The road less travelled: Where to from here for Fonterra?

​Fonterra has been doing it tough lately. That the company's board and management is under pressure is patently obvious. Fonterra needs to respond, but how? Is Fonterra simply a victim of a perfect storm, or could the current problems have been avoided (or at least their effect minimised)?

Some background. Fonterra is New Zealand's largest company, responsible for 25% of the country's GDP. The company, a co-operative, sells milk products around the world. It sells, largely, commodity products and, therefore, is exposed to commodity pricing fluctuations. The prices Fonterra is receiving for its milk products has fallen significantly in recent times, down to US$2176 per tonne (whole milk powder) at the latest GlobalDairyTrade auction on 3 May 2016—less than half what it was two to three years ago (the price averaged US$5000 per tonne in 2013). As a consequence, the price Fonterra pays to its farmer-suppliers has tumbled, from highs of over $8.00 per kilo of milk solids to now $3.90 per kilo. 

During the good times, farmers were actively encouraged to convert land from other types of farming to dairy farms. Many did so, funded by debt. Banks supported these conversions, given the high milk prices. However, few realised that milk prices follow oil prices very closely (the correlation value is something like 0.95 and the lag is measured in weeks). As oil prices dropped, milk commodities followed, and predictably so. Now, many farmers are running up huge losses, and yet Fonterra continues to encourage more supply which, inevitably, will make the problem worse not better. If the company stopped investing in monolithic bulk plants, it would free up hundreds of millions of dollars immediately. That money could be used to support suppliers with better prices, or to make some serious moves further up the value chain, as Tatua and others have already proved is realistically achievable.

So, where to from here? From the outside looking in, Fonterra has several options worthy of investigation. Here's a few suggestions to get things underway:

• Go back to basics. Immediately stop any further capital projects like new plants. Dissect the current reality. Revisit and confirm why Fonterra exists. Without a clearly defined purpose everything else is, simply, activity.
• With purpose determined, review the corporate strategy. Is Fonterra a bulk commodity processor, or is it serious about becoming a marketing company, selling value-added milk-based products around the world? Several years ago, Fonterra went on record saying it was committed to value-add. Yet even now it continues to build huge plants to process bulk milk.
• Structure and operations. Is a co-operative structure appropriate, given the scale and complexity of the business? Would a more conventional shareholding model (i.e., corporatisation) be more suitable? This needs to be looked at, and quickly. Farmers need the choice of becoming straightforward suppliers without any shareholding burden. Some will want to free up capital to reduce debt, whereas others will want to continue to hold Fonterra shares.  A straightforward supplier relationship would also enable the business to negotiate supply terms with farmers, thus giving financial surety to farmers. One possible downside, in the short-term anyway, is that would also introduce more competition. However, this also would have the effect of sharpening Fonterra's operations. The stated-owned telecommunications companies went through this in the 1980s and 1990s but they have come out much stronger for the experience.
• Board, governance and representation. The current governance review, which feels like lip-service to many, needs to be both accelerated and taken seriously. Armer and Gent's proposal (reduce board size to nine, increase competency around the board table) has considerable merit and support in research, and Lockhart's interview lay the issues out in plain terms. If Fonterra shareholders are serious about growing a world-class business and securing good returns on assets employed, the company needs the best minds seated at the board table. The Shareholder's Council (and associated costs) would no longer be required if the company moved to a conventional corporate shareholder structure. The conflicts of interest that farmer directors inherently carry (as shareholders, directors and suppliers) also need to be resolved. Thankfully, some action may be imminent on these matters—but will it be enough?
• Culture. Reading the body language, one correspondent noted the 'arrogance' of the leadership team. This needs to be resolved, and quickly. Enough said on this one.

If the Fonterra board is serious to driving company performance, for the good of all shareholders and the economy more generally, it needs to gather off-site with management urgently for several days. Sleeves need to be rolled up and egos left outside the room, to sort out why Fonterra exists (purpose); formulate a high-level strategy; and, develop a realistic recovery plan. Strong external facilitation will be required (probably a couple of capable independent facilitators with dairy sector, strategy and governance backgrounds) to work through some fairly tough issues. If this can be achieved, the company (and, therefore, the shareholders and suppliers) and the country will be better for the effort.