fonterra dairy partner to the world - senseproviders · 2012. 10. 15. · fonterra – dairy...

authored by: Silvia CastellazziPeer Ederer

August 2011

http://www.fonterra.com/

©2011 Wageningen University --- EFAS All rights reserved. Cases are developed for discussion only, and are not intended to serve as source of data. No part of this publication may be reproduced, stored, transmitted or used without permission of Wageningen University.

Fonterra Dairy Partner to the World

acknowledgementWe sincerely thank Alex Duncan, Andrew Ferrier, Peter Goss, Paul Grave, Eric Hansen, Sir Henry van der Heyden, Abhy Maharaj, Jonathan Mason, Andrei Mikhalevsky, Ian Palliser, Gary Romano and Kelvin Wickham for their cooperation and openness in developing this case study.

language advisorInternational Meeting Point, Joy Christensen ([email protected])

exhibit advisorGansser Consulting, Georgine Gansser ([email protected])

layoutGAW ontwerp + communicatie, Jeroen Brugman (www.gaw.nl)

printPrintService Ede (www.printservice-ede.nl)

Fonterra – Dairy Partner to the World

European Food and Agribusiness Seminar 1

"The policies of all powers are inherent in their geography."

Napoleon Bonaparte, 1769–1821

A Sport of Strength and Velocity

For New Zealanders, rugby is the most widely recognized purveyor of national identity at home and abroad: competitive, humble and courageous1. It is only natural for the top management of Fonterra, the NZD 17 billion (EUR 8.9 billion, USD 12.6 billion)2 revenue strong dairy cooperative to choose the 2011 Rugby World Cup championship semifinals in Auckland as the best occasion to host some of their most important clients3.

Conversations in the lounge above the pitch move from sports to the outlook for global milk production to how one should deal with volatility in the markets. It is early October, spring is in the air and the typical winter rains are subduing. The rains create the country's green and make it a beloved destination for tourists in search of pristine environments. Tourism is the first source of revenue for New Zealand, but at 26% of NZ exports, dairy ranks a close second – because cows love the pastures and benign climate at least as much as the tourists do. Spring arrives during the world cup, and within these six weeks the milk production in New Zealand will leap from its winter low of 2 million kg a day to the spring peak of 78 million kg a day.

"It has been quite a journey," Andrew Ferrier comments on thinking back over the eight years since he moved from his native Canada to New Zealand in 2003 to become CEO of this cooperative with around 10,500 farming members. Ferrier is stepping down September 2011, and Theo Spierings, former head of the Dutch dairy Friesland, will take over as CEO. Since a final merger in 2001, Fonterra has been selling about 90% of the NZ milk, being the result of a century-long consolidation trend, beginning with 256 cooperatives in 1920. Not only are they the primary processor and seller of NZ milk, but the cooperative and joint ventures source additional 30% of their produce from outside of New Zealand. They are not only the world's largest producer of milk commodities – one third of the cooperative's revenues derive from successful, high-margin specialty and consumer brand businesses. (Exhibit 1 for Fonterra key financial figures and Exhibit 2 for Fonterra business portfolio)

Since 2008 the global dairy industry has faced unprecedented volatility and Fonterra, with almost all of its sales in export and most of that into deregulated markets, has had to bear the full impact of this volatility. Concurrently to these events, Fonterra has implemented two far-reaching and transformational changes to the kind of organization it is.

1 Russell Brown, in NZ a widely known media commentator writes in 2003: "The All Blacks bundle up a lot of what New Zealanders choose to think about themselves – strength, humility, courage and the peculiarly practical kind of flair that marks us out from the rest of the world. It has stood for the idea that a tiny country at the bottom of the planet can consistently achieve excellence on the world stage." From http://unlimited.co.nz/unlimited.nsf/growth/god-defend-the-all-black-brand

2 At exchange rates of EUR 1=NZD 1.92 and EUR 1=USD 1.35 as per March 23, 20113 With 4 billion cumulative viewers, the Rugby World Cup attracts the third largest global TV audience, after the Olympics and the

World Soccer Championship.


European Food and Agribusiness Seminar2

While these two new instruments have been under development for many years, volatility has accelerated their deployment:

• Capitalization structure: The cooperative has approved a new capitalization structure with tradable shares among members, and up to 20% non-member investors. The structure is expected to strengthen the financial solidity of the cooperative and enable more strategic investments.

