Being Int. Competitive - the Creation of Fonterra

"Being Internationally Competitive - the Creation of Fonterra"

Address by Andrew Ferrier, CEO Fonterra, to the Dairy Farmers of New Zealand Conference

I'd like to talk about Fonterra, two and a half years into its life, and discuss the creation and the international competitiveness of our co-operative.

In the 1990s, when the dairy industry was debating deregulation and the move to a mega-co-op, there were a lot of sceptics.

They worried aloud that a single company, without any real competition, would become inefficient. They worried the one company would start out fat, and just get fatter. They worried about whether farmers would be able to track performance properly, when they could no longer contrast one co-op's payout with another's.

Nonetheless, the industry successfully argued the case for integrating manufacturing and marketing into one company and Fonterra was created in October 2001.

We're now in our third year, so it's timely to ask if we have proved our critics right and replaced, as one put it "one form of economic inefficiency with another". Is life better after deregulation, or is it worse for the farmers who put their faith in integration? I'm going to argue that it is better, while your natural response would be "well of course you'd say that", there is ample evidence that deregulation enabled our industry to create a truly internationally competitive co-operative, one with enormous potential that is being unleashed.

It was a very bold move to bring three companies, with very different cultures, together. I am full of admiration for the farmers who did not let the enormity of the challenge undermine their confidence in integration. And that confidence was quickly rewarded.

Fonterra's first year was a success with a record billion kilograms of milksolids collected, processed and sold, major moves achieved in terms of international joint ventures and alliances and some important investments in additional processing capacity.

But one try doesn't win the World Cup. It's fair to say that while Fonterra's first year was indeed impressive, so was its bulk. Was this the "bloated monopoly" one particularly vocal critic was concerned about?

I don't think so. Remember, this was year one of a three-way merger that everyone knew would take at least three years to bed down. In that first year Fonterra delivered merger benefits of $88 million. It integrated Kiwi and Dairy Group's manufacturing operations and centralised operations management in the Waikato. It also made some genuine gains in trimming down the supply chain.

But it is important to stress that the first year would always be just the beginning of what will be a lifetime drive for efficiency in Fonterra. There is ample evidence of this commitment.

Within a year of its creation, Fonterra started tackling some of its big structural issues. A major move was integrating the ingredients business, NZMP, into Fonterra. The majority of its Wellington-based roles moved to Auckland and duplications were removed which reduced the headcount by around 200. The new structure consolidated into Fonterra the NZMP roles in finance, HR, information services, sales and operations, research and development and manufacturing.

It also launched a project to examine whether outsourcing our global IT infrastructure was the best move for us. Fonterra was using an inherited IT infrastructure that needed some serious capital investment to bring it up to the world class standards needed to support our business strategies.

That project confirmed outsourcing was our best option. In December last year, we signed a five year contract with EDS. That company is now taking over our global IT assets and more than 100 staff have transitioned to them. Our IT infrastructure is moving on a region-by-region basis from a capital liability to a "pay as you go" service with very demanding service requirements.

Also in December last year, we announced that New Zealand Milk would follow NZMP and make the move from Wellington to Auckland. While New Zealand Milk, as our largest customer, has to operate at arm's length from ingredients for commercial reasons, the business itself does not need to be at arm's length from Fonterra physically. Bringing the team to Auckland will not only support more growth in New Zealand Milk, but will also provide it with more management support and resources.

In making this move, we also created of a shared services business model. Quite simply, a shared service model means we remove unnecessary duplication where it makes sense to do so. It means we can combine resources in areas like finance, HR or information systems and have them service both sides of the business on a user pays basis.

None of these moves suggest a company in danger of starting out big and then becoming bloated, as some of those initial commentators feared. In fact, the picture is quite the reverse. The merger was beginning to allow us to improve our competitiveness.

Of course the major push for efficiency in Fonterra is captured in the JEDI programme. It covers some 40 projects which touch every corner of Fonterra, from manufacturing to production forecasting, inventory management to customer relationships, and how product is ordered, supplied and paid for.

It is due for completion at the end of this year and will deliver: -

* Manufacturing efficiencies which will bring our production costs down by 3%

* Supply chain efficiencies which will bring supply chain costs down by 10%

* $16 million a year in procurement savings

* One transaction point for customers, instead of five

* 45% fewer product specifications

* A 31% reduction in our costs to serve our customers

* A reduction in overdue debtor days will drop from six to two, releasing $100 million in vital working capital.

