Rod Oram went under the covers of Fonterra’s result this week to see if Theo Spierings deserved his $8.3 million salary. He finds New Zealand’s biggest exporter has a long way to go to produce more value from its milk and its key Chinese investment is struggling.

Delivering an upbeat message about Fonterra’s year-end results was clearly a task Theo Spierings and John Wilson, its chief executive and chairman respectively, were enjoying on Monday.

The co-op had delivered its fourth best milk payout plus dividends to farmer-shareholders in the 16 years since it was founded; profits on downstream products held up well despite the 57 percent increase in milk price; and China is now its largest, most profitable market.

Their message: Fonterra’s strategy of shifting more milk from commodities into higher value products was working; and it would deliver much more yet to farmer-shareholders.

Yes, there is good progress. But Spierings and Wilson failed to address three big problems:

– Fonterra is still a massive volume, not value, player in global dairy markets, to the detriment of its owners and the New Zealand economy;

– China is highly problematic for the co-op, particularly its $700m investment in Beingmate, a local infant formula company;

– It is unclear how Spierings and other senior executives are earning their big bonuses; and are they incentivised on the right performance measures?

Where’s the value?

The volume not value problem is obvious from data by IFCN, the German-based international dairy research network.

Fonterra is the second largest dairy processor in the world, just behind Dairy Farmers of America. But Fonterra ranks 18th in the 20 largest dairy companies by sales revenue per kilogram of milk. This is the key measure of value-add, IFCN says.

Fonterra generates only 60 US cents of revenue per kg, way below the top five dairy companies. Danone is best at US$2.40, Nestlé US$1.90, Mengnui and Yili, China’s two largest dairy companies, US$1.40, and Groupe Lactalis of France US$1.30.

US$1 per kg is the average revenue for the 20 largest processors in the world. But Fonterra lags 40 percent below it.

Thus, last year, its ingredients business turned 21.3 bn litres of milk equivalent into $943m of earnings before interest and tax, generating single digit returns on capital; while its food service and consumer business turned just 5.5 bn LMEs into $614m of ebit, for a return on capital of 47.2 percent.

Fonterra does have a strategy to shift more of its ingredients business out of basic commodities into advanced ingredients, a new category it reported on for the first time. These are the likes of nutritional products for medical, pediatric and sports consumption. They accounted for 19 percent of Fonterra’s milk versus 36 percent for basic ingredients. They generated returns on capital north of 20 percent.

But at this pace, Fonterra and its farmer-shareholders have a decade or more to go before they break free from boom bust commodity cycles to reap higher, sustainable profits.

What about Beingmate

Fonterra’s second big problem is Beingmate. It talked up the opportunity of the relationship three years ago when it announced its investment in the Chinese company. The 18.8 per cent stake cost it $700m.

On Monday Fonterra used once again a graphic showing the relationship’s seven potential synergies. Yes, life was tough for Beingmate, Spierings said. Counterfeit product and new regulations had been disruptive, but those were issues for the whole market not just Beingmate, he added.

That’s true. But Beingmate has more than its share of troubles. Since Hong Xie, a food scientist, founded the company in 1992 it has focused intently on supplying Chinese formulated and made infant nutrition, starting with rice cereals.

While it’s enjoyed big bursts of success, it has also had to make dramatic strategy changes to counter the rise of foreign brands of infant formula, e-commerce and other new dynamics. On the first it had developed a close relationship with Kerry in Ireland to provide formula Beingmate markets under its own brands. To that it’s added its relationship with Fonterra.

Already a case study

Beingmate’s history, travails and current strategic challenges are thoroughly documented in a Harvard Business Review case study. First published in 2002 and most recently updated this March it is a far more comprehensive explanation of Beingmate than Fonterra has ever supplied.

In essence, six factors drive Beingmate’s formula business: where milk powders come from; where those are made into formulas; which countries’ standards are used; the retail price; distribution channels; and regulatory changes in China.

The latest regulatory changes are massive. The government is requiring companies to register brands and formulas, to severely limit numbers. Its aim is to sweep away the vast proliferation of products that have made the market so confusing to consumers.

This is a great challenge to Beingmate. Quick changes in its brands and formulas have been a cornerstone of its strategy. The other major new dynamic is the rapid rise of e-commerce, which now has a market share as large as that of the channel of dedicated baby stores on which Beingmate has built its business.

Recent data from Beingmate shows that its cheapest product in the market is Creation+ formula, which is made in Ireland by Kerry to EU food and safety standards and sold through the Chinese e-commerce channel.

This high-spec product is priced so low because of the power of e-commerce in China. The price is similar to that of Beingmate’s products made locally from domestic milk to Chinese standards.

It is unclear how Theo Spierings and other Fonterra executives are earning their bonuses. Photo: Getty Images

So much for bricks and mortar

E-commerce is decimating the bricks-and-mortar channel. Yet, Beingmate’s extensive distribution chain of franchised stores across China was the prime asset Fonterra bought into. But Beingmate has since racked up substantial losses trying to cope with e-commerce and other radical market changes.

When Fonterra announced its Beingmate deal three years ago, it forecast sales of its Anmum brand of formula under an exclusive licensing deal to Beingmate’s stores would reach $100m by 2018.

On Monday, Spierings conceded only 2,000 tonnes were sold through 8,100 of Beingmate’s 40,000 plus stores last year. Based on Fonterra’s typical revenues on formulas, that’s worth only around $10m.

