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How New Zealand’s largest company delivers optimal value
A focus on return on capital as its key financial metric has proved a strategic success for Fonterra, says Chair Peter McBride CFInstD.
New Zealand’s largest company – a farmer-owned co-operative – is in the process of divesting its global consumer business and integrated businesses as it follows a clear strategy and pathway. That means delivering optimal value, leveraging its comparative advantages and living up to its potential.
“We are clear on where and how we deliver value, which is the result of a focus on return on capital, rather than EBIT, as our key financial metric,” McBride says.
“That has enabled us to home in on the parts of the business that generate the greatest returns for farmers today, and highlighted where we see further headroom for growth. It means we have focus on our comparative advantages and are de-risking the co-op from non-core markets and businesses.”
Peter McBride
Fonterra’s evolution over the past five years or so started with two important realisations, says McBride. First, was how the Co-op was operating at the beginning of a new era for its business that was dramatically different to what it had experienced in the decade or so prior. And second, that gearing the organisation to deliver against an EBIT metric was not delivering the optimal total value for its shareholders.
“We are moving out of an era of trade liberalisation and co-operation and into a world that is more expensive, competitive and volatile. Customer and consumer expectations are evolving, and New Zealand milk is becoming scarce,” he says.
“Customers are increasingly calling on us to partner with them to improve their sustainability and innovation capabilities. And recent changes to US policy aside, globally there is even more focus on sustainability from banks, regulators and from a market access perspective.
“The cost of capital has increased, and many industries – including agriculture and our bankers – face higher capital requirements. In the context of this new more volatile era, managing risk remains a key focus for our board.”
“Being a co-op, there’s also an element of compulsion to our capital structure (farmers need to hold a minimum number of shares connected to the milk they supply Fonterra) which increases the scrutiny on performance.”
Fonterra, the 2024 Deloitte Top 200 Company of the Year, is owned by about 9,500 farming families –intergenerational businesses that tend to rely almost entirely on the co-op for their financial wellbeing. As a result, McBride says they have concentration risk which is different to that of retail investors’, and the co-op’s risk appetite needs to reflect that.
“Being a co-op, there’s also an element of compulsion to our capital structure (farmers need to hold a minimum number of shares connected to the milk they supply Fonterra) which increases the scrutiny on performance.
“Recognising that, we have made two key changes to our risk settings. First, our risk appetite statement has been amended to better reflect the concentration risk and comparatively lower risk appetite of our farmer shareholders. Second, when undertaking our now regular strategic reviews, one of the key metrics we look at is the risk- adjusted return on capital.”
McBride says the riskier the type of business or region you are operating in, the higher the hurdle-rate set for the investment to meet.
“At one end of the spectrum, you have our well-established NZMP ingredients business. It is relatively low risk given our pedigree in ingredients, the quality global customers it serves (such as Mars and Nestle) and the stable core regions which we look to engage.
“Then at the other end, you have our consumer business. Consumer businesses by their nature are comparatively riskier, we are a minor player in the market, and we have had consumer businesses in higher-risk geographic locations, such as South America.”
One of those businesses was Soprole, a highly recognisable brand in South America that generated positive earnings for the co-op for years. But the region is geopolitically volatile and McBride says it can be hard to repatriate money at times. “When you consider the WACC (weighted average cost of capital) rate required to justify the risk of being there, the numbers didn’t add up.
“Using risk-adjusted returns or WACC rates to assess strategic choices is also central to the process we are in right now regarding the divestment of our wider consumer business. We estimate the WACC for a dairy farmer is somewhere around 10 per cent.
“Consumer businesses are inherently more capital intensive and riskier businesses to operate – that has played out in Fonterra’s consumer earnings performance over time.
“Overlay that with the potentially higher geographic risk in the markets where our consumer businesses operate, and a respectable return on capital for the consumer business should be something north of 15 per cent.”
“In the past, some of the strategic calls would have involved highly emotive conversations. But once you have clarity on your WACC and hurdle rates, it becomes a far more clinical conversation. The numbers don’t lie.”
McBride says their consumer business had one of its better years in 2024, but despite that, its return on capital was just 6.8 per cent.
“We cannot justify investing shareholder capital into a business that generates returns lower than their opportunity cost of capital, while at the same time exposing the co-op to more risk. Our position is that we are better off returning that capital to shareholders, reinvesting it into the parts of our business where we have a comparative advantage, or a mixture of both.
“Fonterra, as a farmer-owned co- operative and the associated cost of capital that comes with that model, is not the natural owner of a consumer business.”
McBride says, as a director, the shift to WACC has been a powerful tool. “In the past, some of the strategic calls would have involved highly emotive conversations. But once you have clarity on your WACC and hurdle rates, it becomes a far more clinical conversation. The numbers don’t lie.