• Global dairy pricing transparency: The newly created tool GlobalDairyTrade (GDT)provides a recognized, independent reference price for global milk commodities for the first time in the history of dairy. GDT is expected to be an arbiter of value added to the cooperative for external and internal stakeholders alike, and to become a primary risk management tool for Fonterra and its customers.

Most analysts converge in their view that the global demand for dairy products will rise steadily, possibly a cumulative 20% to nearly 700 million metric tons over the next ten years (up from 580 million MT in 2009)4. Most of the upcoming demand accessible to the export market will arise where Fonterra has core markets, namely the Asian marketplace (Exhibit 3 on dairy trade by region, Exhibit 4 on global dairy opportunities). But this positive market outlook need not automatically bring higher profits for NZ dairy farmers nor better fortunes for Fonterra, on examination of the following aspects:

• Expectations of high dairy prices are being priced into the value of land in New Zealand, such that the profit margins of additional dairy capacity created on newly converted dairy land may accrue to the seller of the land, and not necessarily to the operator of a farm – potentially exposing debt-leveraged dairy farmers to a credit crunch during downturns. The price of dairy land expressed in kg producible milk solids from this land increased from NZD 12.50 in 1990 to NZD 50.80 in 2008. Since then they have fallen steadily, with transactions in summer of 2011 priced at NZD 25 per kg producible milk solids (Exhibit 5 on development of NZ land values and milk solid prices). Meanwhile, the inflation-adjusted 30-year average payout per kg milk solids has fluctuated around NZD 5.30 (Exhibit 6 on development of dairy payouts and amount of milk processed). In May 2011 the forecast dairy payout was NZD 8.00–8.10 per kg milk solids before retentions and including a dividend of NZD 0.60 – a record number for Fonterra. Farm operating expenses are estimated to be around NZD 3.00 per kg milk solids5. (In NZ, the reference unit for dairy production is "kg of milk solids", which corresponds to the fat and protein content part of milk. (Exhibit 7 for an overview of the evolution of milk protein and fat content)

• Historically, New Zealand was always the supplier of dairy products with the lowest production costs in the world, but this position has been taken over by some niche producers in Latin America, Central Asia and even Africa. While these are not expected to grow exponentially, NZ experts are building more and more pasture-based dairy

4 The International Water Management Institute (IWMI) expects 720 million metric tons by 2025; the United Nations Food and Agricultural Organization (FAO) forecasts 746 million MT by 2030 and 895 million MT by 2050.

5 Goldman Sachs Thematic Report on NZ Dairy Farming, November 2010



systems at suitable locations around the world and they are beginning to compete, thus beating the home land at its own game. (Exhibit 8 on milk production costs)

• Despite a purchasing share of approximately 90% of the NZ milk market, Fonterra's hold there is more brittle than it looks: Saddled with less productive legacy assets, and regulation forcing Fonterra to accept milk from far flung places, the company faces competitors who enter the market and cherry pick the best locations to build modern, economical processing capacity, thus offering more attractive milk prices to the farmers in those particular regions.

• Globalization and value-added strategies are tasks that demand more and new sorts of talent in an ever more complex organization, increasing the challenge to remain quick-footed.

While Fonterra has strategies in place to manage such challenges, the volatility events of the past three years have shown that nasty surprises can be in store (Exhibits 9 and 10 on dairy price volatility). In the drought year of 2008 Fonterra was faced with a cash outflow of NZD 700 million in share redemptions, entering into the global financial crises of 2009 when milk prices were down, with precious few cushions; and in parallel, they were embroiled in the China melamine milk scandal, which threatened to taint Fonterra's high quality reputation among the trading partners.

Yet, none of the above touches what may be at the core of this enterprise: the cooperative DNA. In its history Fonterra has turned adversity into global market leadership, creating markets and opportunities against the odds. Business events in 2008 and 2009 made it clear that a new era of the dairy world has dawned, and that this era requires different instruments and different governance tools – tools such as the new capitalization structure and GDT. Possibly more important than changing the way Fonterra conducts business, however, these tools may have a transformative impact on the whole global dairy industry – a transformation that is yet to fully unravel, as more and more of the implications are revealed. By embracing volatility and building business models that are robust enough to create value in spite of or even because of this volatility, Fonterra may once again be leading the world of global dairy – are they?

