Parliament has removed the open entry and exit provisions of the Dairy Industry Restructuring Amendment Bill (DIRA).
The splitting of Fonterra’s high value versus commodity business might sound good but it is hard to run a high-value business without having a commodity arm, he says. This is particularly so for Fonterra because it can’t control its supply from farmers because of DIRA.
“Fonterra has about 10,000 suppliers while those other companies have suppliers in the hundreds,” Lees told Dairy News. “Some of the markets the smaller ones are selling into, for Fonterra they probably wouldn’t have a huge impact on their return; they are a small part of the market.”
The smaller companies can “cherry pick” because those markets make a big difference to their profitability, he says.
“Fonterra will always have to be in that commodity business just because they are responsible for 30-40% of the total trade in dairy products in the world. That is a huge volume to make sure they can sell every year. There is a big requirement on Fonterra to sell a large amount of commodities because they couldn’t put all the volume into niche products.”
Lees says, for instance, a good proportion of what Synlait produces is A2 and its share price has followed the a2 Milk Company share price upwards. “But the volume of A2 as a percentage of Fonterra processing would be a very small proportion. Even going into something like A2 probably wouldn’t necessarily have a huge impact on [Fonterra’s] bottom line.”
However if Fonterra had bought the a2 company when it had the opportunity it would have made a lot of money – an example of questionable business decisions.
Lees says in regard Referring to the suggestion of splitting Fonterra in two, Lees says many people don’t realise that any agribusiness or processor needs to have a commodity side to its business.
“Synlait exports a proportion of their product as skim milk powder or whole milk powder or anhydrous milk fat,” he says.
“If you are dealing in niche markets you need to be able to control the volume of supply into those markets because you can easily have a surplus and that will drive the price down.
“If you look across dairy, meat, even seed companies – they will sell product into the commodity market just to be able to manage their high value markets. Those markets generally require a consistent supply of customised product. With a very seasonal system there will be times of the year where there is excess product produced. Unless you able to put that into the commodity market, it will effectively damage your high value markets.
“DIRA is a huge weight on [Fonterra’s] business because it means they have to increase their processing capacity based on farmers coming in to supply them and they also can’t select the quality of their farmers,” he says.
A huge increase in volume has often forced Fonterra to push product into the commodity market, requiring heavy investment in processing and borrowing money. Farmers are fairly indebted so they don’t want to invest more in Fongerra than they have to.
“Synlait, Open Country and Tatua very tightly control their number of suppliers to make sure that matches their demand and processing ability.”
Fonterra has had to make decisions that are less than optimal from a business perspective just because they can’t control suppliers. “They have to accept additional volume and they may not be able to get the best price in the market, because they have such a large amount to sell.”
Farmers could choose to leave Fonterra and supply another company. “But a lot of farmers want to stick with Fonterra because they see that having farmer control is an insurance policy against having the milk price pushed out,” he says.
They see shares as a means of controlling the processing market and a guarantee they will get the best milk price return. “However over the last few years that has been a very high priced insurance policy.”
The DIRA requirement for Fonterra to take more milk is a drag on profitability.
But industry growth may slow and that may help Fonterra.
Synlait has a Chinese investor with deep pockets and they can raise money on the stock market as they did two years ago.
“They don’t have to make volume investment; they can invest in infant formula, canning lines, high-quality products like lactoferrin and niche products that would be a relatively small proportion of what Fonterra has to process.
If you change farmers from having a guaranteed market, they themselves would have to make better business decisions and make the business case for increasing their farm’s production.
• Nic Lees, senior lecturer in agribusiness management at Lincoln University, came to the university with 20 years experience in various agribusiness roles.