Norgate Speech: Where Fonterra is headed

"From Good to Great - Where Fonterra is headed and what it will take to get there."

Craig Norgate Chief Executive Officer

Dairy 2003 Waikato Events Centre, Hamilton

Thursday, 20 February 2003

Good morning. From good to great. This is our goal for Fonterra. When the majority of New Zealand's dairy farmers voted for the merger, I think it was their goal too. Today, I want to canvas how far we have moved towards that goal, what stands in our way, and what we have to do, to overcome these obstacles. I will deal with our performance, and our priorities for the year, showing where they fit with the wider vision of The Fonterra Strategy.

None of this can be discussed in isolation to the world's markets. This financial year is serving as a reminder - if any was needed - of the volatility of commodity markets, and our need to continue to increase the proportion of earnings we derive from value-added products. Given our commitment to shareholders to process all milk - and to achieve higher returns for them - we have to ensure that we continue to make that milk more and more valuable.

The first half of this season saw commodity prices at 10-year lows. I will discuss that impact further on in this address. We are now off those lows, but the current market is far from certain.

Let's consider that now.

Open any newspaper, turn on any TV channel and the talk is of war. Day by day, we see in the media, the case being mounted for conflict in Iraq. Day by day, we see that case debated and disputed. But the emerging view is that conflict is inevitable, and as this view hardens, economic confidence softens.

We are beginning to see the effects in the market. In Europe, for example, demand for milkpowder remains strong. But there are signs of nervousness, among European traders and producers, as the talk of war heightens. While current prices are good, they may not exist in two months, so we are having to think tactically. We have made maximum use of the window of higher prices for SMP and WMP, as deliberations on Iraq continue.

We have been working towards a goal, of being fully sold up for all milkpowders and fats by the end of February. We have almost achieved this goal, and will be fully committed in terms of product availability through until the end of July. The current dry spell, and its impact on production, will almost certainly mean we will have some inventory shortages, as we head through winter.

However, good planning should enable us to keep continuous supply through to our key customers, and we should be able to enter the new processing season with effectively no milkpowder inventory.

Our Australian neighbours are not so fortunate. Murray Goulburn indicated last week they are 23% down on budget. We are continuing to assume they will be out of the powder market until the end of October.

Returns for cheese still do not match those for milkpowders. While they have lifted, the increase is still not enough, and we have been reducing cheese manufacture as a result. We expect this pricing trend to continue into next season. However, where cheese pricing tracks over the coming months, very much depends on which product mix is preferred, in Europe as they progress through their season. If cheese is preferred, there's a risk of oversupply again with more European cheese looking for a home on export markets.

The protein market remains quiet, with prices having stabilised around the US$4000/MT mark for acid casein, with a small premium to caseinates. The New Zealand stock position has improved significantly since earlier in the season.

One looming cloud, is the reintroduction of quota proposals for casein, caseinate and MPCs that have been incorporated into a Bill due to go to the US Senate. While work is going on to have these proposals dropped, US lobby groups are working hard to focus officials on the end uses of protein, and to encourage them to narrow where and how our products can be used.

The market is being closely watched, particularly insofar as it might throw up tactical opportunities for us. It is clear the daily talk of war is disquieting. Many would share the view of The Guardian newspaper in the UK, which suggested Saddam Hussein may have another weapon of mass destruction in his armoury - the economic effects of war. Changes in oil prices and the cost of conflict might well produce recession for us all.

Payout

I know there are many of you who might think right now, that the recession is already here. In the past week, a great deal has been said about our decision to reduce our payout forecasts by 10c/kg MS.

I can assure every one of you here today that we did not reduce the forecast lightly. The $3.70 forecast, set last year, has been under constant review. The last formal review came last week when we finalised our half-year accounts. Those, and eight months of trading, gave us a clearer picture on likely returns. Having got this picture, we were duty bound to give it to shareholders. This is what transparency is all about. Shareholders hammered home the need for transparency during the merger. There was no rider that said "but only if it's good news".

We're not in the old days when the Dairy Board put out a conservative forecast, and the co-ops held their margins close to the chest, throwing in a surprise top up at the 11th hour. That riddled the industry with complacency, and shareholders with uncertainty. Where was the transparency in that? Where was the certainty needed for on-farm planning? If farmers want to hear only the good news - fine. But this is not the transparency you demanded on the merger, and it is not the Fonterra way of doing business.

