As the milk price falls, Fonterra needs to react by rethinking its strategy
Agribusiness is different. Long investment cycles, equally long production cycles and environmental perturbations combine to erode resilience. The current milk price debacle is a clear case in point.
Farmers have responded to the signals they have been sent by their processor and marketing arm (Fonterra) and society (environmental compliance) and achieved productivity gains. The downside of everything they have achieved has been an increase in debt, but the upside has been a booming economy.
The good times are crashing. The slump that is being experienced in dairy prices is part of a global problem. At the beginning of August the FAO announced that dairy and vegetable oil price drops had led the FAO Food Price Index to its lowest level in six years. ‘Lower demand from China, the Middle East and North Africa, and above average European Union milk output’ were cited. The role of Russian sanctions was not mentioned, leaving questions in New Zealand on where Russia is sourcing milk and how full the warehouses in China really are.
And why Fonterra has persisted (until Black Friday 7th) with its Strategy Refresh Volume, Value and Velocity (V3) model.
On the 29th March 2012, ‘Fonterra outlines plan to extend leadership in dairy nutrition’ was a featured headline. The article is still on the Fonterra website with Fonterra Chief Executive Theo Spierings explaining that ‘Strategy Refresh was built on an in-depth look at the Co-op's strengths, social and economic trends as well as underlying projections for a marked increase in global demand for milk’.
"Strong economic and population growth in emerging markets is driving a situation where global demand for milk is forecast to grow by more than 100 billion litres by 2020, with New Zealand expected to contribute only 5 billion litres of additional supply by that date," Spierings said.
That year the Milk Solid payout was $6.08 with a 32c dividend.
In the 2012/13 year the payout dropped to $5.84 (again with a 32c dividend), and on 25th September 2013, it stated that ‘the Co-operative has continuing confidence in its Volume and Value strategy in our key markets. Looking ahead, prospects for the dairy industry and for Fonterra look positive and its growth ambitions remain unchanged.’
Five months later (27th February 2014) the payout was lifted to $8.65. Chairman John Wilson said the higher forecast was good news for farmers, and for New Zealand, and that the increase reflects continuing strong demand for milk powders globally.
Six months further on again (27th August 2014) Fonterra maintained the forecast for the 2014/15 season at $6.00. Chairman John Wilson said the decision to maintain the forecast Farmgate Milk Price reflected the longer term outlook for international prices for dairy.
The slide started shortly afterwards.
Friday’s forecast of $3.85/kg milk solids is the lowest since 2006, and costs of production (which include rates, power, fuel, grazing costs and wages) have increased significantly since then.
Long investment and production cycles mean that decisions made in 2012 in response to Fonterra’s ‘in-depth look at the Co-op's strengths, social and economic trends as well as underlying projections for a marked increase in global demand for milk’ are coming in to play. Expenditure on semen from high breeding worth bulls used in cows in October 2012 resulted in high breeding worth calves in August 2013. The heifers were reared and then put to the bull in October 2014. They are calving and coming into the herd this season. These are heifers that require more than grass to fulfill their genetic potential in milk production, and are part of the efficiencies of New Zealand dairy production.
Research by the International Food Comparison Network released last year categorised New Zealand’s costs of milk production in the US$30-40 per kg ECM (energy corrected milk), whereas the EU, Middle East and China were US$40-50 per kg ECM and the US, Canada, Austria, Norway and Switzerland were greater than US$60 per kg ECM.
Research by the same group released in 2011 put New Zealand in the ‘best management practice’ group for greenhouse gasses per kg of milk (large cow housed herds in the US were more efficient in GHG).
Farmers at the leading edge of efficiencies are likely to be those carrying the debt as the technologies implemented (effluent disposal, animal shelters and milking sheds that reduce labour costs) are expensive. And budgets done on a long term $6.00 payout are not coping this year.
That is why there have been questions, including from dairy companies other than Fonterra, on why Fonterra is continuing to auction milk.
Auctions work well when demand is greater than supply. When the reverse is true, a reserve price is usually set to ensure that the seller is protected. In Auckland a decade ago, as the move from fixed price was occurring, most house sales at auctions were passed in – and agreement reached between the vendor and purchaser afterwards. Negotiation was the key in achieving a contract between the parties with terms that both could accept.
The basic requirements are a reserve price that indicates the lowest price acceptable without negotiation and the expertise of the negotiators if the reserve price is not achieved.
The current auction system is eroding the potential to achieve increased prices in the next few months. The starting price each fortnight is 15% below the last ‘winning’ price, there is no reserve price, and volumes have increased as the season progresses. It isn’t a winning formula. Worse, it locks forward contracts in a dismal slide.
It is this forward contracting that might be why Fonterra hasn’t responded to criticisms of the auctions with anything but a ‘willing buyer’ comment.
After the latest Global Dairy Trade (GDT) auction, Fonterra Managing Director Global Ingredients Kelvin Wickham tweeted that “No one likes low prices but important to remember GDT has not caused low prices – they’re a reflection of what’s happening in the market.”
He went on to say that “Nearly all of the product offered on GDT this week sold to willing buyers.”
Of course buyers are willing at low prices.
But as media reports have made clear – the milk producers are not. They have been voting with their feet and joining other companies over the last few years. This year there could well be uproar at the AGM and elections.
Creating a successful future from the current state will take a rethink of the strategy; it requires a fresh approach. Shareholders have been promised this in the past by people campaigning to represent their interests on the board, but well-intentioned new directors find themselves constrained once they are part of the official Fonterra employment.
Fresh thinking requires a fresh start. If all directors stood for re-election this year, not just the three on rotation, it could give them a chance to let shareholders know what they really think should be done. It doesn’t mean that they wouldn’t get re-elected – it is important to maintain some corporate memory – but it would allow freedom of speech.
They might also explain how they will add value in creating that future - their vision, track record and skills and abilities to assist in creating a credible new strategy.
The latest pay-out forecast at $3.85, plus a dividend of 40-50c, in combination with the falling proportion of the world market indicates that the V3 strategy hasn’t worked.
Strategy refresh is not enough; Strategy clean start is required