Fonterra's core advantage

This is the fourth of five articles aiming to explore dairy industry strategies in NZ and provide a perspective for viewing Fonterra’s strategy.

The purpose of this article is to understand what a core strategic advantage is, why it is important and what Fonterra’s core strategic advantage(s) may be.

What is a core strategic advantage?

Put simply, a core strategic advantage is the aspect or speciality that enables a firm to compete with or outperform its competitors.

This may take the form of a high tech value adding process, human capabilities, physical assets that deliver scale and/or complexity that is hard to emulate. Other ways to gain a strategic advantage are to create a point of difference delivered by branding, legal protection or geographic positioning.

Over the last three articles we have identified the basic strategic positions of three different firms. This builds a picture of what their core strategic advantage may be. For example OCD as a “Cost Leader”, has the core strategic advantage of being operationally excellent. OCD can minimise its processing costs while maintaining considerable product mix optionality. Leading with “Customer Intimacy,” Tatua maximises value with a high degree of technical specification of ingredient products and close working relationships with its customers. As a “Product Leader” a2’s strength is its patents and the clever supplier agreements which allow it to control the supply of a2 going to market.

Another way of understanding the core strategic advantage of a firm is to assess its position on the value chain. In their recent report to the Productivity Commission, TDB Advisory (a consultancy) outlines the position of all major dairy firms in NZ in terms of the value chain. They make the point that moving up the value chain can destroy value if costs increase more than revenues.*

This suggests that firms who stick to their core strategic advantage should have a better chance of staying competitive.

The idea of moving from a commodity return to a value added return that “smoothes payout” is a long time embedded in the NZ dairy psyche. But was it ever realistic? The many attempts Fonterra has embarked upon to “move up the value chain” or build a vertically integrated model have mostly not succeeded. So while over ninety percent of our farmer returns have always come from the milk price, rather than being valued as an advantage, this aspect of the business has been used as a backstop.

So where should we look to find Fonterra’s competitive edge?

Given the fall of Fonterra’s share of NZ milk from 96% to 81% and a Return on Capital Employed (ROCE) below most of our NZ competitors*, it would be misguided when looking for a strategic advantage to  point to any one aspect of our cooperative and simply cry “Eureka!”.

In my view there are three questions we need to ask of our cooperative simultaneously.

What is our core business? What is it we think we are good at? What are we not good at?

Fonterra’s core business is collecting farmers’ raw milk, then processing and delivering it to customers in the market as an ingredient, commodity or food service product with the aim of generating the best milk price possible.

With regard to what we think we are good at, the best insight I have gathered from experienced dairy industry participants pointed to Fonterra’s strategic advantage as being: ingredients, innovation (product and process), logistics and its farmers. This suggests that with Fonterra’s size we have the advantage of being able to supply globally across multiple products to customers (like Nestle) who prefer to deal with bigger suppliers.

Like any business, anything that repeatedly loses money, decreases in value or continuously achieves returns below the firm’s weighted average cost of capital, indicates things Fonterra is not (currently) good at.

The observations we have made of three other firms clearly suggests that there are distinct defensible strategic positions that can return value. It is also clear that these firms understand their core strategic advantage that delivers that position for them.

Identifying Fonterra’s core strategic advantage or required strategic advantage is the key element for the strategy going forward. Therefore understanding Fonterra’s core strategic advantage is the first step in discussing any changes to the capital structure.

In the next issue we will look at what a good strategy should contain.

Simon Couper is a Waipu farmer and a former chairman of Fonterra Shareholder's Council.