This article was first published on October 26, 2021
Fonterra has been talking up value-add as a way to add value for shareholders for a decade, to little effect. Could this time be any different? Business editor Nikki Mandow pores over a decade of Fonterra annual reports.
“We have clear aspirations,” trumpets Fonterra in its 2016 annual report, alongside a soft-focus photo of a nice-looking cream cake. “By 2023, our foodservice operations [a jewel in the Fonterra value-add crown] will be a $5 billion business, supplying over five billion LME [liquid milk equivalent] of dairy products to customers around the world.”
How Fonterra’s foodstuffs business was going to grow from a less than $2 billion operation to $5 billion wasn’t at all clear in that 2016 report, but who cared? There would be New Zealand mozzarella for the world’s pizza chefs, butter for the bakers, cream for the cake makers, and money for the farmers and shareholders. Hurrah!
Except it didn’t happen.
This month, five years after announcing its $5 million aspirations, Fonterra issued a press release about a company milestone: “Fonterra’s foodservice business hits $3 billion in revenue.” Not $5 billion, not even $4 billion. $3 billion.
Meanwhile, in September, in a separate “Path to 2030” strategy document, Fonterra revealed some ambitious new targets: foodservice revenues rising to $5 billion by 2030.
That $5 billion number again, just seven years behind schedule, and with not many more specifics – more of that later.
“Foodservice [restaurants, bakeries, takeaway chains, home-delivery, even hospitals] is a high-value channel for our product,” Fonterra revealed in the strategy document. “As part of our plan to direct our Co-op’s milk to the highest value product, we are aiming to increase milk solids in our Foodservice channel by approximately 50 percent by 2030.
High value, high profit
And of course this is good news – for New Zealand, as well as for Fonterra. Fonterra is our biggest exporter, and while butter may not appear to the uninitiated to be super-high-value, it is certainly an improvement on milk powder in terms of profitability. Products like Fonterra’s patented extra-stretch mozzarella, developed in its research and development centre in Palmerston North and made at a multi-million dollar, purpose-built factory in South Canterbury, are even better.
Fonterra’s financial statements show gross profit margin from selling butters, creams and cheeses for foodservice clients, and from selling its branded products like Anchor butter, Anlene adult milk powder, and Anmum baby formula to global household shoppers, can be double or triple what it is when it sells bog-standard milk powder.
It could be expected the company makes an even better margin from its gut and brain health-related products – proteins to help with mobility, probiotics for immunity and digestion, and lipids for cognition – though Fonterra doesn’t break out financial details on these products and volumes are small.
“We have set up a dedicated team to explore what the future of Nutrition Science Solutions looks like for our Co-op,” the Path to 2030 report says. “Over the next year, we’ll narrow down and priioritise the areas where we can build a competitive advantage and understand what it would take to win.”
The cynical viewpoint
This is not to say this isn’t achievable, and later in the article we’ll explore why things might be different this time around.
But it isn’t going to be easy. First, the cynical viewpoint.
A decade of annual reports, investor day presentations and financial statements show year after year Fonterra talks about the importance of moving more milk to value add.
But the dial doesn’t appear to move.
As the table shows, back in the 2015 financial year, the percentage of sales from the foodservice and consumer parts of Fonterra’s business was 32 percent, versus 68 percent from the more basic products – categorised as “ingredients”. It’s gone up and down a fraction over the last seven years, but this year the figures are 34 percent : 66 percent. Last year was 67.5 : 32.5 – almost identical to 2015.
It doesn’t mean Fonterra hasn’t produced more value-added products over the years. In years when total milk volumes grew, the numbers show consumer and foodservice volumes grew in parallel.
And the picture is muddied because Fonterra’s doesn’t break out its specialised science-driven gut and brain wellness products – probiotics and lipids and the like – now often called ‘Active Living’ products. Instead these are lumped in the figures with basic ingredients.
This means we don’t know how much of the ‘ingredients’ category is actually clever, non-basic stuff, though a spokesman said the percentage was small.