Likewise, three years ago Fonterra said it would receive annual dividends from Beingmate. Based on Beingmate’s dividends at the time that looked like some $16m a year for Fonterra. But given its grave financial situation since, it appears to have made no further dividend payments to shareholders, according to data on Reuters.

Fonterra has said nothing about four more of the seven Beingmate synergies it talked up three years ago: UHT milk, R&D, farming, and the global supply chain.

One of the seven is up and running. Beingmate has bought a 51 percent stake in Fonterra’s Darnum plant in Australia. This was a great relief to Fonterra. The plant had lost its sales to Danone after Fonterra’s botulism false alarm. Danone became a rival by buying up competitor plants.

Fonterra booked a $42m gain on the sale of the stake to Beingmate once it was eventually finalised last year, according to a note in the co-op’s latest annual report.

Three years ago, Fonterra said Beingmate would buy 50,000 tonnes of powders a year from Darnum and 30,000 tonnes of whey products a year from Fonterra’s European milk pool.

But we’re none the wiser of how good a customer Beingmate has become. Spierings and Wilson speak only in upbeat platitudes about the relationship to their farmer-shareholders, other interested parties and media.

Likewise, how secure a customer is Beingmate? Beingmate has yet to solve long-running, damaging faults in its strategy. At the heart of this is a dilemma over using foreign supplies of powder.

On one hand it sees diverse overseas sources as a safeguard in case any one source suffers a foods safety issue; and foreign-sourced product has long been highly prized in China. But the collapse in price of such products in the e-commerce channel suggests that even that attribute is not enough to maintain high premium pricing.

On the other hand, sourcing from overseas requires long lead times and large volumes. This works against Beingmate’s long-standing practice of quick product innovation in short batches using domestic milk powder.

The slow supply chain also cuts down the time available to sell foreign product once it gets to China, which in turn increases the risk of accumulating older stock which has to be cleared at steep discounts.

‘Raising other people’s babies’

Complicating the trade off between foreign and domestic sourcing is some resentment within Beingmate of Fonterra’s use of its extensive distribution network. The co-op highlights this chain as the key benefit of its Beingmate stake. It needs this to work to correct a serious strategic misstep it had made earlier in China.

While Fonterra had long established its Anmum brand of infant formula in other Asian markets, it had neglected to push it in China during the great boom in that market. Instead, it rode the surge in infant formula sales by contract manufacturing product in New Zealand for major multinationals such as Danone to boost their brands in China.

When Fonterra bought into Beingmate three years ago it licensed to Beingmate exclusive distribution of Anmum in China. Since Beingmate is strongest in third and fourth tier cities with tens of thousands of outlets, Fonterra is relegating Anmum to a lesser brand and price point, while counting on big volume. But as Spierings disclosed on Monday volume is still meagre. This is yet another volume versus value play by Fonterra, but one which has yet to work.

One explanation for the surprisingly low Anmum volumes to date is the resentment of Fonterra by some senior people within Beingmate. While Anmum sales might be good for Fonterra, what does Beingmate get out of pushing them through its extensive distribution network?

“You don’t want to raise other people’s babies,” one executive told the HBR case writers.

Amidst all this turmoil, Fonterra only took a $35m impairment charge in its latest results on its $700m investment in Beingmate.

They showed him the money, but not shareholders

Fonterra’s third big problem is how to incentivise its senior executives. Two years ago, it switched from traditional bonus measures such as return on capital to a new set of measures based on its “Velocity” corporate overhaul.

This work, developed for it by McKinsey, the global management consultants, has delivered some $2bn of cost savings and improvements in working capital. Some 5,600 employees have been rewarded for their work on this. But Fonterra won’t say on what measures or how that bonus pool was shared.

The biggest beneficiary, though, was obviously Spierings. His total remuneration rose by 78 per cent to $8.32m last year. From the scant detail Fonterra offered, it was clear his Velocity bonuses were the biggest contributor.

Shareholders have a right to know in detail the measures on which his bonus was calculated. Fonterra is woefully short of world best-practice governance on this.

“Companies should clearly disclose and justify the performance measures chosen and the related targets,” is one of the key Principles of Remuneration devised by the Investment Association. It represents more than 200 investment managers who collectively manage over £5.7 trillion ($10.6 tr) on behalf of clients in the UK and around the world.

Wilson said Spierings’ bonus was benchmarked against comparable Australasian and global companies. But the co-op has declined to identify which.

Here’s one they should use: Royal FrieslandCampina is a Dutch co-op running a global business. Its sales are similar to Fonterra but it only processes half the volume Fonterra does. As a result, its revenues were US$1 per kg of milk solids, 40 per cent higher than Fonterra’s.

Last year, the six person senior executive team at the Dutch co-op were paid a total of euros 9.3m ($15.15m).

Back in 2008, Spierings led the merger of Friesland and Campina but he missed out on the top job. Four years later, he became chief executive of Fonterra. Last year, he alone earned the equivalent of half the pay of the entire top team of the company he left.

There is a simple remedy available to Fonterra’s farmer-shareholders and to the outside shareholders in Fonterra’s stock market listed Shareholders Fund. They can join the Say on Pay investor movement.

Shareholders have a right to know the exact details on how CEOs are remunerated for delivering on the right strategies for their companies, and then to vote on them. This right is guaranteed in legislation in a growing number of countries, such as the UK since 2013.

If Fonterra’s owners empowered themselves this way, they could fast forward the co-op’s strategy and returns, and reward their employees appropriately for those achievements.

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