The eight processors featured in our milk mrice review account for around 85% of Ireland’s milk pool of 7bn litres. Combined, they are making operating profits of around €100m each year over the last five years, or 1.7c/l. This demonstrates how thin dairy processing margins really are.

What we have seen over the last five years is that there is huge variation between processors in terms of milk price and profitability. On average, profitability has ranged from 4c/l (Carbery) down to 1c/l and below (Aurivo, Arrabawn and Tipperary) over the five years. This represents a 3c gap between the highest and lowest over this period. On 7bn litres this gap amounts to a loss of €200m per year, or €1bn over five years. This is significant.

Glanbia’s Belview factory, which processes some 500m litres of milk per year and is seen as one of the most efficient in the country, cost €180m to build.

So if each processor is receiving the same raw ingredient from farmers why is there such a difference in processor profitability and milk price?

Despite farmers ultimately owning these businesses, it is difficult to get behind the numbers. This is partly due to the complexity of the product mix, coupled with little visibility around the performance of each product stream in a given year. Obviously if it is not in the milk price it must be left in the profits, or in reinvestment back into the business. And if these are not present, the returns aren’t being made from the market.

At year-end, outstanding debt across these eight processors was just over €0.5bn (or 8c/l on every litre processed). This ranged from 11c/l in the case of Glanbia, down to 1c/l in the case of Aurivo. Firstly, it is important to look at what this debt is for.

Is it for new investments to future-proof the business, either to process more milk or add value to it? Both are important given the 40% increase in supply over the last five years. But a high net debt is not necessarily a bad thing, once it is for productive assets and can be serviced through good cash generation. On average across these processors, net debt levels are running at twice the earnings. This is not bad considering over €1bn has been invested in the last five years alone (and a substantial sum more if we go back a few years earlier to the preparation for quotas lifting).

On average it is serviceable. Where it becomes a problem is when processors over-invest, leveraging the balance sheet too much and then run out of steam to generate the cash to pay a solid milk price.

Processors will argue that the investments made have allowed them to process the wave of milk that has been coming at them. No doubt it has. They will also argue that a home was found for all that dairy product in the market place. This is also true.

The reality here is that as long as there is a collection of processors building empires around relatively small milk pools, the milk price paid to farmers will be reduced over the long term.

There are a number of reasons to believe this. This is a capital-intensive business, so investments and milk prices must be looked at over the long term.

We can look to individual processors and see where the milk price is coming from – for example in the case of West Cork Co-op and Carbery, it is reaping the benefits of investments made in ingredients and flavours outside of primary processing and returning these – the result of a solid strategy.

The same could be argued for the Glanbia model, however in this case the farmer gets a fraction of the higher-margin business profits as it is paid back as a dividend (the co-op owns 31% of the PLC and it receives a dividend of up to 35% of profits). Beyond this the majority of the industry is paying a milk price based on processing raw milk and for the most part selling a commodity.

And this is the key point – no matter how much we convince ourselves that we are value-added or have differentiated products, the reality is that the majority of milk processed is manufactured into commodities that are fungible. This means that each unit of commodity is exactly like every other unit. And people who produce commodities are price-takers with no control over the price. On any given day they must take what the market offers them.

We need to embrace commodities

The industry fears to talk about commodities, preferring to believe and tell the story that we are a value-added, differentiated industry. Yes we are, but only for a fraction of the milk. This story enables fragmentation across the processing industry. Ireland is unique as one of the world’s largest dairy exporters, not just because of its grass-based system but in having 46 dairy processing sites dotted across the country. These include 15 liquid milk plants, 15 cheese plants, 17 butter plants and 16 powder plants.

Liquid milk plants are a prime example where we continue to invest significantly in capacity – yet we consume the same amount of milk as we did 20 years ago. If the supermarkets want to use milk as price leaders, 15 plants and their associated overheads don’t seem like the model to deliver efficiencies through economies of scale for the industry. Of course the current model works for the supermarkets, as each processor competes against each other.

Ireland is also unique because our grass-based system has created a seasonal milk supply (similar to New Zealand), leading to a high peak-to-trough ratio in processing. As a result we must accept the consequences of a reduced number of opportunities available, and confine ourselves to products such as whole milk powders and skim for an increasing portion of the milk pool.

It also means the industry needs more stainless steel than our international competitors. Couple that with the fact that each processor has diversified its products beyond its core to now offer a range of products from liquid milk, butter, cheese, casein, along with whole and skim milk powders, and each processor has become more complex, with more capital tied up in stainless steel to process the milk at peak.

The rest of the time this stainless steel is underutilised at every processor. It would be interesting to conduct a survey of dairy processor capacity utilisation for the island.

A number of processors are producing relatively small volumes of base products, and are not in a position to enjoy the economies of scale being enjoyed by larger operators. At the same time, the cost of doing business in Ireland continues to rise – labour is becoming increasingly expensive and at 5% unemployment the country is practically at full employment.

There is a need for a change in the industry configuration to create greater specialisation and scale in the production of base products, improve overall efficiency and meet the growing demands of environmental, food safety and quality standards.

Price competitiveness is the critical factor for success in the international markets for dairy products, such as butter and powder. Taking it out of the milk price paid to farmers is not satisfactory.

Given the commodity-type characteristics of these products, the key focus of processors operating in this product segment has to be on process and cost efficiency.

Therefore, everything that affects or that can improve the cost efficiency of processing is of vital importance to the industry. Costs need to be tightly managed and constantly scrutinised to identify waste and efficiency improvements.

Our main competitor countries (Denmark, Netherlands and New Zealand) have adopted a number of aggressive strategies in their ruthless pursuit of efficiency and cost competitiveness on international markets. The Irish industry needs to refocus on cost and price competitiveness. It needs to be driven by farmers who want a better milk price.

But adding scale coupled with complex management structures adds cost. The industry that is owned by farmers must not lose sight that we are commodity producers and, therefore, price takers. We need to strip out cost and build scale to be the lowest-cost producers beyond the farmgate.

Read more

Financial health of the dairy processors

Milk price review: big jump in milk prices for 2017

Milk price review: share-up differs between processors

Milk price review: Lisavaird holds top spot for 2017

Milk price review: ranking tweaked when compared on milk solids