Allan Barber reviews our primary sector's structural evolution and finds that strategy, governance and operating performance have resulted in fit-for-purpose arrangements

By Allan Barber

Fonterra’s half yearly result, while disappointing, underlines the importance of maintaining a solid operating performance and at the same time being cautious with milk price forecasts.

Fonterra is in no danger of falling into the hands of an overseas buyer.

This is in stark contrast the vulnerability of Australian cooperative Murray Goulburn which, subject to ACCC and FIRB regulatory approval, will be sold to Canadian dairy company Saputo. For a New Zealand comparison, we only have to go back to last year’s sale of 50% of Silver Fern Farms to Shanghai Maling. Both these overseas sales are as a direct result of poor financial performance and a stressed balance sheet.

According to accepted management theory strategy should always come before structure, but New Zealand’s primary industry sectors may not have always followed the recommended path. In most cases they have evolved over many years to meet the needs, not necessarily of their customers, but more likely their suppliers.

There are essentially two options: the first and most obvious business structure is a cooperative where suppliers come together to ensure their production has critical mass for processing, distribution and marketing purposes. The alternative to a farmer owned cooperative is an investor owned company which pays a competitive price for the suppliers’ output and takes the downstream marketing risk.

A substantial percentage of farmers, dairy, meat and horticulture, prefer the implied security of belonging to a cooperative which, in theory and usually in practice, results in their receiving a ‘fair’ price for their produce. The ability of the cooperative to continue paying suppliers a competitive price depends entirely on consistently profitable financial performance, obtained from good strategic decisions, efficiently maintained assets and excellent operational and marketing performance. If any one of these falls off the pace, competitive capability is compromised.

The first dairy cooperative started in Otago in 1871 and this has remained the dominant dairy industry structure ever since, although the last 10 years have seen the start-up of several privately owned companies. Since its formation in 2003 when it enjoyed over 90% of milk processing, Fonterra’s share has steadily fallen to nearer 80%, while still being required under DIRA regulations to supply its newer competitors with milk for processing, thus ensuring free competitive entry.

The meat industry was always less committed to the cooperative structure because livestock, unlike milk, does not require daily collection. Auckland Farmers Freezing Company (now AFFCO) was formed by Waikato based farmers in 1904 to process all species of livestock, although it didn’t become a cooperative until the 1970s. Alliance and PPCS, now Silver Fern Farms, were established after the second world war. Today Alliance is the only remaining true cooperative, although SFF is still 50% owned by its suppliers; AFFCO’s farmer shareholders had lost all their equity by the early 1990s and the company was rescued by its bankers before listing on the NZX and eventually passing into the private ownership of Talley’s Group.

Kiwifruit has arguably seen the most successful implementation of a grower controlled export marketing structure with the establishment of Zespri which effectively functions as a cooperative, while post- harvest pack houses and coolstores are split between cooperatives and private ownership.

Whether the primary sector’s structural evolution has occurred as a result of a conscious strategy is doubtful. However, this process has produced an industry structure which, in each sector, appears to suit its participants or at least provide the one they deserve. What is less certain is whether, in every case, the structure best satisfies consumer needs or generates the best returns for supplier and business.

Investment further up the value chain, either domestic or international, has been comparatively rare because of the cost and risk of doing so. More often than not it has been farmer owned entities which have been large enough to make the leap, although a number of investor owned dairy companies – A2, Synlait, Open Country and others - have more recently joined the race. Fonterra has invested heavily and as yet unsuccessfully in trying to control the value chain for infant formula in China, but mostly the investment is the other way round, with Chinese capital boosting the size and scope of New Zealand companies wishing to expand or survive. Synlait and SFF are two prime examples of this trend.

Fonterra is New Zealand’s only example of a major international company with an industry leading share of global trade which places it in a unique and not always comfortable position. Its 100% farmer ownership is both a strength and a weakness: on one hand it has committed supply contracts which guarantee its annual throughput, although shareholders are free to transfer to another processor at the end of each season; on the other hand, it is constrained from attracting outside ownership for the consumer products part of its business which could benefit from more investment than is compatible with its cooperative status.

New Zealand’s position as an exporter of the greater percentage of its produce makes it vulnerable to being exploited by its overseas customers. It is impossible to control the value chain without investment or successful partnerships which, as Fonterra’s experience with San Lu and Beingmate shows, are very hard to achieve.

There is no right or wrong ownership structure, but only good governance, strategy and operating performance.

This article first appeared in Farmers Weekly. It is here with permission.