Fonterra's milk spill runs deep

The face of Fonterra's milk disaster

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Fonterra's naivete in China came through loud and clear at its press conference this week. Responsibility for that, and the tragedy it triggered, comes back to the co-op's management and board. And to its shareholders for the corporate culture they promote.

The harder chairman Henry van der Heyden and chief executive Andrew Ferrier tried to explain how the co-op got caught in the Chinese milk poisoning scandal and then responded to it, the more they sounded like innocents abroad.

It was clear from their comments Fonterra had next-to-no idea of what was going on in Sanlu, the large Chinese dairy company in which it has a 43% stake. Its links to its $200m investment ran only to three directors on the board and a handful of technicians. Only one spoke Mandarin.

So it was frighteningly easy for Sanlu's management to hide from Fonterra all knowledge of the deadly serious issues with its infant formula. According to China's state council, the company knew last December of the problems. But it told Fonterra only on August 2.

Then for the next five weeks, Fonterra struggled to get Sanlu and local authorities to recall the product. They assured the co-op they had escalated the issue to the central government. But subsequently, Fonterra wasn't sure it had been until the New Zealand government got involved.

Foreign investors with a modicum of local knowledge recognise these realities of China and put systems in place to safeguard themselves. Yet, Fonterra said it relied on Sanlu's management to "cascade" serious issues up to the board.

"I would be absolutely disgusted and appalled if information was held back," van der Heyden said. Outrage after the fact, though, is no substitute for prevention before.

Fonterra's inadequate management systems have left a widening trail of human and financial disaster. With its year-end results this week Fonterra wrote off $139 million of its investment in Sanlu, reflecting the cost of the product recall and the demise of the Sanlu brand.

The investment's $62m residual value might be worthless too. Sanlu remains shut down by Chinese authorities, leaving its milk suppliers, including Fonterra's own 3000-cow farm scrambling to find other buyers. The company could prove impossible to revive as a going concern.

As the third largest dairy processor in China, Sanlu's plants would have some value to a company willing to build a new business. But Fonterra seems singularly unequipped to be the one to try, lacking the range and depth of staff wise in the ways of China.

All this is nothing less than a serious failure of Fonterra's management and governance. The root causes go back to its history and culture. Farmers had always kept their co-ops and the Dairy Board on a very short rope, with adverse consequences for finance and governance.

With such cost-conscious shareholders, the businesses always had to invest piecemeal. This resulted in patchwork of less than-ideal international holdings that Fonterra, created in 2001 by the mega-merger of the co-ops and the Dairy Board, is still trying to meld into a coherent global entity.

Shareholders' penny-pinching only makes management's job harder. It's obvious, for example, Fonterra should have devoted much more management resource to Sanlu to enable deep and functional relationships to develop.

Likewise, Fonterra should have moved very quickly to achieve security of milk supply at Sanlu. Instead, it relied on a myriad of tiny farmers and third-party collection agents with highly suspect standards.

At the rate it was going, Fonterra would have taken almost a decade to fully supply Sanlu from its own farms, although there were other ways it could have achieved a similar outcome faster without the on-farm investment or management headaches.

Governance is the dairy industry's other great weakness. Farmers have always believed in excessive control of their co-ops. This resulted in bloody, highly personalised and dysfunctional politics in the old days of multiple co-ops and the Dairy Board.

Since the creation of Fonterra, the culture has got a little better. Farmers have at least accepted a few non-farmer directors who bring skills they lack. But the board is still far too short of people with deep international experience.

Moreover, the board fails at least three other good governance tests: van der Heyden and some of the other farmer-directors are far more intimately involved in the running of the business than they should be, blurring the division of labour between board and management; Ferrier is not on the board even though a chief executive should be; and risk assessment is woeful, judging by China.

Fonterra faces a long, hard road ahead as it tries to apply the lessons it says it has learnt from this disaster.

The two main ones van der Heyden and Ferrier identified in their press conference were:

* The need to have absolute control of the supply chain, not necessarily through ownership but at least through very tight procedures.

* The need to have at least joint control of ventures with other parties.

Yet, the points are so fundamental to the business it's amazing it took China to teach Fonterra the lessons.

And while China is no doubt the most difficult place to do business on those two counts, Fonterra faces challenges, of lower risk, in some other parts of the world.

Crucially, its operations in South America remain a hodge-podge of subsidiaries and ventures. Bringing a functional structure to them is vital because the region is on-track to become one of the world's great sources of dairy products.

On ownership, Chile remains problematic. Although Fonterra bought out the religious foundation that had been a troublesome minority shareholder in Soprole, it still does not have total control of the business. Some 900 farmer-shareholders, constituting barely 0.25% of the dairy company's equity, refuse to sell. More troublesome is Prolesur, Soprole's sister processing company. The foundation has retained a 12.5% stake.

By far the biggest chunk of Fonterra's South American production assets are tied up in Dairy Partners America, a joint-venture with Nestle. By most accounts this is running well but there are occasional conflicts when the two companies make competing demands on DPA's production capacity.

These challenges, though, are dwarfed by a third point Ferrier and van der Heyden made. "The sad thing is you can never be 100% absolutely certain against a criminal contamination of your milk supply," Ferrier said. And van der Heyden repeated the point twice in similar words during their 90-minute press conference.

That will come as a shock to highly respected companies that entrust Fonterra to process and package infant formulas and other very sensitive products under their brands. Unless Fonterra can guarantee those products have utter integrity and safety, it will lose that profitable business.

Clearly, Fonterra has a lot of relationship re-building to do around the world. Yet, that can't happen until board and management heal their most intimate relationship of all - with shareholders.

First the flop of capital restructuring and now the calamity of China have left many shareholders rather shaken. Some of the more intemperate ones are calling for heads to roll. That would be a serious mistake for three reasons:

* Van der Heyden and Ferrier have learnt a lot from these events. They should be given the chance to see if they can apply them to improving Fonterra.

* Board and management are hardly stacked with deep talent to replace them.

* Shareholders must take some responsibility and change their culture too.

Of the three, the biggest issue is probably the last.

Shareholders must have courage at this difficult time to stick to the plan to make Fonterra a global company.

They must be willing to invest sufficient effort and money to ensure overseas ventures work and they must play their role in improving Fonterra's culture and governance.

If they can, they will enjoy a more profitable future than they would from retreating into the limited strategies of the past.