Reference no: EM132688652

FONTERRA: CREAMING THE PROFITS IN DAIRY

• Fonterra is easily one of the world's top six dairy companies -quite an achievement for a firm based in the small, isolated country of New Zealand. An important part of its business is supplying bulk ingredients such as milk powder, butter and cheese to international markets. By 2013, it was the world's largest global processor and trader of milk products. It also owns valuable international brands including Anchor, Anlene and Anmum. Despite an industry downturn in 2014-2017, Fonterra's strategic posi­tion still looks attractive given that global dairy con­ sumption is forecast to continue outstripping supply growth in India, Africa and much of Asia. On the other hand, size and prominence seldom come with­ out controversy. Fonterra faces conflicting pressures on its strategy from the farmers who own the busi­ness and from other influential stakeholders. Fonterra, in its present form, was founded in 2001 by a merger of the two largest farmer-owned cooperatives and the Dairy Board, which at that time held a statutory export monopoly. Since then, the dairy industry in New Zealand has con­tinued to expand, growing production volumes from 13 billion litres of milk to 18 billion litres by 2016.
• This expansion has been possible because New Zealand's climate allows for a highly efficient model of milk production: the cattle graze almost exclusively on natural pasture, eliminating the expense and energy consumption of heated barns and food concentrate. As a result, milk production is not only cost efficient, but also generates lower car­bon emissions than other production methods, even after accounting for shipping. The costs of produc­ing a kilogram of milk solids in New Zealand have historically been lower than in almost any other country, although increased land prices and wider international adoption of industrial-scale dairying threaten this lowest-cost position. In common with other dairy businesses around the world, Fonterra is a farmer-owned cooperative, with 10 700 owner-suppliers.
• The principle of the cooperative is that farmers own shares in propor­ tion to the quantity of milk they supply. Fonterra's shares are not traded on any stock exchange, as non­ suppliers cannot buy them, and the New Zealand government has no direct involvement with the business. The shares represent a significant finan­cial commitment for the dairy farmers. Many of the farmers are actually highly indebted, due to the cost of land purchases and investment in irrigation, facilities and stock that many have made during the recent expansion. Indeed, to help them through lean times, in 2015 Fonterra offered its suppliers loans on favourable terms. Fonterra's governance structure reflects its con­stitution as a cooperative. Not only do the farmers directly elect nine of the thirteen board members, but they also have further oversight of the board via the 35-member elected Shareholders' Council.
• The Shareholders' Council in turn appoints a Milk Commissioner to mediate in any disputes between Fonterra and individual shareholders. In prac­tice, the farmers indeed have a strong influence on board behaviour. Given the trend towards fewer, larger dairy farms, this influence seems destined to increase. Another important constraint on Fonterra's stra­tegic freedom to manoeuvre is the reliance many of its shareholders have on dividend payments.
•  This limits the firm's ability to fund growth and investment through retained earnings. When farm­ers increase the volumes of milk they supply to the cooperative, equity capital flows in and the busi­ness can use this capital to fund capacity expan­ sion. However, this dependency on gaining supply volumes biases Fonterra's management towards pro­ cessing bulk commodity products. In 2012, Fonter­ra's board introduced a revised capital structure that avoids redemption risk in the event that too many suppliers leave the industry or elect to supply a rival processor. Fonterra suppliers now trade Fonterra shares between them, and can sell economic rights to some of their shares to a separate fund that is open to outside investors. Farmers retain control of the business, as the outside investors do not have voting rights. However, even with the revised capital structure, the firm still has fewer options for raising capital than its larger multinational competitors.
• A recurring strategic issue at Fonterra has been how, and to what extent, to build businesses that add value beyond the efficient processing and trading of commodity dairy products. In 2016, its commodity-focused business generated over two-thirds of corporate revenue, despite initiatives to prioritize growth in higher-returning products. Although New Zealand's efficient dairy industry means that farmers can profit from the sale of com­modities, volatile commodity prices and exchange rates undermine the value of this strategy. So too do trade barriers and farm subsidies in major markets such as the European Union and the United States. Many of Fonterra's options to develop new sources of value creation draw on its processing and logistics expertise to manage international opera­tions. This often involves partnership agreements with overseas suppliers and customers. The coop­erative sources almost 20 per cent of its milk from outside New Zealand. From a shareholder's perspec­tive, this can be problematic because it means that New Zealand farmers' capital helps finance ventures that, by some arguments, compete with their own milk production.