Even more confusing is for a few years Fonterra reported sales of something it called “advanced ingredients” (see wheel below).
“In our financial year 2018 interim results we said 19 percent of our volume went into advanced ingredients,” Fonterra’s group finance director Chris Rowe told Newsroom. “Advanced ingredients is not the same as what we’d now call Active Living. Advanced ingredients was broader and included some product we now classify as Core Ingredients.”
Clear as mud.
Turning the wheel
In 2017 and 2018 Fonterra used a handy wheel-like graphic to demonstrate its much-promoted move from commodity dairy and base ingredients to value added – particularly consumer, foodservice and advanced ingredients. In 2018, Fonterra’s then new chief financial officer Marc Rivers talked about the wheel turning, as the company moved more milk (measured in liquid milk equivalent, or LME), into consumer, food service and advanced ingredients (see top wheel below).
Six months later, after the wheel started turning in the wrong direction (see lower wheel above), Fonterra appeared to abandon its wheel.
Further back, Fonterra had another value-add strategy. It was called V3, or “driving more Volume into higher Value at Velocity”.
As chief executive Theo Spierings said in 2017’s full-year results presentation: “V3 is at the heart of our ambition and provides the foundation for us to fund and drive innovation and sustainable value creation.”
Fonterra’s “V3 strength” had enabled the company to deliver “solid earnings in an environment of rapidly increasing milk prices”, Spierings said.
V3 didn’t seem to drive as much volume into higher value as Spierings might have hoped, let alone at velocity.
V3 isn’t mentioned in the Path to 2030 strategy document.
(For more on the situation with value-add in 2018, see a Newsroom article from that year.)
The way forward
And so to 2021, and Fonterra’s Path to 2030 strategy announcement includes $1 billion targeted for investment into moving milk into higher value products over the next eight years.
That includes investing in some of the company’s manufacturing facilities and boosting the total annual research and development budget by more than 50 percent to around $160 million in 2030.
Around $60 million a year will be specifically targeted at products in the health and wellness space, including the dedicated team mentioned above.
Then there are those ambitious foodservice targets – $5 billion in sales by 2030 (up from $3 billion now) and a 50 percent increase in milk solids used. How is Fonterra going to get there? The projections in the Path to 2030 document appear based on broad demographic data not firm marketing projections.
For example, Fonterra talks about benefiting from a US$2.3 trillion global foodservice industry, from a global middle class forecast to grow from 3.7 billion in 2020 to 5.3 billion in 2030, and from the share of the world population in urban areas rising from 58.5 percent in 2020 to 61.9 ten years later.
Innovation and new products will be key to “build relationships with up to 40,000 new customers over the next five years and up to 70,000 new customers in the next 10 years”, Fonterra says. The company will concentrate on Greater China, Southeast Asia and the US, and wants to “collaborate more with like-minded partners, leveraging our intellectual property and skills, rather than only making significant capital investments of our own.”
“We are still working through the business cases – what are the areas we want to go to and how big are those markets, what will it take to get there?”
– Judith Swales, Fonterra
Who? When? Where? How? Basically, there are few specifics.
Be patient, says Judith Swales, chief executive of Fonterra Asia Pacific, and the former head of the company’s innovation and transformation business unit. It’s too early for specifics.
“We are still working through the business cases – what are the areas we want to go to and how big are those markets, what will it take to get there?
“We’ve now put a team behind that to do that work, because we see that’s where our biggest opportunity is to win in the long term.”
It needs to work; Fonterra’s earnings per share forecasts out to 2030 are ambitious to say the least, based on the last decade at least.
The company is also targeting a 40-50 percent increase in operating profit by 2030 (from $952 million this year to at least $1.3 billion), increasing the company’s dividend to 40-45 cents per share (it was 20 cents this year), and an average farmgate milk price of $6.50-$7.50 per kilo of milk solids over the next decade. That compares to an average of $6.25 over the last decade and a range from $3.90 to $8.40. This week Fonterra
“Moving milk into the highest-returning products will be key to unlocking our earnings potential,” the company says.