Our way, is to keep our forecasts under constant review, and to keep you fully informed. Many factors impacting payout move almost on a daily basis. They can push our estimates down, or they can push them up. When we believe there is a shift of 10 cents or more, up or down, our policy is to let you know. As far as we're concerned, this is the only way we can ensure that you have the reliable information you need to run your businesses. This is a significant step up from the days, when the Dairy Board forecast three times a year, knowing full well they had plenty of fat in hand to deliver.

Achievements

I am the first to acknowledge that no-one welcomed the forecast adjustment. But I would urge you to look beyond $3.60 and look at our underlying performance. This is something the media has failed to do. In focusing on the emotion rather than the facts they have failed all of you.

The fact is that significant movements in commodity prices and exchange rates have far outweighed what is excellent progress at operating level. Quite simply, on the things that we can control, we are performing.

Our operating profit, which includes our value added activities offset by the milk price gap in our commodity business is forecast to improve by over $300m on last year - that's almost 30c in payout.

If you add that to the approximately $500m of hedging gains currently forecast, you will realise that payout could have been below $3 if you had just been left to feel the full impact of commodity prices and exchange rates.

Clearly, some very strong performance gains have been made. First, we lifted the achievement rate in merger benefits. We delivered more than $116 million in annualised merger benefits by 30 November. This has been independently confirmed by Deloittes. We are well on track to deliver the promised total merger benefits of $310 million.

Manufacturing and supply costs were down 8%, whilst handling record volumes. Whilst some of that is due to exchange rates, it's still an important achievement, so I will restate it. We handled record volumes, and we drove costs down in manufacturing and in transport. Those record volumes meant export shipments were up 40%, including a spectacular month in November when we shipped 211,000 tonnes.

We have made significant progress, in clearing surplus inventory. Our strategy was to move these large volumes, and get into a position to help to lead market prices up. That strategy has been successful, and is acknowledged by our competitors around the world. It is why you created Fonterra.

Particularly concerning - almost frightening - is the commentator who suggested doing so was responsible for the poor payout! If we had not exported these higher volumes, the result would have been considerably worse, we would still have had warehouses full of unsold products, and prices would still be at their early season lows. You don't make money in commodity markets by sitting on warehouses full of perishable product.

NEW ZEALAND MILK, our consumer products business, has achieved a 78% increase in earnings to $194 million - a significant achievement.

And there are more achievements. Last year we released The Fonterra Strategy. It answered some very fundamental questions, about the business created through the merger. First, what are we good at? Second, what can we be the best in the world at? Third, how are we going to get there? That strategy now has the full support of the board, shareholders, leadership team and our staff.

And again contrary to what some commentators have claimed we are not backing away from any of the targets we set when we promoted the merger. The $30b revenue aspiration came from the 1998 Industry strategy. It was about doubling the size of the business every five years. In fact we had almost doubled it by last year. But it was never a target for Fonterra. We have always talked about the bottom line -what ends up in your pockets.

Out of last year's strategy work we have translated that into a targetted total shareholder return of 13-15% with growth in earnings of 15% per annum. These are targets right up there with the best of our global peers - and the important thing with Fonterra is that we can measure ourselves on that basis.

By most measures, we're making good progress. And we will achieve more this year. Which brings me to my topic, from good to great.

The Hard Yards

Aspirations like "great" are never achieved easily. They are not achieved by one quick flash of clever market manoeuvring. They come from the day-to-day hard yards, with all your effort focused on what really matters.

When I was given the title for this speech, I had no doubts that it was appropriate, given the priorities that Fonterra now needs to focus upon. And whilst it's true that the goals must be considered in the context of our uncertain times, I see no reason for using the current global uncertainties as an excuse for inaction.

In fact, the reasons to get moving are compelling. Our grace period is over. Our shareholders voted for the chance to move from good to great. You are not only expecting us to deliver, you are demanding it.

Five Priorities

Doing the hard yards is the current focus for this company. It has driven the thinking behind the five priorities, that my leadership team has set the company for the year. These priorities are about pushing in one direction, as one company, building tangible results along the way. This is about all the staff in Fonterra, from myself down, taking our own area of responsibility and doing what's needed to lift Fonterra's performance. It's about turning our strategies into successful plans and winning, step by step.

Customers

Our first priority is our customers. I make no apology for putting them first. A New Zealand Herald article the other weekend talked about how many companies have "commitment to customers" as a catchphrase. Yet so many freely admitted they also put the bottom line ahead of that PR line. Big mistake. Without customers there is no business and no bottom line.

