Stephen Franks: Leave Fonterra to sort itself (or not)

The amalgamation/monolith structure of Fonterra was a mistake. But it is what we have and pulling it to bits now could compound the mistake.

The Fonterra monopoly came from a conjunction of  dairy politics with the instincts of a leftist Clarke Cabinet, at a time when they needed to rebuild trust with business. The Fonterra ‘capture the value chain’ slogans appealed to a Cabinet nurtured on coop=good/big battalions/commanding heights socialism. So they legislatively outflanked the Commerce Commission, relegated official reservations, and created the monolith.

The Herald has an excellent review of the reasoning and the outcomes by Tony Baldwin, an official at key times. But his recommendations could be used to support those who’d like now to pull levers the other way, and impose new structures, equally well meant, equally sloganistic,  and equally without knowing the future any more reliably.

I led the legal team working for the Dairy Board on the Globalco proposal that got killed by the Commerce Commission in 1999.  As an MP I sat on the Select Committee that refined the Dairy Industry Reform Act after the deal to set up Fonterra.

My personal view had been that the stand-out best solution was to set up two competing coops, preserving the competitive challenge of their different cultures. But deliberately creating a cluster effect instead of a monolith was anathema to the coop fundamentalists of that era.

The McKinsey and Boston Consulting Group work focussed on the potential gains from size. In my opinion they were too influenced by what they thought was politically acheivable. They  knew what Dairy Board people who were expected to win the internal political struggle wanted to hear. So the relative sophisticates of NZ Dairy Group from Hamilton were subordinated to the cult figures of Kiwi, gathered around Craig Norgate in Hawera. The latter seemed  better at shed politics.

I am a strong believer that coops are a robust and sensible mechanism for collective farm gate marketing by and for farmers. I do not share the scepticism about the ability of farm leaders to become excellent directors. But I am deeply sceptical about the group think that emerges in any institution insulated from the constant reality challenge of genuine competition in its key operations. ‘

I am aware of no evidence that business is necessarily better when it is bigger, and especially when it gains monopoly power. Jeremy Moon’s business did not come out of the Wool Board. It was not an insight of raw material suppliers. Whittakers Chocolate is tiny by world standards but it is taking on Nestle and Cadbury and their big owners and winning in Australasia, apparently without the outside capital people believe Fonterra must have, and without legislative preference. But the rewards for that kind of entrepreneurship go to those whose unique skills and experience create the value. Farmers can’t buy that income stream just by recognising that it is a great source of value, and setting out to capture it.

This is not to contend that scale is irrelevant. It was sensible to create coops at least big enough to afford efficient scale processing plant, and to attract the kind of management talent that might develop breakthrough gains to match the huge gains in on farm productivity.

However the farmer-rule faith folk had persuaded themselves that coop needed monopoly, to eliminate “weak sellers” and competition at the farm gate. They believed that size gave the power to dictate to markets and consumers, so you could cut out the returns that otherwise go to ‘parasitic’ middlemen, like marketing experts and entrepreneurs.

So we got a single dominant player, with all its problems, including a lack of local alternative employment for ambitious execs who challenge orthodoxy within Fonterra.

Baldwin cites the Aus Competition and Consumer Commission’s common sense:

“if you cannot beat your rivals at home, how can you hope to do so overseas?”

His material from the Australian Productivity Commission (ACP) may have been covered in agricultural papers in New Zealand before, but if so I’ve not seen it.

The farmers pressing for the merger of Alliance and SFF, and legislative ‘rationalisation’ of killing capacity, wanted the Fonterra model. Were they asked for the analysis to justify ignoring the ACP “dismissal of the claim that a single dairy co-operative would give it market power to influence international prices — a myth that has dominated and constrained the New Zealand industry for so many decades?

Baldwin goes on “While the Australians have preserved effective competition at the farm gate, New Zealand’s industry leadership has for decades focused on eliminating it. Fonterra claiming that it’s our “national champion” is equivalent to saying we should have the All Blacks without the Super 15 and ITM rugby competition”

But does that mean Fonterra should now break up?  The logic is not obvious just because the value added businesses could use more capital. Successfuly challenging Nestle et al needs much more than capital. Quantitative easing has made debt capital almost free. But even if removing the capital constraint would set that side of the business free, it would still be risky. We’d get the benefit of knowing what the market saw as the increased risk from what it might pay for those businesses separately.

Baldwin implicitly treats returns of 5-8% on capital as inadequate. If they are relatively low risk over the long run, they are actually good. Just not as good as pomised by the Fonterra creation puffery. And if he is ignoring the return from land values the criticism is misleading. All around the world increases in rural production are captured into land value increases. They always make returns on capital employed in farming look poor. But they are real gains, obtained over centuries.

What alternative investments would farmers make with capital released from Fonterra? Cutting debt probably. But we need to know if the return on that is better than the return on the under-performing businesses withing Fonterra, as they are now valued. If  they have option value for Fonterra it may not be worth splitting them out. It is  a respectable achievement not to lose money consistently in ancillary and experimental businesses.

In the absence of compelling analysis I hope Fonterra now holds its course against criticism. But the NZ government should ensure there is nothing in the legal environment to prevent  its (NZ owned)  competitors from growing rapidly:

1. so New Zealand farmers have more eggs outside the Fonterra basket, and
2. so Fonterra has more domestic competition for milk, for employee brains and for strategies.

Stephen Franks is a principal of Wellington law firm Franks & Ogilvie and a former MP. He blogs at www.stephenfranks.co.nz.