Building a Profitable Future From the Current Base

  • John Luxton
Food, Fibre, Biosecurity and Border Control

PALMERSTON NORTH

Last June, I spoke to the Dairy Section of Federated Farmers about the pressing need for us to consider future alternatives to the current structure of the New Zealand dairy industry (copies of speech available). At that time, I urged farmers to recognise the very serious risks inherent in the current approach of not allowing sufficient investment or competition into the most vital parts of the dairy industry. And I said that the removal of the statutory base was inevitable, so the industry was better to be proactive rather than reactive.

I am pleased that since then, there has been considerable discussion and debate on the issues, which, as I recall, were dismissed by some at the time.

The Vision:
To have a constructive debate we need to know what we want to achieve. What is the vision? I want a dairy industry:

where your hard work counts, and is rewarded;
where you have control over your capital and earn a good return from it;
where your standards of living improve, not decline;
that encourages innovation and attracts capital so that we can capture the maximum value from the consumer in the international market place;
that is focused on commercial performance and not distracted by politics;
that is market driven and has the right incentives;
where you don't underwrite all the risks;
where you don't just take a residue payment after everyone else has subtracted their costs and profits;
that is out of the commodity trap and provides more value added jobs within New Zealand;
that your sons and daughters will want to join to build on your efforts.
Have we got such an industry?

Farmers need to question performance:

While farmers continually work to improve on their side of the farm gate, the performance and current structure of those who service the farmer and provide monopoly marketing services on the other side of the farm gate, needs to be addressed.

In 1972, when I began dairy farming, I received over $6/kg ms in 1998 dollars. Now I receive around $3.50. At the present level of commodity sales, this may halve again over the next 25 years. Quite simply, dairy farmers continue to be commodity traders. Farmers, on their side of the gate, have doubled their average herd size to almost 200, increased production per cow, cows per acre, spent more capital and produced at record levels in response. Fluid milk production in the 1996-7 season reached a record level of 11,500,000 tonnes, around double what it was 20 years ago.

To me, any export industry that gets asked to take a 20% drop in income when the trade weighted index drops around 20%, is not delivering as well as it could. Over the years we have heard rhetoric that payout would be higher, if only the dollar was lower.

As owners and operators of medium to large businesses you need to have sufficient information on performance so that you can make sound business decisions about where and how you want to invest your capital, time and effort. The returns from your dairy operations have to measure up against other uses for your capital such as the share market, motels, other productive and manufacturing activities or the return from simply having money in the bank.

To me, the key performance measure of the dairy industry, indeed in any industry, is economic value added or EVA. That is firstly, cash from the fruits of your labour, secondly, the cash return on your capital, both on farm and off farm, and thirdly the improvement in your net worth over the period.

Currently you have little information and are outlawed by the current Dairy Board Act from making normal business choices. You have little ability to make informed decisions.

You might ask a few direct questions about the performance of the multinational business that you own. The sorts of questions you could ask, for example, may be these:

1. What is the dollar amount and % return on your capital you have invested beyond the farm gate in processing, in marketing, in foreign subsidiaries and joint ventures over the last 10 years and what is it really worth on an open market?

2. How much new investment there has been beyond the farm gate over the last decade and where has it been sourced from: NZ farmers, foreign interests, debt? What has the specific return been to each of these investors, if any? What is the cost of each type of capital?

3. What are the onshore and offshore operating costs of the Board and what efficiency gains have been made? As with Carter Holt Harvey last year, has $300m been taken out of cost structures this year?

4. What is the return on your investment of subsidiary companies over the last decade? Has Aspack Foods, as NZ's major margarine product, given a market return?

These are just a few suggestions, but as owners of the business, you are entitled to the answers, even if you were not allowed to attend the Dairy Board AGM.

Just as Government is accountable to taxpayers, so too should your processor and your monopoly provider of marketing services be accountable to you. They are taking and using your money, as Government does with taxes, which you have no option but to pay up without any real choice unless you sell the farm.