The manager to oversee this transformation is CFO Jonathan Mason, who joined Fonterra in February 2009. Previously he was with Cabot Corporation, as executive vice-president and CFO since 2006. Between 1990 and 2006, Mason worked in various roles at the USA-based International Paper, rising eventually to vice-president and treasurer. An American by birth, Mason and his family hold dual citizenship in New Zealand and U.S.A. Mason holds a Master of Business Administration and a Master of Arts, International Relations, both from Yale University, Connecticut, U.S.A., and a Bachelor of Arts, Economics and International Relations from Beloit College, Wisconsin, U.S.A.

Fonterra managers and their customers are enjoying the Rugby tournament. Rugby and Fonterra share some common traits. As a team sport that requires strength and velocity, it represents a fundamental element of the Kiwi identity and links a remote country in the Southwestern Pacific to the rest of the world – and it is a sport at which New Zealanders are the champions to beat.



Dairy in New Zealand

Back in the nineteenth century, Napoleon asserted the role of geography lato sensu in shaping the strategy of a power, be it a nation or other organization. New Zealand is no exception. A remote position in the Southwestern Pacific Ocean, a deregulated economy with few raw materials (at least not the type their neighbor Australia has), and the abundance of fertile land and water are the triggers that turned the Kiwi dairy system into the most cost-effective in the world and made it renowned for quality.6 Indeed, with four million people and at least that many cows, the country could not be dedicated to anything other than export. Of the milk produced and processed in New Zealand 95% is directed to other countries, 96% of which are north of the Equator. For that reason, most of the milk the country produces is processed and exported in the form of commodities with a long shelf life, such as powders, caseins or butter.

A Fonterra commissioned study quantified the significance of the dairy complex for the national economy of New Zealand in 20097 (Exhibit 11 for a model of the economic impact):

• 26% of the entire exports of the country were dairy products. • 2.8% of GDP was related to dairy if direct activities are considered, at least twice

as much if induced effects and collateral activities are taken into account. • On-farm employment accounted for 24,000 jobs in the country, plus 10,000 more

in the processing chain – not including those farmers listed as self-employed. • Through taxation, the dairy sector contributes consistently to services and welfare

in New Zealand. Calculations show that dairy growth in the past decade benefited schools, hospitals and police services with an increase of up to +0.7% more funds in 2009.

• The dairy business drives many rural economies and keeps the country together: "When dairy farmers are smiling, the whole region is smiling." 8

The amount of land available, coupled with plentiful precipitation, has allowed a flourishing pasture-based dairy system to develop which delivers products of above-average quality. Pasturing cows deliver dairy products of consistent characteristics, intense flavor and color, and high nutrient content. They are an integral part of the landscape of the country, adding an emotional nuance of healthiness and natural goodness to the products that cannot be easily replicated in other dairy environments.

The dairy production chain and cost structures in New Zealand differ substantially from those in feed-based dairy complexes. In New Zealand, the main inputs for dairy farming are land and grass: after having invested in the land, everything else comes at comparatively little additional cost. It translates into high fixed costs (for the land), low variable costs, and a relatively limited capacity to increase or decrease production in the short term.

6 Rabobank on NZ dairy: "As the purest of export players (with 95% of milk exported beyond its borders) and with an industry model forged by years of competition in a largely deregulated environment, New Zealand's cooperatives have been able to fully capitalize on the sharp increase in the value of dairy commodities." Rabobank Dairy Outlook 2010, p. 4

7 Figures from NZIER Economic Report on Fonterra8 DNZ, 2010



For comparison, the inputs to a feed-based dairy system are soybean meal, alfalfa hay and corn, the most common mix to feed dairy cows housed in a barn. In this case, production volumes can be adjusted more easily, to some extent through nutrition.

Differences in the input impact a series of other aspects down the chain. The pasture-based systems are more dependent on weather, as it ultimately determines the available amount of feed for the livestock. In this setup the land asset attracts value appreciation and capitalization most strongly. Feed-based systems, on the contrary, are exposed to feed price volatility, which greatly impacts the prices of the final products as well, also exposing dairy to the fluctuations driven by global food-feed-fuel dynamics more than it is the case for pasture-based systems.

