Keith Woodford wants Fonterra to get rid of the spin, communicate with its shareholders and other stakeholders with transparency, through good times and bad

By Keith Woodford*

Within the coming week, Fonterra will release its six-month accounts. There should be plenty of good news there, including profit guidance for the whole year of more than $800 million. The key issue is how will Fonterra spin that story?

Drivers of profit

The key reason profit will be strong this year is that milk powders have low value. The investor market has taken some time to understand this inverse relationship between milk-powder prices and profit. This relationship exists because the farm-gate price of milk, which farmers get paid, is a cost to Fonterra itself. But milk powder is just part of the story. 

Owing to quirks in the way that the milk price is calculated, using five so-called reference products, the profit will also be raised because commodity cheese – which is not a reference product – has been more profitable than the reference products.

The latest figures I have seen indicate that Fonterra is producing about 18% more cheese this year than last. The net earnings from commodity cheese, relative to the alternative of producing milk powders (whole and skim) and/or butter plus anhydrous milk fat, will go to profit.

Sorting out the components

Analysts need information on at least eight profit streams if they are to interpret the true meaning of the headline figure.

The first of these is the earnings from toll processing of milk into the five reference products. These earnings are calculated from formulae that assume Fonterra is an efficient processor, and include both assumed operating costs plus assumed cost of capital. I expect these payments will amount this year to about $2.8 billion, from which Fonterra will have to deduct its actual processing costs.

The second earning streams will be from commodity sales of cheese and other commodities, outside of the five reference products, minus the value of the milk therein if it had been used for reference commodity products.

This net figure for non-reference commodities can be either positive or negative. In 2013/14 it was negative and this is why Fonterra had to underpay farmers in relation to the calculated milk price; otherwise they would have had a cash flow problem. But this year it will be strongly positive.

The third profit stream is from New Zealand consumer operations. This should be positive, given that it comes from selling consumer products to New Zealanders in an environment where there is little competition. Fonterra never separates out these returns for outside scrutiny.

The fourth income stream is from Australia and this has been negative in recent years. This is because Fonterra has been uncompetitive in Australia relative to competitors. To get supply, it has had to purchase milk from its Australian farmers at considerably higher prices than are paid to New Zealand farmers.

This year, Fonterra has exited from its Australian yoghurt and custards business. It still sells milk to Woolworths at what can only be a low margin. This milk then sells for AUD $1 per litre as Woolworths’ house brand. The upside of the Woolworths contract is the quid pro quo that Fonterra’s ‘Mainland’ cheese is now back on the Woolworths supermarket shelves.

The fifth stream is specialist ingredients for specific clients. These ingredients earn a margin over basic commodity products.

The sixth stream is food-service products. Essentially these are ingredients which go to manufacturers of final consumer goods. In all likelihood, this is one of Fonterra’s goldmines. The boundary between this stream and the ingredients stream can be opaque. 

The seventh stream is Fonterra’s own consumer products sold outside New Zealand and Australia. The key brands are Anchor and Anmum, although not all Anchor products are from Fonterra. This is because Fonterra sold off some of the brand rights some years back. This stream also includes products sold by Fonterra’s subsidiary companies such as Soprole in Chile.

The eighth stream is Fonterra’s farm operations in China. Last year they made a net loss prior to any deductions for interest of $44 million. Where are those numbers going this year?

And then there are two big cash costs to take account of. The first is corporate overheads – including salaries for the reportedly 1500 staff operating from Fonterra’s new Auckland headquarters. And then there is Fonterra’s cost of debt on about $7.5 billion. There is also a book cost for depreciation and any asset write-offs.

Sorting through the fog

In past years, I have never been able to separate out all of the above with any confidence. That simply illustrates that Fonterra’s annual reports are largely good news stories of spin and obfuscation. 

Of course Fonterra will claim that providing information on all of the above is commercially sensitive. Well, Fonterra’s competitors will be able to work out from their own numbers as to where Fonterra sits in the segments that are relevant to them. But the rest of us are largely left in the dark. Hence, no-one, except perhaps a few in senior management, gets the overall picture.

In relation to the company balance sheet, Fonterra always highlights their debt-to-debt-plus-equity ratio. The current spin is that it will come back to between 45% and 50% this year. But what is often lost in translation is that the only debt that is included here is debt that incurs interest.

Part of the reason that debt-to-debt-plus-equity will improve this year is that Fonterra has been moving its non-milk and service suppliers to 91-day payment terms. This delayed payment reduces the debt on which Fonterra pays interest and shifts an equivalent amount to liabilities which don’t incur debt. So yes, the so-called debt-to-debt-pus equity ratio will improve, but in part this is at the cost of their non-milk and service suppliers.

In the latest July 2015 accounts, Fonterra had total liabilities of $11.656 billion and net equity of $6.569 billion. I have never seen Fonterra refer to those two figures together.

In previous times, Fonterra has been able to get away with obfuscation. Fonterra used to earn huge respect from its sheer size, and farmers were generally happy with the returns they were receiving. But Fonterra has spent that goodwill.

Farmer disappointment

Most of the farmers I talk to remain fiercely loyal to co-operative principles but are deeply disappointed by Fonterra’s performance.

At the last AGM, a majority of shareholders voted for a reduction in the size of the Governance Board. Farmers tell me they voted this way, not because of fundamental belief that a small Board is necessarily better, but because they wanted to send a message of dissatisfaction.

Quite simply, the public relations spin has been found wanting on too many occasions and the fundamental trust has now gone.

Over the last few years, Fonterra has come up short too many times. First there was the San Lu investment debacle and the subsequent melamine scandal. Then there was the botulism scare. Then the wheels fell off the China farms operation. Somewhere along the line Fonterra missed the early opportunities to invest in UHT manufacture. They also missed, and are still missing, the A2 opportunities which are now turning into a threat.  And the price guidance to farmers over the last five years has been consistently woeful, with a failure to communicate the extent of uncertainties, and updates unnecessarily delayed. 

Community relations

In regard to the broader community, the delayed payments to non-milk and service suppliers have left many a sour taste. In essence, it has been bully-boy tactics. And more broadly, much of the nation has now turned against Fonterra and our largest export industry.

Back in 2014, following the release of reports on the botulism scare, there was a breath of fresh air with independent director Sir Ralph Norris recognising the fundamental flaws of corporate culture that needed to be addressed. In contrast, other leaders provided defensive spin about everything being under control. Well, in late 2015 Sir Ralph resigned, for whatever reasons, and the old PR machine seems to be back in control.

There are good things going on at Fonterra. Recent innovations include the mozzarella factory at Clandeboye and the sliced-cheese processing at Eltham. Fonterra tells us that they can now manufacture enough cheese for 300 million pizzas and 3 billion hamburgers. To me, those numbers look like PR spin, rather than solid figures like tonnes of cheese or kg of milksolids.

Getting rid of the spin

Within the last week, Fonterra’s chief of spin-doctoring and related matters has resigned. We can only surmise as to the ‘personal reasons’ that led to this outcome. But in reality it does not matter who is in charge of the spin-doctoring. Corporate culture is determined at the very top. 

So how can Fonterra address this?

A good starting point would be to cut out all the spin when the interim profit figure is announced next week. Just tell it as it is, with total transparency as to the good and the bad, the strengths and the weaknesses. 

Keith Woodford is Honorary Professor of Agri-Food Systems at Lincoln University. He combines this with project and consulting work in agri-food systems. His archived writings are available at http://keithwoodford.wordpress.com