Fonterra’s latest results shed light on three critical elements of its strategy.
While the insights help justify the co-op’s optimism, they also raise big tensions for shareholders.
The three elements are: To turn less milk into powders and more into higher value products; the marketing of «100 per cent pure milk»; and the new capital structure.
The first element is in its infancy. But over the next decade or so it could make Fonterra more profitable to shareholders and thus more valuable to the wider economy.
It is an historic shift. While the dairy industry began by exporting butter and cheese, milk powder turned it into a global force. The technology solved three problems with exports: dealing with seasonal production, reducing their weight and extending their shelf life.
But powders carry three financial penalties: They are irredeemably commodities, generating only a 3 per cent or so EBIT profit margin; they require heavy investment in plant; and prices are volatile.
If New Zealand dairy output continues to grow by 2-3 per cent a year for a decade, Fonterra would need to build five new milk driers at $150 million a piece, says Theo Spierings, its chief executive. It would rather build one and handle the rest of the extra milk by investing in plants to make the likes of UHT milk or cream cheese.
Such a shift in investment has a financial benefit: The value-add products have higher profit margins – typically 5 per cent to 8 per cent for commodity UHT milk, 8 per cent to 10 per cent for cheese and 10 per cent to 15 per cent for Fonterra’s Anchor brand UHT milk.
But the shift also carries a penalty: High commodity powder prices reduce the margins on value added products. If food manufacturers were able to fully pass on high milk costs, the price of processed products would rise 50 to 60 per cent, Spierings says.
So the co-op has a dilemma. High powder prices lift the milk price it pays to farmers but the volatility is very hard for the co-op and its farmer shareholders to manage. However, if Fonterra can build premium brands then the value added products could potentially be more profitable and predictable, with higher returns reflected in a higher dividend on Fonterra’s shares.
The co-op is convinced of the latter course. Last season 53 per cent of its products were commodity powders and the rest derived directly from milk or were high value ones such as infant formula derived from powders.
Over time, though, Spierings says, the co-op’s portfolio of plants will shift away from commodity powders into plants producing the co-op’s three broad category of higher value products – food service; «everyday nutrition» such as UHT milk and cheese; and «advanced nutrition» such as infant formula. Two recent examples of the shift are Waitoa’s $126m UHT plant and Te Rapa’s $61m cream cheese plant.
Waitoa is supporting Fonterra’s new push on UHT exports to China, where the product category is growing by 30 per cent a year. Even better, the co-op says, its Anchor brand of UHT commands a 20 per cent premium over its rivals.
But Fonterra faces two challenges. First, the premium depends on Anchor’s brand and marketing. The messages on the cartons are «Anchor, since 1886,» «imported 100 per cent pure milk», «New Zealand quality». They are backed by images of green grass, black and white cows and a snow-spangled mountain.
This marketing drive is the second of the three strategic elements highlighted in the latest results.
More explicitly than ever Fonterra is staking its consumer reputation on 100 per cent purity and New Zealand quality. Those are fine attributes but ever-harder to deliver, as events this year have shown.
Take «100 per cent pure milk». The UHT cartons list only one ingredient: raw milk. But what constitutes raw milk gets ever more debatable now Fonterra’s tests can find substances down to single digit parts per billion. Inevitably the milk will reflect what the cows ingest.
Earlier this year, for example, some samples of raw milk contained DCD, the nitrification inhibitor. There are international standards for DCD residues in other foods but not yet milk. Should «100 per cent pure milk» have any? And what about other trace elements that nature did not intend to include in milk?
To live up to its claims of «100 per cent pure milk» and «New Zealand quality» Fonterra and its farmers have a lot of work to do on their farming practices and on communication with consumers. For example, do these messages imply that milk from Fonterra’s Chinese farms is inferior?
If they fail at either, they will destroy the premium on which Fonterra’s whole strategy is becoming ever-more dependent.
The third element of strategy is share trading among farmers. This started last November and has already proved its worth. During the previous big drought in 2008, farmers cashed in $742m of shares to cope. But under that old capital structure, Fonterra had to borrow at high interest rates to fund the hole in its balance sheet.
Now with permanent capital, Fonterra was able to help farmers by increasing advanced milk payments rather than having to resort to expensive borrowing.
But Fonterra is forecasting no increase in dividend this year. This will disappoint non-voting, non-farming unit holders, particularly when the milk payout to farmers jumps thanks to high commodity powder prices.
Fonterra has to resolve these three strategic tensions if it is to prosper.
Source: Stuff