The two systems also have different production curves: pasture-based systems are highly seasonal, while feed-based systems spread the production more evenly over the year. In the first case, farmers synchronize the calving period with spring, when grass is most abundant. During spring, production across New Zealand can peak at 78 million litres per day. The less grass is available, the less milk is produced. In winter the supply of milk is lowest at 2 million litres per day, which is barely sufficient to satisfy the NZ home market. Thus, the production curve of a pasture-based system like that in New Zealand resembles a shoulder. (Exhibit 12)

Such a steep production curve has effects further downstream, in processing and logistics. While processing plants and shipping compensate with a flexible workforce and other means, the utilization of processing plants and logistics systems is well below 50%. Though it adds substantial cost to the system, this is more than offset by economies of scale and the cost advantages of the pasture-based feeding. For Managing Director of Trade and Operations Gary Romano, it translates into yet another source of volatility and risk to be dealt with:

"Because of the production curve being quite peaky and demand for dairy being rather flatter over the year, stocks may accumulate for a long time until sale. When you make the production decision, allocating quantities of milk for processing into a certain type of product, you have to decide on the forecast four or five months in advance; but once I have made a certain amount of cheese, for instance, I cannot change it, I have to put it on the market. So most of my job is really about risk management and risk mitigation."

Dairy Global Trends

According to statistics for 2009, the EU and the USA accounted together for half of the 580 million tons of milk produced in the world. Of this production total, 7% was not consumed in the country of production, whereby the EU and New Zealand each contributed a third part of the 7% of milk products which were exported9.

9 Goldman Sachs & Partners, New Zealand, Economics – Farmer Fragility Despite Robust Dairy Price Outlook, November 2010, p. 2



There is consensus among analysts and operators that the demand for milk will increase over the years, based on global trends which can be observed and which are here to stay: demographic change and ageing populations, urbanization, growing middle class entering a protein-based diet (Exhibits 13, 14 and 15). The challenging questions are: Who will be able to satisfy the increasing demand and what are the priorities for taking advantage of these new opportunities? Fonterra's Director of Optimisation, Trading and Sourcing Ian Palliser summarizes:

"The EU and USA account for 60% of the value of dairy product consumption. However, growth in consumption has been driven by Asia. In particular, Chinese consumption has increased fourfold between 2002 and 2008, with particularly strong demand for fresh dairy products. … The largest importers of dairy products are China, Mexico, Japan and Russia." 10

"The additional dairy demand in Asia over the next ten years amounts to about eight Fonterras. So, the question is not whether we are going to grow – the question is how can we pick the most profitable part of that growth?"

In parallel to increasing demand, analysts believe that both higher price levels and higher volatility are here to stay. According to Goldman Sachs:

"Over the past nine years, there have been regular imbalances between global growth and demand of dairy products. These in turn have created large changes in international dairy prices, ranging between -44% and +85%. We believe global imbalances are magnified by being traded in a relatively small international market for dairy products. Low levels of inventory in any one year can exacerbate price movements." 11

Rabobank assesses:

"…some major structural shifts have occurred in the global dairy market in recent years. Central to these shifts are that global dairy commodity prices have shifted to a higher average trading price. The combination of cost push pressure, strong demand growth and supply constraints in key production regions have all combined to exert considerable upward pressure on the prices of dairy products in international trade. … Regardless of price levels, price volatility is likely to remain high. The price-inelastic nature of dairy supply and demand in developed markets, which still dominate global consumption, leaves the dairy market prone to sharp price fluctuations when subject to destabilizing shocks. Such shocks are becoming more common, in the form of climate change and increased input cost volatility." 12

10 Goldman Sachs & Partners, New Zealand, Economics – Farmer Fragility Despite Robust Dairy Price Outlook, November 2010, p. 3 11 Goldman Sachs & Partners, p. 412 Rabobank Dairy Outlook 2010, p. 3



The dairy market is in a peculiar position among commodities, with neither cash nor financial market equivalents to offset volatility. The system does not have established hedge instruments, mainly because the market for dairy trading has historically been small. Given the volatility of the last couple of years though, the progressive abolishment of quotas in the EU, and the opening of new sales opportunities in the Middle East and Asia, the time may have come to create such markets for dairy as well. Romano concludes:

"Over the next years, we will witness an increase in the proportion of traded products. Now, about 7% of the dairy global production is traded; it is deemed to go up to 9% within ten years, and we expect it to continue growing after that. A 2% increase might not seem a lot in relative terms, but in absolute volume terms this increase is as large as our annual output. This is significant for us, since we are so extremely export-oriented. The trading opportunities which will arise will change the way we think dairy. It all comes down to managing the volatility. Volatility makes us very uncomfortable because of our long term contracts, so it should not be a surprise that we go from bilateral trade to spot market to a financial market. The New Zealand Stock Exchange has offered a futures market for whole milk powder since 2010, and in 2011 it has added futures contracts for anhydrous milk fat and skim milk powder.""

