That shock loss

New Zealand’s world-class performance on the international stage took a hit this week with a shock loss. While it might be the All Blacks' loss to the Springboks that has people talking, there is another loss that is even more concerning. Our largest company, Fonterra, confirmed a net loss for the 2018 financial year of around $200 million dollars.

By any measure, this is Fonterra underperforming. It wasn’t a complete surprise. Dissatisfaction with Fonterra’s board and management has received something of a focal point with Shane Jones tapping into these feelings for political gain. When populist politicians go after large businesses something is definitely amiss. But even under that pressure the outgoing chair of Fonterra had talked up its performance only a few short months ago, suggesting it was enjoying margins that weren’t available to its competitors. These statements are difficult to reconcile with the latest financial figures.

Large companies like Fonterra are complicated, and I can’t pretend to know all of the factors that are going wrong. I can, however, pinpoint a major likely concern that falls within my area of expertise. It is that regulation of the price that Fonterra buys its milk from its farmer-suppliers is weak, and this damages the incentives to perform like a competitive business should. Let me briefly spell out the situation.

Fonterra’s business can roughly be divided into two parts. One part is the ‘commodity’ business. This involves selling large quantities of standardised milk products. When you shop for milk in the supermarket, all of the ‘blue top’ options are essentially the same, even though they may have different brand labels on them (and might be sold at different prices). This is a commodity market, and winning in this segment of the market is a numbers game – simply sell as much as possible.

The other part of the business is the ‘value added’ part. This is where Fonterra tries to process milk into new or innovative products, or otherwise add some ‘value’ to the dairy products they are selling. This could mean making extra stretchy cheese, for example, or simply selling under a premium brand. Again, the supermarket isle provides a pretty good example. Fonterra sells its milk in ‘light proof’ bottles to better protect the quality of the milk and differentiate its product from its retail competitors and justify a higher price (although the marketing and innovation team that developed those bottles clearly had never read Donoghue v Stevenson). It takes more effort (and costs more) to play in this premium end of the market, but get it right you make more money per unit.

To get really good results, to some extent you have to choose which of these two lines of business to focus on? So, which one should Fonterra choose? The answer might seem obvious – target the higher value products and, over time, make more money. Trouble is, this is difficult in practice. There are huge international competitors to contend with, like Nestle and Danone, and they are very, very good at selling their premium products at the expense of yours. So it’s not something that can be achieved overnight. If you want to play with the big boys and make the big bucks, you have to invest for the long term.

Why is that a problem? Because you can make a reasonable profit in the short term by continuing to sell your commodity products without the same kind of risk or need for investment. And if you have a bunch of owner-suppliers who want a decent pay out every 12 months so that they can stay in business, you might understandably focus on the short term rather than the long term (even though in the long term we are all likely to be worse off).

All of this is a long-winded way of saying that Fonterra faces conflicting incentives – it can live for the now or invest for the future. At the moment it is trying to avoid making a hard choice and so it is doing both (after all, what CEO or board would want to make that kind of call and risk getting it wrong). And the FY18 results show the outcome of that approach.

It is these conflicting incentives that have led some commentators to argue that the government should split Fonterra into two businesses. The incentives within each business would be much cleaner, and they would focus on doing what they do well. I have some sympathy for the instincts in play here – the thinking is heading in the right direction – but it really is a nuclear option. There are no examples of a forced structural separation working anywhere in the world that I am aware of (it has been tried regularly in the telco sector where the results have been less than stellar), and so it probably wouldn't work in this case either. Cleaning up the incentives needs to work more naturally (or, if you prefer, be more market driven) if the goals is to have successful international businesses at the end of the process.

There is actually already a regulatory tool working in the market which is designed to help deal with this sort of issue. The price Fonterra pays its farmer-suppliers is regulated in the sense that although Fonterra dictates that price it is required to demonstrate that it meets certain standards consistent with contestable markets. A genuine market price for a farmer’s milk is impossible, because Fonterra is just too big and too dominant to allow market forces to work unaided. But if a good proxy for the market price can be established through regulation, then this would send important price signals to Fonterra about which of its two main areas of business it should focus on. Robust regulation of tis type would achieve much of what forced structural separation is aiming at, but in a much more natural (or market-driven) way. Fonterra gets to decide how it splits up its business units depending on its costs, ability to outperform and competitive dynamics.

Unfortunately, while the intention of this regulation is good, its operation in practice is less than desirable. There is no real objective scrutiny of Fonterra’s price setting, and so it continues to set prices how it likes. The final milk price that farmers receive is therefore more a reflection of where Fonterra wants the price to be (driven by its conflicting and contradictory incentives) rather than any kind of reflection of what a contestable market price might look like. Fonterra has, in effective, manipulated an ostensibly objective price setting mechanism to reflect its subjective needs, all while the presence of the regulatory regime itself allows Fonterra to disavow that it is undertaking any such strategy.

That its not working is now abundantly clear. Fonterra has cited higher than expected farm gate milk prices as part of the reason for its losses, but Fonterra sets that price itself. And importantly, the regulator, its competitors and investor all know that it is currently setting that price arbitrarily high in a way that no working market would set it. Why does Fonterra set a key input price so high when it is making a loss? We don't know for sure, but it does show how out of step with reality Fonterra's conflicting incentives can be - those incentives lead it to dogmatically argue that it is setting a market price when all the evidence proves the contrary.

I think this is a significant problem, and is something that the government needs to take action on. The Ministry for Primary Industries, who are responsible for the regulatory regime, are looking at this and other issues as we speak. I can only hope that they will recommend to the government that the process for setting the farm gate milk price is made more objective and robust. Fonterra looms so large in our economy that its success really is our success, and so we need to give it the right incentives to really succeed on our behalf.

#regulation #dairy #Fonterra

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