors have been asked by farmers about Australian values, they have used the 2017 sale price for Murray Goulburn as justification. However, Australia’s dairy industry is now very different to 2017.

Looking forward, my expectation is that Fonterra has ongoing prospects in relation to food service, with this depending very much on what happens in China. Food service is essentially ingredients which is Fonterra’s traditional strength.

In contrast, I see nothing very exciting happening in relation to consumer-branded goods. When history looks back over the last 19 years since Fonterra’s formation, it will record a zig-zag journey for Fonterra’s branded products, with Fonterra getting left behind while others marched forward. 

The current strategic directions of Fonterra are focused on maximising milk returns to farmers. This is exactly what most farmers want, given farmers’ concerns about the financial stability of their own businesses. Most farmers would like to lower their debts.  Accordingly, they don’t want Fonterra heading off into entrepreneurial endeavours.

This conservative philosophy is now firmly embedded within the Board. The strategic flip from entrepreneurial endeavours to conservatism occurred two years ago as a direct consequence of Fonterra’s dismal record overseas as it tried to move further along the value chain, particularly under the leadership of CEO Theo Spierings and Chair John Wilson.   The ‘management-speak’ within Fonterra acknowledges that the Spierings and Wilson-led team ‘over-reached’, although some of the danger signs were already looming well before that leadership team took over.

In this last year, Fonterra’s new capital spend was only $419 million and a similar spend is planned for the coming year. That may sound a lot when looked at in isolation, but it is puny in relation to Fonterra’s overall size. One of the rules of business is that if you don’t spend enough on new capital projects, then eventually you go backwards.

A further indication of Fonterra’s strategic mindset is that it is removing the payment incentives to reduce peak production in the spring relative to total production. Fonterra’s argument is that it has enough processing plant in place and the spring peak is no longer forcing it to invest in more plant.

The unstated corollary to this is that removing the spring-capacity adjustment removes already small incentives for farmers to produce a flatter seasonal production curve that aligns more with consumer demand. It reinforces the evidence that Fonterra’s focus is towards commodities and ingredients with long shelf life. To a large extent that means China.

Given the total mess that Fonterra made of its attempts to move closer to overseas consumers, it is hard to argue against much of what is now happening. However, the outstanding omission to face the future is the failure to engage meaningfully with the A2 issue.

Back in early 2018, Fonterra and the A2 Milk Company (ATM) announced that they would in future work together. It was an exciting announcement. However, the reality is that Fonterra signed a very bad agreement with ATM, which effectively took Fonterra out of the market as ATM’s potentially biggest competitor.  

Nearly every major international competitor now has an A2 project. Given that New Zealand’s A2 status is superior to almost all other countries, Fonterra could have been and probably still could be the prime source of A2 ingredients. The key A2 patents have long since gone. It is now all about a ‘business to business’ ingredients brand and ability to supply.

I sometimes reflect back to a discussion with a Fonterra director back in 2008 where that director, with a smile on his face, told me that Fonterra could ‘take out’ ATM whenever it wished. At the time ATM had a capital value of less than $50 million.  It now stands at over $13 billion, more than twice the capital value of Fonterra.  

*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. His articles are archived at http://keithwoodford.wordpress.com. You can contact him directly here.