Simplicity is genius, or so the saying goes. It’s certainly something Miles Hurrell will be mulling over in the winter months ahead, as he begins to find his feet as the new chief executive of Fonterra.
Appointed in August, Hurrell’s first duty as Fonterra CEO has been to explain the company’s dismal financial performance for its 2017/18 financial year to the end of July, where the farmer-owned dairy co-op racked up net losses of NZ$196m.
The language used by Hurrell in the financial results presentation was telling. Fonterra needs to get back to getting the basics right and set more realistic forecasts – Hurrell plans to simplify the business.
In truth, this is the correct strategy. Much of the recent problems in Fonterra has been the added complexity that’s been built into the business over recent years.
Fonterra is a monopoly processor that at its height collect 96% of all the milk in New Zealand
According to New Zealand industry sources, Fonterra had grown too complex and bloated over the last number of years under the leadership of former CEO Theo Spierings, a Dutch native who joined from Friesland Campina and spent eight years at Fonterra.
When we look at the history of the Fonterra business we can see why. Established in 2001 under the Dairy Industry Restructuring Act (DIRA), Fonterra is a monopoly processor that at its height collect 96% of all the milk in New Zealand. It collects just over 80% of New Zealand milk today.
The Fonterra business model from the start was always focused on being the most efficient processor of milk on the planet, thereby enabling NZ farmers to compete in the global dairy market.
Weapon of choice
To do this, Fonterra chose whole milk powder (WMP) as its weapon of choice.
The co-op focussed its efforts on drying milk into WMP in an incredibly efficient and cost-effective manner, quickly earning New Zealand the nickname in global dairy markets as WMP Inc.
A simple business model, but it worked.
Fonterra’s low-cost ultra-efficient processing model has served Kiwi farmers well
Through Fonterra’s scale and efficiency, New Zealand dairy quickly eked out massive market shares in global dairy markets, particularly for basic dairy commodities and milk powders.
In 2017, New Zealand shipped more than 1.3m tonnes of WMP on to world markets, giving it a near-70% share of the 2.1m tonne global market for WMP.
New Zealand also accounts for over 50% of global butter trade, shipping just under 0.5m tonnes of butter last year.
The island country is also a significant exporter of cheddar cheese (345,000t) and skimmed milk powder (401,000t) to world markets. But WMP remains the core business.
Fonterra’s low-cost ultra-efficient processing model has served Kiwi farmers well in the main. The average farmgate milk price in New Zealand since the creation of Fonterra has been far superior to what farmers were paid before the consolidation.
However, in recent years, as milk quotas have ended in Europe and US exporters seeks to gain a greater foothold in world markets, dairy commodity prices have become increasingly volatile due to supply spikes, which is difficult for New Zealand farmers exposed to the full force of global markets. Irish farmers have some experience of this in recent years.
In an attempt to tackle this, Fonterra, under Spierings’ leadership, sought to move further up the dairy value chain and into more added-value ingredients, such as infant formula powders.
However, this strategy has proved difficult for Fonterra and has not translated into milk prices.
If we take Fonterra’s milk price for the 2017/18 season just gone, the composition of the milk price is still heavily weighted towards basic commodities.
As can be seen in Figure 1, almost two-thirds (64%) of Fonterra’s farmgate milk price is weighted towards WMP, while SMP accounts for 20% and butter a further 9%.
The move towards more value-added dairy ingredients hasn’t translated into the milk price for Fonterra suppliers.
On top of this, the co-op has had some serious setbacks, most notably the 2008 melamine scandal in China, as well as the false botulism alarm in product sold to Danone in 2013.
The fallout from the false botulism came to a head earlier this year when an arbitration court in Singapore ordered Fonterra to pay €106m to Danone in compensation for the food scare.
This compensation payment to Danone was one of the reasons Fonterra reported such a hefty loss for its 2017/18 financial year.
The loss was also caused by the NZ$405m (€230m) write-down of the value of the co-op's investment in an 18% shareholding in Beingmate, the Chinese infant formula company.
Beingmate has been consistently losing market share in the €30bn Chinese infant formula market over recent years as Chinese consumers opt for European product.
The different aspects of Fonterra’s business were not singing off the same hymn sheet
Aside from these exceptional setbacks, the strategy to move further up the dairy value chain has added significant complexity to Fonterra’s business model that the co-op has struggled to make work on a practical day-to-day level.
At Kerry Group, the “1 Kerry” strategy implemented under Stan McCarthy’s time as CEO was seen as a major step for the global business that connected all aspects of a broad and diverse company under one connected system.
This is something Fonterra failed to do and many arms of its business operated completely independently to other aspects of the co-op that would have some shared overlap.
Put simply, the different aspects of Fonterra’s business were not singing off the same hymn sheet.
However, all is far from lost at the world’s largest dairy exporter.
While the challenges are many, the soundings from New Zealand in recent weeks are that Hurrell is the right choice for the co-op and already the internal workings of the company feel much more open.
Perhaps the most immediate tasks facing Hurrell will be regaining the trust of the co-op’s farmer suppliers and reducing the co-op's debt position.
Announcing the financial results for 2017/18, Hurrell made specific reference for the need for Fonterra to regain some financial discipline within the business once again.
The collapse in profits this year, which more than halved (-51%) even excluding the exceptional items to NZ$382 (€215m), leaves Fonterra very highly leveraged, with a debt to earnings ratio of 4.5 times based on borrowings of NZ$6.2bn (€3.5bn).
Reducing this significant debt will be a priority.
The co-op also needs to improve its messaging to farmer suppliers around milk prices and forecasts.
Hurrell has set out his stall that, moving forward, the co-op will set out much more realistic milk price forecasts for the season ahead, which will give farmers the confidence to invest in their business and plan for the year.
What is certain is that Fonterra will be an interesting business to watch over the next one to two years to see if Hurrell can get the dairy giant back to basics and back on track.