“From a management perspective, the change has also been empowering. It’s enabled Miles [Hurrell, named 2024 CEO of the Year] and his leadership team to simplify the business. The teams have clarity on how Fonterra creates value, and we have clear measurable targets that drive the right culture and behaviours within the team.”
How concerned should boards be about new world orders emerging and the risk to New Zealand’s economy and way of life?
It is difficult to say what the signalled changes in US policy will mean for New Zealand, but increased nationalism and trade protectionism isn’t great for New Zealand’s exporters. The US-China relationship, in particular, has deep implications for New Zealand’s economy and security.
The US is a key market for Fonterra, but they are not the only country taking a more protectionist stance. We also need to consider the flow-on disruption caused when tariffs are imposed against individual nations. Their product must go somewhere, so a trade war between two nations tends to spill over and impact multiple markets.
That can create both risk and opportunities, but the overnight volatility it can create is hard for a lot of other organisations to manage, especially if they are a smaller single market/single product player.
One of the best examples is the UK joining the EU. That was disruptive for New Zealand dairy. But on the flip side, the aftermath of Brexit has created more opportunity for New Zealand. Your agility to adapt to these sorts of geopolitical changes is critical as an exporter.
How might different types of capital – financial, human and social – be better leveraged to achieve goals?
The three are inextricably linked. In a rural community you need a thriving economy to have appropriate social outcomes. The dairy industry is a great example of that. On average, for every dollar they earn, dairy farmers spend about 50 cents within their rural communities. Directly or indirectly, the dairy industry is responsible for creating quality jobs and opportunities in regions where they would otherwise be harder to come by.
For more than a decade, Fonterra farmers also funded Milk for Schools and now the Kickstart Breakfast programme, to name just a couple of the community initiatives.
From a human capital perspective, I think it is often undervalued. We look at our balance sheets and value hard assets but overlook the people aspect. Without good people, you don’t have anything, so we try to look after our people and develop key talent in the same way you would look at your other most valuable assets.
Are there opportunities in digital transformation, automation or expanding into new markets that could deliver short-term efficiencies and long-term strategic benefits?
Technology and digital transformation have already driven huge efficiencies within the industry, both on-farm and within Fonterra itself. The impact on our operations has already been significant, and if you think about AI and the potential for efficiencies that could bring in areas such as accounting and finance, the rate of change will continue to be rapid.
The level of automation within our supply chain continues to increase, freeing up staff time for other tasks and reducing administrative burden and quality errors within the manufacturing assets.
At the other end of the supply chain, in 2022 we launched an online dairy platform for our NZMP ingredients business to make it easier for our B2B customers to buy anything from milk powder to specialty dairy proteins online.
It has freed up the co-op’s sales team to help customers unlock the most value possible from its advanced products, seek out new customers and new markets. The customer experience has been improved too. Customers can buy online at any time, access order data and insights, and track their orders in real time.
How might the board support the attraction of investors interested in social or environmental impact alongside financial returns?
Our co-op status makes us a little different to other listed entities in this regard. Our main focus is on delivering for our current shareholders, rather than actively targeting potential retail investors. There’s an element of compulsion within Fonterra where supplying farmers need to hold shares that represent a minimum one-third of their milk production. So, it is important the co-op operates in a manner that is reflective of their values.
The overwhelming majority of farmer shareholders want to leave their local environment in a better state than they found it. They are also members of an intergenerational business, and for that reason we need to treat all three aspects of sustainability equally.
We are also cognisant that Fonterra is New Zealand’s largest company and there is a leadership role that comes with that, contributing to our rural communities and maintaining our social licence to operate with all New Zealanders.
None of this would have happened without the support of our farmer owners and shareholders. It is fair to say that has been tested over the years. The co-op hasn’t always treated their capital with the respect it deserved or lived up to performance expectations.
The change in strategy and financial settings has given them greater clarity on the co-op’s true performance. That transparency is important as they rightfully look to hold us to our commitments.
We still have work to do – you never reach the destination. But there is a huge amount of confidence and positive momentum in the co-op. The team has found their mojo, and underpinning all of that is that our farmers produce what I think is the highest quality sustainable milk in the world – which is the ultimate comparative advantage.
How optimistic are you about New Zealand’s future in the short term and the long term?
From the perspective of the New Zealand dairy industry, we are very optimistic. The co-op’s potential is exciting. It’s all about leveraging our comparative advantages – of which there are many – and living up to that potential.
Our quality, sustainable New Zealand milk is becoming increasingly scarce at a time when the world’s premium dairy customers are placing a high value on those attributes.
There is increasing competition globally, and plenty of volatility due to geopolitical events and extreme weather. But the co-op is well-positioned to manage those challenges and take advantage of any opportunities that arise from the volatility.
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