You have no way to know whether the next dollar invested by coercion in an offshore subsidiary, the Board, or your local dairy company is going to give as good a return than if you used your money to reduce you overdraft or mortgage. And of course you are outlawed from having that choice anyway.

Existing constraints
The current industry structure is determined by Parliament and not the market place. It requires the will of Parliament and politicians to agree to make changes to your structure which a normal corporate could make at a general meeting.

It restricts innovation by allowing only the good ideas of one marketeer out of New Zealand, and by outlawing the competition needed to encourage innovation. Currently around 80% of your product is sold as a commodity or to someone else to add and capture value.

It limits capital investment which, if unlimited, could add much more value to the New Zealand dairy industry and the economy. The Dairy Board and processing co-operatives face an increasing shortage of capital and cash. This constrains the industry's ability to grow and invest, and competitors with fewer capital constraints will become a greater threat in future. Rapid growth requires substantial levels of investment in infrastructure, support services, marketing research and technology.

Capital constraints are not exclusive to the dairy industry. Demutualisation is sweeping across the insurance industry in an attempt to attract new capital and to grow rapidly in a very competitive market. Already the involvement in the Chilean dairy industry shows the way.

The industry lacks transparent, market-driven performance indicators. While comparisons can be made between manufacturing co-operatives, the Dairy Board, which contributes the bulk of farm payout, has no competitive benchmark organisations.

The incentives can be perverse. While farmers are the owners and chief source of capital, this isn't properly recognised. Current payment systems encourages production. Ownership needs to be better identified with a tradeable asset or share. Much, if not a majority, of a dairy farmer's wealth is now off the farm, but largely invisible, unavailable, inaccessible and not managed with adequate accountability. It does not allow you as business people to redirect your own capital to where you might get a better return. It simply takes it away from you.

While they may own the industry, farmers themselves have little direct control. Apart from trying to voice concern at Dairy Company meetings, they have no way to influence management.

Management does not have an ownership stake. Normal business incentives do not fully operate. As farmers, you might behave differently if you did not have an ownership stake in your business, or had less external competitive pressures.

Your biggest competitors market a range of products from milk chocolate to coffee through their marketing infrastructure. Is your asset underutilised?

Why can't you sell an apple or kiwifruit through your structure to the same supermarket you sell cheese to? It is like running two separate trucks to deliver toothpaste and mouthwash to the same supermarket. Why do we require vertical segregation by agricultural product line from this country when it doesn't make economic sense?

It creates very big risks when the industry gets it wrong, for example this year's forward exchange decision, and the decision to hold on to stocks when prices were very high a couple of years ago. You totally underwrite those risks, and simply receive a lower payout once the cost has been deducted. The main way you have to control your current risk is to sell the farm.

A possible solution:
So how do we improve things? How do we build from our current base to improve the business of dairy? I am pleased there has been debate on future structures over the last year and different models have been suggested. The current debate is whether the future should be in a single compulsory company after 5 years, or a marketing company controlled by the existing dairy companies. To my mind the answer is somewhere in between.

It is important with any change that we maintain the existing marketing infrastructure and support services. We don't want the marketing, infrastructure and support services of the Dairy Board to be scattered to the four winds. Such a change could result in New Zealand losing marketing opportunities in the short term until the industry adapted to the significantly different export marketing structure.

Any structure, if it is to succeed commercially, must be market driven. As the Dairy Board's Operations manager, Mr David Pilkington, said last week in the NZ Herald, "No matter what the industry evolves to it has to become much more commercial. We have driven down the cost side but the natural evolution of where we are going is the real world of commercial principles" ( NZ Herald 4 March page E7). I agree 100%.

When we talk about structure it is important to remember that structures are a means to an end, not the end themselves. Dairy farmers should not be subservient to structures. Rather it is the structure that should be the servant of its owner - the dairy farmer.

So where does this lead us? The dairy structure involves three aspects; Government regulatory structure; ownership/control structures; and the internal dairy industry procurement structure (e.g., the cost model). I will look at each briefly in turn.

Government Regulation

Corporatise all the commercial assets of the Board into a company, the New Zealand Dairy Corporation, under the Companies Act.