Fonterra's History and Key Figures

Dairy in New Zealand has undergone several structural changes to be able to survive and thrive in the global market. Due to its natural assets, New Zealand has always had an inclination for grazing animals (sheep and cows). Back in the 1960s and early 1970s, the main destination of Kiwi dairy production was the UK: because of historic and cultural ties, that country was the obvious landing point for the great majority of New Zealand exports.

When the UK entered the EU in 1973, that country found its hands tied to the EU Common Agricultural Policy, and so did New Zealand. Quotas, intervention, subsidies and livestock limits also ended free importation from the Southern Hemisphere. This placed New Zealand under pressure to diversify production and find new markets for their produce (Exhibit 16 for the evolution of the EU Common Agricultural Policy support model). Palliser recalls:

"New Zealand had to change its trading patterns. The country was on its knees, the reference market, the UK, had disappeared. The New Zealand Treasury had a catch phrase, back in those days:TINA – There Is No Alternative. We could have accepted that our sales were shrinking, or we could have pulled our sleeves up and gone out there searching for other markets. Guess what we did?! You know, they were like pioneers in those days. The teams went out there and started searching for other markets. Venezuela, Cuba, Morocco, the Middle East. We found those new markets."



Much as elsewhere in the meanwhile, a process of consolidation of cooperatives and farmers occurred in New Zealand: starting with 256 coops in the 1920s, Fonterra resulted from a final merger in 2001, leaving only two minor competitors. Since then several new dairies have entered, gradually whittling Fonterra's purchasing share to below 90% of NZ milk. (Exhibits 17 and 18 on top global dairy companies and milk processors)

While their British market vanished, Fonterra and the NZ dairy market spread to other parts of the world. As time passed, those markets matured in quality and quantity, and Fonterra underwent further transformation. At first the main goal was to place as much commodity as possible. Then Fonterra began to value-enhance the commodities with logistics and customer services, investment into and leverage of intellectual property rights, specialty products and development of brands. In the course of that, the cooperative began to look and behave more like a corporate business.

In parallel to this, the cooperative tackled the issue of sourcing. To offset risks deriving from weather, biosecurity and regulatory intervention, customers increasingly asked for multi-site production, which was the starting point for Fonterra to begin sourcing from Australia, Brazil, Chile, China and India. More sources of milk equal greater security of supply for the customers. From the Fonterra viewpoint, they went "…from being 20 years ago a leading dairy exporter to being a major multi-origin dairy trader".13 (Exhibits 19 and 20)

In 2010 Fonterra totaled a revenue of NZD 16.7 billion, with exports in 140 markets, 10,000+ shareholders, 14.7 billion litres of NZ milk processed and a further 6 billion litres sourced outside of NZ (including joint ventures). The cooperative generated NZD 1.07 billion in earnings before interest and taxes.

Fonterra being a cooperative, the bottom-line for farmers has naturally always been the milk price payout. Because there are no competitors in New Zealand that can match the size of Fonterra, the cooperative has to measure itself against a hypothetical competitor in an internally developed mechanism designed to find the buying price. The system is such that the final price paid to the farmer consists of two elements: an actual milk price, deriving from the sales minus the cash and non-cash costs of Fonterra, and a dividend, or distributable profit, which derives from all the other non-commodities operations (sales of branded products, food specialties, ingredients B2B, pharmaceuticals etc). The calculations are complex, but essentially they amount to a simulation of what an efficient milk producer should have been achieving in terms of payout to the cooperative member. Fonterra is legally bound to purchase all the milk offered by farmers in New Zealand, and farmers have to buy shares in Fonterra corresponding to their milk output. The proceeds from these share sales finance the processing facilities.

13 Fonterra materials



Managing Upcoming Risks

If there has been an annus horribilis in the history of Fonterra, it was 2008. In that year and well into 2009 a combination of events – drought, equity loss, global financial downturn, sharp volatility of the commodity prices, melamine in China14 – struck the cooperative and fast-forwarded a series of wide-ranging changes affecting the whole of the organization. Strategy, capital structure, pricing mechanism, priorities, governance – all have had to be rethought and adjusted to make sure the cooperative is well armed to face the future.

A severe drought in early 2008 shrank milk production by 8%, which led farmers to redeem their shares in the cooperative (in order to raise capital and because they delivered less milk). Back then shares were to be bought by Fonterra on certain dates planned for the year. When that day arrived in that year, hundreds of farmers decided to cash in, and Fonterra suffered a net loss of equity of about NZD 700 million from a total of NZD 4,829 million.

