Edition 192: Friday April 20th, 2007.

The Farmingshow Straggle Muster

Dairy Industry At Crossroads

Business Commentator Rod Oram offers his thoughts on Fonterra, its structure, its future and AFFCO's entry into the dairy industry. View his Sunday Star-Times article by clicking here. A full transcript of his chat with Jamie Mackay follows:

JM: Business commentator Rod Oram writes, "Two events in recent weeks, neatly encapsulate the big strategic choice facing the NZ Dairy Industry. Should it remain an export business or become a global business. The first it's traditional model relies on shipping products from here, but its viability has weakened by the day. Some other countries are rapidly becoming cost effective competitors in the scramble to meet the rising demand for milk products. The second, its new model relies on deploying New Zealand technology, management skills and capital around the world to make the most of those exciting market opportunities." Rod Oram, do you think Fonterra is heading down the second track?

RO: Yes it is, very clearly and it's made really good progress since it was formed from the great merger of Dairy group, Kiwi and the Dairy Board, but there's still a long way for it to go and there's some really big challenges in that.

The most pressing one in many respects is that the whole nature of competition for dairy companies is changing overseas, as are consumer habits. So, on the competition side there is growing competition from farmers and dairy processors in second world or even, in a few cases, third world countries that are becoming quite effective producers and processors of milk.

One of the best examples of that is what's going on in Uruguay, where there is a very good processor in the form of Conaprole, which in recent years has done very well getting into overseas markets like the US. All the costs of production are far lower in Uruguay, in particular the land costs, and we are seeing New Zealand farmers investing through the new Craig Norgate vehicle that's raised money on the Stock Market for New Zealand Farmers Systems Uruguay, as a way of investing in that. That's the big change on the competitive side.

Then, on the consumer side, we're starting to see consumers change their pattern a bit.

In the past they would come into dairy if they were new to dairy foods, typically at lower level products like milk powders or perhaps UHT milk. Now there seems to be a growing trend to come into dairy higher up. They're coming straight into liquid milk, fresh liquid milk or yoghurts or dairy desserts, which is good news as those are more expensive products.

The result of that is you need to get more dairy processing happening right in markets rather than being able to do the big long distance things you can do with milk powder. So, you bring all these factors together and you find Fonterra being very effective in global dairy commodity markets because it has control over quite a large share of the supply of those markets, therefore it can't manipulate those markets but it can exercise some discipline over those markets; that being one of the contributors to the very nicely rising price of milk powders on global markets.

JM: You point out that one of the challenges facing Fonterra is the fact that it painstakingly has to convince thousands of farmers of the wisdom of its strategy. Has it got the wrong ownership strategy? Has it got the wrong structure being a corporative?

RO: No, I don't think that being a corporative is necessarily a handicap but it does require a much higher level of communications than a shareholder, stock market-listed company would need to do with its financial investors.

But there's good in that also, because where a co-op can work very closely with those farmer shareholders and not just keep them very well in tune as to the overall strategy but to help drive, quality, productivity, new innovations in product mix or what ever through the supply the chain at that front end of the supply chain up on the farm, that works very well. But that requires a huge amount of work and commitment to keep those communications flowing well and I don't think, so far, Fonterra's really being articulating very well this crucial shift in the company.

Pre Fonterra's conception, the nature of the New Zealand industry was essentially still an export one that was just taking product from here and getting it out to market. Now, it is increasingly being a truly global business with operations not just processing milk but sourcing milk elsewhere in the world. That's a really big change in strategy and Fonterra needs to be able to articulate that very well to farmers here in NZ so they can understand what their role is in that global model.

JM: Has Fonterra done a very good job of explaining this value added portion of the payout? I'm confused by it and I'm sure some dairy farmers are as well.

RO: They haven't done a good job on that and they didn't help at the end of last season when they said they were coming up with something of a change in methodology.

So what we are now seeing in this season's payment will be a significantly higher value added payout which will, in part, reflect improvement in that part of the business but will also partly reflect that change in methodology. I think it's going to be about 45 cents out of the payout and a large part of that value added payment come from these overseas activities and overseas operations and they also have been contributing very significantly to the increase in the Fonterra share price. Because that share price is worked out every year, the value of those overseas operations is built in to that calculation as to what the share price is worth.

This then presents farmers with a big problem. Here in New Zealand, if you want to increase supply you've got to buy more shares in the co-op but those shares are getting ever more expensive and yet the payout is not rising equally as fast. So the capital is getting more expensive along with land and other things but the payout is not rising fast enough.

So Fonterra has got to do, it seems to me, three really big things:

First of all, it's to grow that value added portion of payout far faster. Secondly, articulate that strategy and the nature of that payout being much better for farmers. But thirdly, and this is far more challenging, it's got to reassure farmers of what their role is in this new global business.

Because if, as I believe is the case, over time other commodity producers will be producing milk more cheaply to supply to Fonterra than Fonterra's farmer/shareholders can do here in New Zealand because we've got higher land prices and other inputs, high share prices, you name it, it seems increasingly less obvious how those farmers will make money out of this.

It seems to me that Fonterra has to find a new role for those farmers, rather than just a supplier of largely commodity milk.

Now I don't know what that strategy is, but it seems to be milk that is much more customised in various ways. You wouldn't be just throwing it all in the same tanker or running it all through the same dryer. It will be much more customised to try to generate a much bigger return for that milk than is happening at the moment. I keep raising this really central issue with them, but I'm not getting any response from them.

JM: Can I finish with the comment you made about Affco entering the dairying industry. You said that's bad news for the dairy industry because meat processors, Affco included, are irresponsible commodity players. At home, they compete fiercely for supply often screwing farmers in the process. They have no idea how to build brands and markets. That's exactly what Fonterra is trying to do overseas. So do you think the entry of Affco into the dairy industry will undercut it?

RO: Potentially yes it will, because Affco with its plans for processing plants around the country will be a very, very low cost processor because it won't have any of those extra overheads that Fonterra has from trying to build the global business.

So, it will be able to undercut Fonterra on price, in terms of what it is prepared to pay farmers to get milk supply for them. And that will work for a while and if Affco is only five, six or seven percent of the milk processed in the country that's kind of inevitable and not that serious of problem. Especially with commodity prices high internationally, Affco won't have that much difficulty selling powder overseas.

But that's a very short term strategy because again in this view of the world where there's growing competition from far cheaper places to farm than New Zealand, then that Affco model won't hold up very long and it will only be a short term play which will be undermining that bigger need to build a truly global dairy industry rather than one that just survives on exporting some powder out of NZ when the times are good.

Rod Oram has over 30 years' experience as an international financial journalist. He has worked in Europe and North America for leading publications such as the Financial Times of London and travelled extensively in those continents and in Asia. Rod and his family emigrated from the UK to New Zealand in 1997. Read Rod's weekly thoughts by clicking here for the Sunday Star-Times.

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