Keith Woodford explains how Fonterra is embracing A2 because it lacks alternative options

By Keith Woodford*

It is now more than a month since Fonterra and The a2 Milk Company (A2M) announced that they are going to work together. After the initial shock, and with Malcolm Bell, National Market Manager from New Zealand-dominant dairy-semen provider LIC describing it as “the biggest announcement to come out of Fonterra since its formation”, there is a need for some analysis as to what it is going to mean.

From the perspective of A2M, there is a simple answer. It will provide a supply base of milk free of A1 beta-casein that A2M desperately needs for the coming years of growth.

For Fonterra, the issues are far more complex. Why have they made a U-turn after 17 years of condescending denigration of the A2 concept? And why is Fonterra doing it as a joint venture rather than striking out on its own?

The reason that Fonterra has made the U-turn is that it has come to a conclusion that it could not afford the risk of further delay. Someone influential in the company will have looked out five years or so ahead and, particularly in relation to the all-important Asian markets, will have said ‘we have no option; we have to get on-board now, or we are going to be left irrevocably behind’. 

Someone else from Fonterra, with responsibility for stemming the leakage of Fonterra’s farmer suppliers to other companies back in New Zealand, will have said, ‘we need to provide an A2 option to our farmers or else more farmers will transfer their supply away from Fonterra’.

Someone else in the China part of Fonterra’s business will then have said, ‘this is a way we can differentiate and get a premium for our Chinese-produced Fonterra milk, which currently sells at commodity prices below our cost of production’.

Getting all of Fonterra’s supply across to A2 is going to take well over ten years. But New Zealand has many large-scale dairy farmers - both genuine corporate and family corporate - with multiple herds. These multiple herd owners can re-organise their herds very quickly so that about half of the corporate herds can supply pure A2 milk. 

In theory, these large-scale producers have the capacity to produce some billions of litres of A2 milk within as little as two years. In practice, it won’t happen that quickly, but it is easy to see potential for several hundred million litres of A2 milk becoming available in that time period, and then rapidly expanding up from there to say four billion litres (or more) within five years.

For the smaller farmers, very few of them will achieve pure A2 herds within those five years and many will struggle to get there in ten years.  And this will be a source of tension that leads to a running sore within the co-operative.

 The decision of Fonterra to go with a joint venture rather than developing its own A2 brands is linked to the failure of the Beingmate project. The combination of Beingmate with its distribution systems and Fonterra with its international brands was supposed to be a ‘game changer’ to quote Fonterra CEO Theo Spierings. But alas, the Beingmate distribution systems related to the old world of China rather than the new and were loaded with inefficiencies.

Equally important, Fonterra’s so-called premium brands are not perceived as being lead brands by the Chinese or indeed most other people around the world. So rightly or wrongly, Fonterra has decided it needs to use the ‘a2 brand’ to sell dairy products that are free of A1 beta-casein.

If we really want to understand the brand issues facing Fonterra, we have to go right back to January 2007 when Fonterra Brands chief Sanjay Khosla departed for the more promising territory of Kraft Foods. Essentially, Fonterra at that time decided it was going to be an advanced ingredients company rather than a direct competitor of the brand leaders such as Nestle and Danone.

It was never said publicly, but at that time those involved in determining Fonterra’s strategy decided that New Zealand was ‘50 years too late to take on the big brands’. Yes, those words were indeed used in private. That private conclusion was based on judgements that Fonterra had neither the skill set nor the culture nor deep enough pockets for what would have been needed.

However, what Fonterra did not factor correctly at that time were the obvious emerging markets of Asia in general and China in particular, together with the associated disruptive opportunities. Thereafter, through an ongoing series if mis-steps, Fonterra has never found the value-add pathway to bring the brands that it does have to become front-of-mind for most Asian consumers. 

So, once again Fonterra has decided – although it will never admit it in public – that it has neither the skill set nor the culture nor deep enough pockets to now strike out on its own with products free of A1 beta-casein. And that is why it is partnering up with A2M which has a first-mover brand-dominant position.

Let there be no doubt that there are no legal constraints preventing Fonterra or other companies from developing their own brands of dairy products that are free of A1 beta-casein.  In Fonterra’s case, it even held a 50 percent share of the original patent (now expired) for producing milk free of A1 beta-casein. A2M subsequently obtained its share of that patent through purchasing the other 50 percent share owned by the New Zealand Child Health Foundation.

Events have now played out such that A2M has developed a market value of more than $NZ10 billion and is New Zealand’s largest company. This is not just New Zealand’s biggest dairy company by value (yes, it does now rank above Fonterra on that measure), but also for every other type of New Zealand company. 

It is indeed unfortunate for New Zealand that most A2M shares are now held by Australian and other overseas institutions. Once again, as a nation, and with our production-focused mindset, we did not see the value that others saw and let it slip away. We have only ourselves to blame.

The details of the joint venture arrangement between Fonterra and A2M are not in the public domain. But it is notable that immediately following the announcement, the A2M shares soared whereas those of Fonterra stayed becalmed and have since drifted back. So that tells us what the investor market thinks as to where the benefits will lie.

There is a number of logistical challenges that Fonterra will have to face in putting together the necessary pools of A2 milk. All other things being equal, Fonterra will prefer North Island rather than South Island supplies, as that will better fit the desired processing configurations. Fonterra will also be wanting a Victorian supply in Australia. But all things are not equal in terms of potential availability of supply. Much of the potential supply will be in the South Island.

So, one of the big questions is whether Fonterra will initially offer premiums across New Zealand or just in some regions. That decision too has potential to become a running sore within the co-operative.

Fonterra is not alone in deciding recently to ‘go A2’. In Australia, ASX-listed firm Freedom Foods, which has access to some of Australia’s largest dairy herds, has stated recently that it plans to market A2 products under its own brand. Freedom Foods has been working towards this for quite some time. There are other companies in various countries who are also making plans but at this stage largely working below the radar.

Disclosure of Interest: Keith consults internationally for a range of dairy companies that hold a range of stances in relation to A2 Milk.

*Keith Woodford is an independent consultant who holds honorary positions as Professor of Agri-Food Systems at Lincoln University and Senior Research Fellow at the Contemporary China Research Centre at Victoria University.  His articles are archived at http://keithwoodford.wordpress.com. You can contact him directly here.