The innovation hub
Earlier this year, Fonterra hosted a group of journalists at its Research and Development Centre in Palmerston North. It’s a seriously impressive place. There’s a large central manufacturing facility for testing new products – all stainless steel tanks, pipes and people in pristine white boiler suits and hair nets.
There are almost 300 scientific and technical staff from more than 40 countries, labs with glass jars and petri dishes, testing and tasting rooms and, in the basement, storerooms holding thousands of dairy cultures, collected over decades which can be accessed for new product development and are now being genome-sequenced. It’s one of the largest dairy innovation hubs in the world.
We tasted cream cheese lollipops for kids’ lunchboxes, mainly in Asia, and drank Chinese nai gai cha (milk-lidded tea), which has a pourable cap of cream cheese and cream on top.
We heard about Fonterra’s world-first ‘ambient’ cream that doesn’t curdle when it’s transported in hot countries even without refrigeration, saw labs developing new probiotics and tasted a high-protein milk product intended to improve nutrition in older people.
It didn’t taste bad at all.
Journalists got the overall impression staff and executives were enthusiastic about what Fonterra was doing, and optimistic about the potential for adding value to milk.
On the other hand Fonterra, or at least its past NZ dairy company iterations, has had a dedicated R&D facility in Palmerston North for almost a century – the first centre opened in 1927.
It holds 350 milk-related patents and several world firsts – from spreadable butter to long-shelf-life milk powder to mozzarella that matures in a few hours, not four months.
Yet still the company has struggled over recent years to move that value-add wheel.
Why it might just work this time
While Fonterra’s track record of moving to value-added, higher margin products (or at least reaching its targets on that front) aren’t super-encouraging, there are reasons to be optimistic the next decade might be different.
The first positive sign, ironically perhaps, is Fonterra will almost certainly have less milk to deal with over the next decade. The era of mass dairy conversions is largely at an end (with some land going the other way, from dairy to forestry, or even dairy to oats for oat milk – see this podcast from The Detail) and concerns about the impact of dairying on water quality and greenhouse gas emissions will almost certainly see the number of cows reduced.
Meanwhile, there’s competition from companies like Synlait, Open Country Dairy and Westland. Fonterra used to process about 96 per cent of all New Zealand’s milk; now it’s close to 80 percent. Talking to shareholders in September, chairman Peter McBride told shareholders this percentage could fall by another 12-20 percent unless the company adopts a less restrictive capital structure.
On the other side, Fonterra is no longer forced by legislation to take all New Zealand milk. A July 2020 amendment to the Dairy Industry Restructuring Act, the original legislation which merged New Zealand’s two largest dairy co-operatives in 2001 to form Fonterra, allows the company to refuse milk from new dairy farmers or ones which fall short in terms of standards of conduct.
Brad Gordon, board member at wealth advisory company Hobson Wealth, says the requirement for Fonterra to push increasing quantities of milk through its plants has been a double-edged sword. Just processing and selling all that milk has been tough, and it has been even harder to put more investment into making and marketing value added products.
“A real challenge for Fonterra has been how to deal with the peak seasonal cycle every year – they have to be fully geared up for production and marketing to deal with that.”
By contrast, a competitor like Synlait is able to get higher margins because they only need to buy and process the milk they need, Gordon says.
If New Zealand is at so-called ‘peak milk’ – the top of the growth curve – this could help Fonterra.
“Once it is not just investing in supply growth, it might be able to better work on value add,” he says.
Fonterra’s Judith Swales puts it a little differently. It’s do or die – kind of.
With a static or falling milk supply, Fonterra has little chance of achieving the ambitious 2030 growth targets it has set itself, without making more profit from the milk it has.
“Ergo, we have to sell more high-value products.”
As well as investing around $1 billion into R&D, innovation and value-add, Fonterra has also committed to spending around $1 billion on reducing on carbon emissions and improving water efficiency and treatment at its manufacturing sites by 2030.