I believe that even the most skeptical of commentators, who worried aloud that an integrated co-operative would be a cumbersome and inefficient monolith, would applaud the streamlined efficiency that the JEDI programme is ushering in.

Let me give you a glimpse of just one area. In August the Fonterra Global Customer Service Centre will go live. It will service customers 24 hours a day, 365 days a year in their own language. It will manage order execution for all our customers and will play a significant role in providing customers differentiated service, tailored to fit the size and shape of our business with them. We are also streamlining the entire transaction process with the establishment of Fonterra Business Services.

This will be the central hub for many of our administrative functions in our ingredient business, including financial transactions such as accounts payable and receivable. This, and the Customer Service Centre, provide the two key supports for our new Sales Network Structure, designed to give our customers the service appropriate to their needs at a cost that is right for Fonterra.

With Fonterra Business Services handling administration services for the whole business in one place, our Network team will be freed up to concentrate on strengthening the relationships with our key customers.

An important point to make here is that this short, simple chain from the farm out to our customers could not have happened before deregulation. The industry's structure made this simplicity impossible.

A lot of the fear about deregulation concerned the loss of the Dairy Board which many regarded as a highly efficient marketing organisation. But when one looks back, it's clear there were inherent problems.

Remember, this marketing arm, as recently as 1997, had to deal with 12 different manufacturing co-ops - and it was obliged by law to buy all the standard products produced by processing companies. Its ability to influence product mix was rather limited, and in fact co-ops produced only around 50% of the products wanted by the Dairy Board. Production in co-ops was frequently driven by perceptions about market pricing rather than demand, so when sales teams asked for milk powder, they got cheese because the co-ops saw cheese earning more.

Co-ops were certainly efficient - the introduction of standard cost models for manufacturing in 1987 ensured that. But years of trying to beat the cost model meant a focus on large runs of bulk goods, rather than any real emphasis on value-add niche products. The more market focused commercial pricing model, designed to reward companies that produced more innovative products, did not come into effect until 1998.

The Dairy Board achieved a great deal, but even with the best will in the world, it could never have established the simple supply chain that Fonterra is developing. With a marketing arm separate from manufacturing, the industry before deregulation could never achieve clarity around inventories, finely match demand with production or develop accurate demand forecasting systems.

Where the Dairy Board was, by nature, a tactical seller, by contrast, Fonterra is focused on long-term supply contracts. We have divided up our customer base so we serve them efficiently, and cost effectively in the way that best meets their needs.

With our major customers, for example, we forecast demand and match production to it. We manage our inventories in line with that demand, and since we know what we can produce, and what we have in stock, we can also determine how much supply we need to source from third parties in Australia, Latin America, the US and Europe. This combination of factors mean Fonterra is far better equipped than the industry in the past to offer the secure and stable supply sought by major customers and we're way ahead of our competition.

It's important to acknowledge here that scale is also critical to these closer customer relationships. Ten years ago, New Zealand's share of the global market in dairy exports was around 20%. Today we are closer to 40%.

Another criticism leveled at the single company concept was that it would prevent innovation.

Have these fears been realised? All the evidence points to the contrary. Take the Fonterra Strategy, for example. It has seven themes, four of which are concerned with innovation and the development of high value specialty products.

That strategy is supported by structure. Innovation is a discipline in Fonterra and our Marketing and Innovation team is its engine room, working on three fronts. First they are developing new products and applications for selected customers, and this is a great way to lock down relationships with the important buyers who account for almost half our revenue. They are also growing new businesses, and we have a portfolio of four Growth Businesses that will soon grow to five. Their third area of work is in productivity improvements where M&I is developing technologies to cut manufacturing costs and improve product quality. Innovation in consumer products is shown in the introduction globally of roughly one new product each week.

Innovation as a discipline means setting goals. For example, M&I had the target to have 70 ideas for new products, or new technologies, developed into concepts by the end of May. Of these, around 10 will be fully commercialised - and this is a good average.