• The problem is compounded by the fact that many of the opportunities for Fonterra lie in fast-growing but less developed markets such as China and India. This in turn increases the risk involved in such ventures and requires more specialist skills at managing politically complex transnational relation­ships. Commentators have argued that the skills and preferences of Fonterra's farmer-dominated board are not closely aligned with managing multinational ven­tures. Furthermore, the higher levels of business risk sit uncomfortably with the financial position of many of Fonterra's owners. One of Fonterra's international ventures was a joint venture agreement with the Sanlu dairy com­ pany in China.
• This arrangement came to an abrupt end in 2008 when Sanlu was struck by a milk con­tamination scandal that affected thousands of infants and led to the death of at least six. Because it held a 43 per cent equity stake in the business, Fonterra became embroiled in the scandal. It became clear that Fonterra's oversight of this business was weak at both board and operational levels to the extent that it either did not know about, or was unable to curtail, the contamination scandal for many months after it first came to the attention of Sanlu's management. When Sanlu went bankrupt, Fonterra had to write off over NZ$200 million of its investment in the venture. In response to these events, Fonterra took more control of its supply chain in China, including investing in several farms and managing them to its own standards. At the same time, dairy businesses in China sought the safety of New Zealand-sourced milk. For example, Bright Dairy took a major stake in Synlait, a rival milk processor to Fonterra. This highlights the importance of New Zealand's reputa­tion as a source of pure product: some commenta­ tors have questioned the wisdom of part-sourcing Fonterra-owned brands from elsewhere.
• As well as dealing with pressures from sharehold­ers, Fonterra must manage its relationship with other influential stakeholders. In lobbying for support, dur­ing boom times in 2012 it was not shy to point out that it contributed 26 per cent of New Zealand's export revenues. It also makes much of the economic spin­ off effects of its activities, which extend beyond dairy farmers to communities, regions and cities. These spin-offs mean that the economic fortunes of the busi­ness have a major influence on those of New Zealand as a whole. However, power and importance at this level often do not engender popularity. Fonterra not only controls a very high proportion of the liquid milk supply to the domestic market, but also owns several of the major brands of cheese, butter and yoghurt. When the international commodity milk price is high, dairy prices rise for domestic consumers, which they tend to see as profiteering at their expense.
• Another important area of stakeholder interest in Fonterra comes from the environmental impact of its activities. Many of these impacts come from dairy farming itself, and hence Fonterra does not directly control them, although stakeholders still consider them to be inextricably linked to Fonterra. Intensive dairying is both a major consumer of water for irrigation and potentially a polluter of water via runoff of effluent and nitrogen fertilizer. The pol­ lution endangers local ecosystems and threatens to undermine the unusually pure municipal water sup­ ply enjoyed by domestic consumers.
• The high water consumption threatens these same water supplies due to over-extraction of this historically lightly­ regulated resource. Fonterra has initiatives and tar­ gets to improve the industry's performance in these areas, but critics say these are still not enough. Even in 2014-2015, the industry acknowledged that almost 6 per cent of the country's dairy farms were in significant breach of standards for effluent runoff.
• Perhaps the most crucial long-term stakeholder challenge for Fonterra and the dairy industry is its contribution to New Zealand's emissions of green­ house gases. The problem arises principally from methane emissions, a by-product of cows' digestion. Methane is an especially potent greenhouse gas, such that in 2014, emissions of methane and nitrous oxide (largely from agriculture) made up 54 per cent of New 2.ealand's total greenhouse gas output. Because New Zealand has committed to the Kyoto Agreement, it must pay directly for above-quota emissions, trig­gering the government to consider the possibility that farmers should contribute to this expense. Despite this apparently daunting set of chal­lenges, Fonterra remains a successful, growing firm that is a leader in its industry. The decision Fonter­ ra' s board and management face if it is to sustain its performance is whether and to what degree to take into account the diverse set of stakeholder con­cerns.
• If it spends heavily to address these concerns, it risks compromising the immediate interests of its owners, hence losing their support. If it does too little, it risks undermining its operating environ­ment (for example, by stimulating unfavourable legislation), and hence compromising its owners' future interests. The board and management must deal with the latent conflict between competing shareholder interests. They have a delicate path to tread in resolving the tension between respecting the fundamental values perceived by many owners and keeping pace with a dynamic global industry. Quite a few issues to chew over.

Problem 1. Which perspective of the profitability vs. responsibility paradox is most pertinent in Fonterra's endeavors in China?