This will also help the company get a premium for its milk in international markets, Swales says.
“We know consumers are caring more and more, not just about their own health and wellness, but about the health and wellness of the planet. So provenance and sustainability is increasingly important to them. And the best story we can tell is around New Zealand milk.”
The second thing that could be different for Fonterra’s next decade, as opposed to the previous one, is that executive, board and management time – as well as large sums of money – won’t be deflected into troublesome investments overseas.
While previous chief executives tended to be global hires, Miles Hurrell, appointed in 2019, was born in Christchurch and has been more than 20 years with Fonterra. The focus back on New Zealand milk has been Hurrell’s cornerstone strategy.
Fonterra’s China Farms joint venture ($1 billion investment for little return) was finally sold in June this year and two China farming hubs went in April, along with the final shares in Fonterra’s disastrous $750 million Beingmate investment.
In November last year, the company offloaded its 50 percent stake in another non-core business – palm kernel animal feed importing business Agrifeeds, and the sale process for its Dairy Partners Americas Brazil joint venture with Nestle and its Hangu China Farm continues. Fonterra recently announced it has started the process to sell its Chilean operations – Soprole and Prolesur to focus (almost) entirely on New Zealand milk.
This frees up money to invest in developing and manufacturing new products, says Frances Sweetman, portfolio manager at investment company Milford.
But it also frees up headspace.
“Senior management has previously been extremely focused on growing offshore,” she says. “It would have taken time and energy – you need to understand those markets and manage size and disparate businesses.
“Now they are focusing on one area and milk stream.”
It’s not a guaranteed road to riches, but it’s a positive step, Sweetman says.
“Across all the listed businesses we look at, the ones with a simple strategy, a simple corporate structure and clear targets seem to be able to achieve better results.”
Until she was made chief executive Asia Pacific, Judith Swales’ job title at Fonterra was ‘chief operating officer for transformation (velocity) and innovation’.
Is it frustrating that the company spent a decade on expanding overseas, when it could have spent that time focusing on dairy innovation?
“The leadership at the time made those calls,” Swales says diplomatically. “The world has changed in ways we didn’t expect and couldn’t predict. We are where we are, but now we want to be really single minded with our focus on New Zealand milk, maximising the value through our food service, consumer and advanced ingredients businesses, and making sure we are the most sustainable dairy producing country on the planet.”
Will it work this time?
Swales says yes.
“Doing less allows us to focus, to prioritise, to channel our money and the people we have into marketing and innovation,” she says.
“We’ve done it in the past, but now it’s about how we dial it up and go faster. And who do we work with, because we won’t do this on our own, we are going to have to partner with others.
“There will be some announcements coming out in the next few weeks about some new partnerships we are entering into.”
“Fonterra is a big ship to turn, but the Titanic is now no longer getting bigger – it becomes more maneuverable.”
– Brad Gordon, Hobson Wealth
Looking in from the outside, Sweetman and Gordon are cautiously optimistic.
“Miles Hurrell has done a good job simplifying the business,” Sweetman says. “I like the strategy, it has a lot to offer.
In addition, focusing on the environment and boosting research and development – a strength for Fonterra in the past – is a positive step, she says.
“I’m more optimistic than I have been for a few years, but Fonterra’s targets are going to be difficult to reach, and there is a lot of execution risk.”
Brad Gordon is also happy with the new chief executive and the direction he is taking the company. But he agrees it isn’t going to be easy.
“Everything he says has been very good,” he says, and that combined with an industry-wide dynamic of static or declining supply makes moving to more value-added production possible.
“If they don’t have to invest into plant growth they can convert factories into producing more value added,” Gordon says. “I think that’s started, in the last year or so.”
Will the company meet its 2030 targets? Maybe, Gordon says.
“Fonterra is a big ship to turn, but the Titanic is now no longer getting bigger – it becomes more maneuverable.”