To get 10 commercially viable innovations, M&I operates an innovation pipeline designed to capture as many ideas as possible and then compare their relative merits. Ideas flow into the pipeline, and each one is developed into a concept - just a couple of pages of information. If the concept looks good, it is taken to a feasibility study. If it still looks good, we develop a business plan. At the end, the big prize is an idea taken to commercialisation.

Here is one example. In June, we will add Organics and Super Kosher to our portfolio of value-add Growth Businesses. Organics started out as an incubator business in M&I. It now has 10 high premium product specifications, more than 40 customers in five countries and very good growth prospects.

This new Growth Business joins our portfolio of established growth businesses - Health and Nutritional Solutions, Pharmaceutical Lactose, DairiConcepts and Fresh Dairy. Their combined EBIT in 2002/03 was $90 million and these businesses have targets of 15% compound annual growth rate and a 15% gain in earnings each year.

Growing our value-add earnings is one of the Fonterra's three priorities and the driving force here has to be innovation. New Zealand's dairy industry has a proud track record in research and development and Fonterra is not only carrying on the tradition, but investing considerable resources in this area.

Cost efficiencies were one area the critics of deregulation seemed to agree on. They could see that amalgamation would take out costs. The much discussed merger benefits, calculated at $310 million, will all be delivered on schedule by October this year. What the critics feared though, was that once these benefits were locked down, the lack of a local competitor, against whom we could benchmark performance, meant we would no longer regard cost reduction as a priority.

Let me assure you, costs are always a priority. The lack of a local competitor is irrelevant. Our competition is international. New Zealand has traditionally been the lowest cost producer of commodity dairy products. That edge is being eroded, mainly through currency volatility, so we have Argentina, Brazil and even the US, where on farm production costs are dropping, as likely competitors. The drive for operational efficiency will always be with us.

Of course, the ultimate litmus test in life after deregulation is returns to farmers.

Payout is a constant measure, influenced by currency, commodity process and our costs. You will be aware that the forecast for this season is $4.15 kg/MS, a welcome increase on last season's net payout of $3.60. As we indicated last week, the Board intends meeting within the month to revisit this forecast in the light of recent gains in commodity markets. At the same time, it will consider the forecast for next season of $3.50.

The Fair Value Share is also a valuable measure of performance. Before deregulation, co-ops shares had a nominal value. The Fair Value Share gave farmers a transparent way of measuring whether value of their investment in Fonterra was rising or falling.

The trend has been consistently positive, reflecting the underlying value of our business. Last week, the Board set the Fair Value Share price for the 2004/05 season at $4.69, an increase of 31 cents or seven per cent on the current season's $4.38 price.

This is the third successive increase in the value of a Fonterra share, and shareholders can feel encouraged by the independent confirmation, provided by Standard & Poor's that we are making steady progress and creating greater wealth for them.

The largest factor in the last increase was the decline in debt. The reduction in working capital, and in particular a reduction in inventories driven by better supply chain management, was a significant contributor to this. In addition, the valuer has also acknowledged Fonterra's strong performance by assessing an increase in Fonterra's underlying enterprise value.

Is life better after deregulation? Has our competitive position improved? All the evidence points to the affirmative and I believe the case is only just beginning to be established. Remember, Fonterra's history is very short indeed. In October, we celebrate our third year. What you see today is the results of a great deal of intensive work to lock down the merger and its benefits, develop our strategy and to begin its implementation. Much more can be done. For example, the full benefits of our Jedi programme have yet to come on stream.

I think the industry's critics were right to signal warnings about costs and efficiencies. Fonterra has to be constantly on our toes to ensure that costs do not blow out, or that we become complacent about efficiency. We are constantly mindful that our shareholders are looking to us to deliver the full benefits they voted for when they approved the merger. They want to have confidence in their decision and in the industry that represents their livelihood.

With the higher standards of governance and performance measurement the new co-operative model in Fonterra ushered in, I believe many of the concerns about performance transparency have been addressed. But it is up to us to keep raising the bar, so that our shareholders are confident that we are delivering the best results for them.

Is life better after deregulation? I am very confident about Fonterra's future and about life after deregulation. It is my belief that Fonterra is a truly competitive international business, far more potential than farmers envisaged when they voted for the merger. My commitment to Fonterra, and to our shareholders, is that we will unleash that potential.

Thank you.

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