This is the reality that we need to drive home in Fonterra. Our industry has traditionally been very poor at linking our suppliers at home, to our customers in the global markets - despite the fact that 95% of production is bought by those very customers. Here in New Zealand, over the last decade, senior managers have almost always had to look inwards, yet great companies look constantly outwards toward customers and markets as the key source of sustainable competitive advantage.

That disconnection has to go. We no longer operate in a market overshadowed by the European Union, with its high costs and its export subsidies. That market required us to be very good at short-term tactics, reading the signals and securing the sales. In manufacturing in the past, we've often put the quick tactical gain ahead of long-term value.

Today, we have to be much more strategic and long-term in our thinking. The past five years have reshaped the global market. We have seen more than 600 mergers and acquisitions in the global dairy industry. Every one was designed to make our competitors bigger and better. These mergers have all been designed to deliver them manufacturing gains, access to new markets, higher market share and power, and more access to supply, and to capital.

The same global consolidation is happening with our customers. The top five food retailers in the United States, represent more than 40% of food retail sales; in the United Kingdom, the share handled by the top five is now more than 70%.

Fonterra, as a low cost and competitive producer, must foot it with the dairy giants, and must be on the "must have" lists for these influential customers. The total size of the market is not going to grow significantly in the near future, so the market share captured through these customer partnerships, rather than market growth, will drive profitability.

So will expanding the market opportunities, through promoting the case for free trade, at every opportunity. This year we have made the important appointment, of the Rt Hon Mike Moore as Senior Counsellor on trade and global strategy. I can think of few people with more experience, in arguing the case for a free and fair global trading system - and even fewer still, who can give us a global trade perspective with a distinctly New Zealand flavour.

We have strongly supported the Government, in the WTO services negotiations, under the General Agreement on Trade in Services (GATS). Whilst we are mainly concerned with freeing up the international trade of goods, specifically in agriculture, Fonterra recognises the value, of having a set of clearly defined rules, that bring transparency and consistency, to the way New Zealand's trading partners regulate trade in services. We will continue to support the Government, in its efforts to promote, more open access, for New Zealand's exports, in the international market. We will continue to argue the case as a company.

Until those markets open, and even more so when they do, strong customer relationships will be fundamental to our future. The Fonterra Strategy stresses this time and again. If we are to achieve leading positions in specialty milk components, consumer nutritional milks, and the foodservice sector - all major themes of our strategic plan - we have to get close to our customers.

We must think beyond products, and add our skills to the mix. We have enormous capability in this area. Our technical resources are as wide, and as deep as you'll find in most dairy organisations in the world. But we have to focus now on taking that capability, building on it, and really getting inside our customers, and understanding what makes them tick. We have to be more responsive, more innovative, and much more customer focused.

By the end of this year, each senior executive will be taking specific steps, to strengthen the relationships that we have with our key customers. Right across the business, every Fonterra employee, regardless of their roles, location or responsibilities, knows that customers are our number one priority.

Innovation is one of the most important things, that we have to deliver, to secure these strong customer relationships. Innovation is in danger of being one of those worn out words. Today, every new product is labelled "innovative". We're not talking here about a new colour or a new flavour. We are talking about genuinely new ideas, and intellectual property.

This need to link our drive for innovation, to the needs of our customers, underpins one of the most significant moves in the reorganisation announced before Christmas. This grouped our Marketing Group alongside our Fonterra Research Centre. There is no better fuel, for an innovation engine, than the desires of our customers. Having these two teams working as one, will enable us to rapidly deliver innovative solutions, to our customers in a manner consistent, with the very best of our global competitors.

As I speak to you today, there's a conference going on in Auckland, called Knowledge Wave 2003 - The Leadership Forum. I will be chairing a session at this Forum tomorrow. Our involvement is a natural fit. One of the key themes of our strategy, revolves around knowledge and intellectual property, those acknowledged drivers of economic growth. It is knowledge and intellectual property, that have the potential to deliver new value-added earnings for Fonterra, with limited capital requirements. Milk is not just milk any more. I call it nature's medicine. It has a remarkable array of components, that can improve overall health, fight specific diseases and be used in an almost unlimited number of ways. The race is on to identify them and, more importantly, to show the market how they can be used. Fonterra is stoking up our innovation engine. We have to win this race.

