Monday , May 29 2017
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Keith Woodford: Fonterra and China

There is no escaping that Fonterra’s path forward has to be closely linked to China. No-one else needs and has the ability to pay for New Zealand milk in the quantities that we have available to supply.

Whether that means we are over-exposed is a matter of perspective. But that perspective does not alter the reality that China is the opportunity. Whether or not the associated risks also become a reality is largely up to Fonterra itself.

The last fifteen years should have been easy for Fonterra. The world has wanted milk. New Zealand and others have been there to produce it. On a rising tide all boats are lifted. With the wind at one’s back, it is easy to smile.

Yet Fonterra’s path in China has been fraught with mistakes.
At a political level, Fonterra continues to have good standing in China because the Chinese respect size and power. Also, Fonterra and our Government earned gratitude for the way the San Lu debacle, coinciding with the 2008 Olympics, was handled. But one way or another, San Lu was always going to be a commercial debacle.

Some months before the San Lu melamine scandal, I met Fonterra’s China manager in Shanghai. We talked about the Fonterra structure in China. I expressed surprise that Fonterra’s manager was not a direct report to CEO Andrew Ferrier. One of the first rules for any business going to China is that the in-country manager should be a direct report to the international CEO. China is too big and too complex for it to be any other way.

San Lu was an old-style Chinese dairy company with old-style management. Fonterra thought that San Lu needed financial discipline whereas the prime underlying problems were San Lu’s archaic logistical and quality systems. It was a terrible partnering choice from the outset. Fonterra’s top level management badly read that situation.

UHT (ultra-heat treated) milk to China has been another lost opportunity. To some of us, it was obvious by 2007 that the stars would align for transporting long-life milk to China. But Fonterra was focused on how the stars currently aligned rather than where the future alignment would be.

By 2012 Fonterra was trialling UHT milk branded ‘Country Goodness’ in supermarkets. Together with a colleague, I came across this milk in inland China [See photo]. The packaging was awful and it also looked like the packets had been kicked around a football field. We took photos, convinced we had found a cheap fake brand and sent them to Fonterra. The next day we got a response that it was indeed a real Fonterra product.
Fonterra is now expanding UHT milk production for sale in China, but they are late comers to the market with all the disadvantages and challenges that entails.

Both with UHT and branded infant formula, the Europeans are winning that battle hands down.

There was good logic to the plan to set up farms within China, but only as a means of getting closer to the market. Fonterra struggled with its first farm on a low lying site and with a poor design, but then got things right with the next farms. Everything went well through to early 2014, but more recently the farms have been loss-makers. The key aim of using these farms to advance Fonterra’s brands in China has not yet come to fruition.

Fonterra used to be a key supplier of infant formula for Danone’s operations in China. But alas, that went astray with the botulism scare. Danone remains very angry with Fonterra for the lack of warning. Long before botulism was suspected, the powder was known to have other quality issues, but Fonterra kept Danone in the dark.

And that goes to the nub of one of Fonterra’s problems in China. The Chinese Government may like Fonterra but Chinese companies find Fonterra arrogant and difficult to deal with. The constant churn of staff also makes it very difficult for Chinese companies to develop the partnership arrangements they seek. And that makes them uneasy.

In amongst all of these negatives, one potential bright spot is the new partnership with Beingmate. With strong logistics across China, Beingmate looks like the perfect partner to cover for Fonterra’s weaknesses. Whether the potential will actually be realised, remains to be seen.

Other bright spots for Fonterra have been ingredients and food service. They fit with Fonterra’s seasonal supply.

I mentioned that Fonterra often fails to identify opportunities sufficiently in advance. That is a cultural thing for which both management and the directors have to take responsibility. Their governance team has lacked people who understand the impact of new disruptive technologies.

The next big opportunity that Fonterra should be moving on right now, is extended shelf life (ESL) milk. This is different to UHT milk. It has the taste of fresh milk and has a shelf life of five to nine weeks. A key aspect of ESL milk is that it includes micro filtration.

In Germany, some 30% of consumer milk is already ESL.. It is also becoming widely available in the USA. It won’t be long before both of these countries are sending large quantities to China, and it will be the new premium milk. Where will Fonterra be?

There is little doubt that China’s demand for dairy will grow. What is less certain is how much of this growth will be for milk powder. But if Fonterra is to move away from standard powders, and focus on value-add products like ESL milk, it will have to convince farmers to supply milk 12 months of the year. That will require a revolution down on the farm.
 

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