This company would have no statutory functions or hindrances.

This company should operate on purely commercial principles, driven by the market place, paying a dividend to shareholders for the use of their capital.

Remove the requirement of the Corporation to purchase all export product, but perhaps allow it to retain a real advantage by allocating it the quota market premiums.

Other people with good ideas, technology, capital and trade relationships would no longer be outlawed from investing in, and adding value to, New Zealand's dairy produce. Nor should they require a licence.

There should be commercial incentives, not compulsion to supply.
Ownership/Control

51% of the new Corporations shares could be held by the current shareholders in the Board for a limited time (ie the current dairy companies). This would ensure initial majority indirect farmer control. However, the dairy companies may ultimately want to sell down their shares as it made sense to do so.

The other 49% would be put directly into the hands of dairy farmers. These would be floated on the stock exchange and could be freely traded. This would be in a similar manner to the successful Telstra float in Australia recently, West Farmers or that of Kerry Dairies of Ireland a decade ago. This approach would free the Board from the dominant control of Kiwi and NZDG to ensure that real market signals were not distorted.

The Dairy Companies could possibly be structured in a similar manner if that is what farmers wanted.

If farmers decided to keep their shares, they would of course, collectively control 100% of their current industry assets. However, farmers themselves would make their own decisions on much of their own off - farm capital. They would be able to spread their risk.

Additional equity could be raised from outside the industry.

Farmers would receive 3 revenue income streams; a payment for their milk product, a dividend from their shares in their local processor, and a dividend from their shares in the new Dairy Corporation.

Any capital gain from land or shares in beyond farm gate assets could be realised separately.
This would enable farmers to own as much of their current industry assets as they chose to, while giving them options on where they invest their capital and how they wish to receive income. It also allows them to benefit from alternative sources of capital, ideas and trade relationships.

This would also enable top management of the various companies to be offered a stake in the company that they manage, therefore giving them added incentive to perform, rather than just be salaried employees.

Internal industry structure

The cost model is already being changed to be more market orientated and to reduce the huge incentive to produce commodities. This announcement was made last week and is a step in the right direction. The Business Development Project is a good start to getting market signals through to companies and farmers. It does not yet adequately deal with adding value and the rule making system is still controlled by its commodity suppliers of milk processors. The two large commodity producing companies are able to exercise a veto which inevitably leads to a distortion of the market signals.
The commercial marketing company needs to have an independence from its processing suppliers to act on the basis of the market for its shareholders, rather than its processors. This is perhaps the key difference from the current proposal before the industry

Any new internal industry structure should be set up as an umbrella organisation which would allow takeovers of processing facilities to occur in return for new shares issued to farmers or other owners. Alternatively, processing companies may prefer to sell product through the Corporate on a commission or other form and retain their independence.
This is a rough outline of a structure to which the dairy industry could evolve quite quickly. This model enables farmers to build a profitable future from the current base. It will free up the existing Board from existing constraints and allow it to utilise its recognised skills and expertise to grow and harness new opportunities.

I believe that the timetable for change needs to be sooner rather than later. Each year that goes past is another year of falling behind.

As Sir Dryden Spring said in his AGM speech of the 14 October 1997, "Notwithstanding these difficult conditions, we achieved a record sales volume of close to 1.3 million tonnes of product; an increase on the previous year of 258,000 tonnes. To put this increase in perspective, our total branded consumer sales are around 260,000 tonnes and it has taken us over 15 years of concerted effort to reach that volume" (page 3). That is just 20%.

For those of you who want to retain a "single seller", I would suggest the best and most profitable single seller isn't one forced by politicians but one based on commercial performance. One based on "a brand" that is highly desired by consumers who are prepared to pay a premium.

Under your current structure and arrangements, after 15 years of concerted effort you now have only 20% of you product sold as consumer branded product. If you are to prosper, we now need to make changes so that we can quickly capture a higher return of the other 80% which is currently sold as commodity or to other manufactures.

The status quo leads to peasantry. I believe that the dairy industry has a rosy future if it addresses the challenges and opportunities that it faces. The choice is yours.