Shareholders

Our next priority is our shareholders. They are as fundamental to the business, as our customers. The word "loyal" isn't just about retaining New Zealanders' support for our America's Cup defence. It's what we, at Fonterra, have to win from our shareholders. We had better win. We know the grace period is over. That loyalty will only come from consistently delivering better returns, and better service.

This year we will start the journey, to deliver suppliers a level of service, that outperforms anything received in the past. We will address the issues like peak notes, that are a constant frustration for suppliers. We will continue the push for better communications, and embrace the relationship with the Shareholder Council.

We have to make that connection between our shareholders - and what they produce - and our customers. We have to increase the flow of customer and market information to the farm. We have to place more emphasis on finding ways to support our shareholders in their business. We must see productivity gains on farm of at least 3% each year. This doesn't necessarily mean more milk. It means producing more efficiently, and we can help provide the tools. The broadband initiative, with its potential to deliver better quality information, and business tools, is just one example.

Another is our environmental package, designed to help our suppliers lift on-farm animal welfare and environmental practice. This again is driven by what we know our customers, are increasingly demanding. Our challenge is to ensure that all of our suppliers, recognise that improving environmental performance, is a customer driven initiative, and to ensure that the cost of progress in this area, is manageable and sensible.

Organisational Alignment

Our next priority relates to how we function as a company. The Fonterra Strategy sets a clear vision, and clear strategic priorities. But they will not be achieved until we align our entire organisation to it, in terms of direction, structure and cost.

The current reorganisation is critical to this. It has caused some upsets. But we have to be clear that the merger is behind us. We have to deliver and exceed the benefits promised. Fonterra has to think, act and be one company, clear in our goals and focused on our customers.

As CEO, I, and my leadership team will give the clear direction, needed for this single focus. But responsibility does not stop with us. Every Fonterra employee must be personally aligned, to our direction and our strategies. It's time to all push in one direction.

We have, in Fonterra, agreed values and principles. They embrace being: - focused on the future, - acting with complete integrity, - being energised by innovation and - delivering uncompromised results. These values and principles, must underpin all that we do in Fonterra.

Our Values highlight our belief in our ability to succeed. That success will come from one aligned team pushing in one direction.

Processes

Our fourth priority moves from people to processes. In our first year, the business of staying in business, meant that we made do with some inherited systems and processes. Systems and process that were quite simply hopeless, given the fundamental change in the business with the creation of Fonterra. That is now being addressed.

Again, the driving force is The Fonterra Strategy. To achieve our goals, we simply must have accurate and timely information, superior market intelligence, accurate financial data, and better systems for managing our customer relationships. Overhauling our key systems and processes, is an absolute priority. It is an enormous task, but we are already making good progress.

In Programme Jedi we will deliver a supply chain capable of delivering outstanding customer/manufacturing links. This supply chain work will deliver savings of around $80 million per annum, but the gains are not just financial. Already, we are seeing the benefits of having our sales and manufacturing teams working together, because the higher levels of communication are making us even more responsive to customers.

We are also working towards a significant step up in our global IT infrastructure which is aimed at giving us a system with maximum flexibility and is specifically geared to our future. We are fundamentally overhauling and improving our financial reporting systems, and our information management systems.

These systems are the foundations of any organisation. By ensuring that they are world class, we free up our energy to focus on customers and the market - from which our real source of competitive advantage must come.

Bedding in the Strategy

I have referred to the Fonterra Strategy repeatedly today. Having spent much of last year developing it, we now have to put it into action. The Strategy gives us real clarity in its seven strategic themes. Our priority this year is to develop the specific business plans, that will form the basis for our operating plans. We will be on track to achieve these plans by the end of the year.

The pressure is on. This financial year we have seen commodity prices at their lowest levels in more than a decade, and we have seen the New Zealand dollar reach recent historical highs. In our markets competition is increasing throughout the entire value chain. Consumer demand is changing in respect of health, nutrition, and convenience.

Despite delivering underlying performance that vastly exceeds that promised, the jury still remains out on Fonterra. This is the time to be eyeballing markets with a focused eye on the future. To be building relationships with customers that become our key source of competitive advantage within a few years. Fonterra has the capability to do that.

Our vision and strategy are clear. Our priorities for the year are under action. We know where we are heading, and how we are going to get there.

And despite the double whammy, of low commodity prices, and the rising dollar, we have begun the journey, from good to great.

Thank you.

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