Through the years, the cooperative had shown a preference towards distributing most of the dividends back to the farmers – on top of the milk payout – limiting retention to the minimum required to "keep the ship going", as they put it. This satisfied the priorities of the farmers, but exposed the cooperative to operation on a limited amount of equity, whereby the little that was available had to be kept liquid in case the farmers overwhelmed Fonterra to redeem the shares – as it happened in 2008. Less than equity, Fonterra had only quasi-equity available. It became impossible to ignore the tension between farmers' individual interests and needs on one side, and the collective need of the cooperative to retain capital for investments and security on the other.

Fonterra also suffered financial exposure to volatility and farmers' share redemptions in another, more subtle way. Chief Economist Group Strategy & Corporate Finance Dr Eric Hansen explains:

"Back then, Fonterra was managing a good portion of its sales in one-to-one, medium- to long-term contracts with customers, thus taking on its shoulder the task of offsetting volatility both for buyers and for sellers. This set-up worked fine as long as volatility was soft, and also represented a consistent competitive advantage for the cooperative. When volatility peaked though, we got exposed. We could not pay the spot market price to the farmers because of the long-term contracts, and some of the competitors quickly stepped in, offering a higher price. The risk materialized with farmers leaving Fonterra for some of the competitors, again cashing in on shares and taking away more of the equity."

14 Fonterra was a major shareholder of the Chinese dairy SanLu, owning a stake of 43% in the company, which was involved in the melamine adulteration scandal in China in summer 2008: contaminated baby milk powder led to six infant deaths and about 300,000 illnesses within a couple of months. "The contamination was reportedly made by suppliers to dairy producers, who used the chemical substance melamine to convince quality checking devices that there was more protein in the product," reports the Australian Food News magazine in September 2008. It was Fonterra who alerted the Chinese authorities to the irregularities, but this was a tough instance of crisis management and several voices have complained about a delayed response of the cooperative and reluctance to release information about the issue. Towards the end of 2008, SanLu was declared bankrupt.



The lack of investable funds appears to have held back attractive business prospects. Managing Director of Global Ingredients and Food Services Andrei Mikhalevsky explains:

"I would like to be able to say that the biggest value will come from leveraging our intellectual property. We have a lot of patents, but we have never really understood how to commercialize them. We are leading on proteins, we understand applications. I would love to be able to say that the most value we are going to get is in driving the innovation we have. Unfortunately, for that you need capital for growth. During this whole process of capital restructuring there was no capital to invest. I have gone through three years without any opportunity of really investing any money."

The underlying theme for Fonterra in all of this is how to manage volatility, opportunities and risks better for the business and for customers, and thus remain in the pole position to take advantage of the global growth in milk:

a. The redemption risk has to be solved by raising more capital and restructuring the whole cooperative in a way that limits the amount of equity washing in and out of the books. Otherwise, the capacity of the cooperative to invest in value-added downstream activities would be curtailed.

b. On a more structural level, the cooperative has to provide itself with risk managing tools to offset the increasing volatility of the commodity market. In doing so, Fonterra is decided on taking the lead in moving from one-to-one contracts to creating a real, transparent cash market for trading its commodities, which would eventually lead to a further and more advanced modality of trading, i.e. to financial instruments (derivatives) to hedge volatility.

c. Strategically, all these risks sharpen the need for a broadly understood vision of Fonterra's future and the need to create mechanisms by which the underlying dichotomy can be resolved between the cooperative's need for immediate payout and the corporation's requirement for long-term investable funds.

Trading among Farmers and the GlobalDairyTrade Platform

Following an intensive, decade-long debate, members approved an action called Trading Among Farmers in June 2010, which is to be introduced in the course of 2012:

• With Trading Among Farmers, it is no longer Fonterra that must redeem shares, having created a market among farmers. This way, farmers can buy or sell shares within this market on every day of the year, without putting the equity of the cooperative at risk.

• Furthermore, a secondary market is being introduced, open to external investors who do not need to be farmers themselves. They can buy units which correspond to shares and contribute thus to the capital of the cooperative, and receive a dividend at the end of the year. These units are listed on the New Zealand stock exchange. They do not



include voting rights,15 as farmers rejected the possibility for external ownership to enter the cooperative; and these investments are limited to 20% of the overall capital stock.

The new external investors create an external price signal for the value of the member shares and provide welcome equity capital to the cooperative, but they also introduce a new dynamic: while the member farmers achieve their returns mostly via a high milk price, the external investors are interested in the profit achieved above the milk price, i.e. in the creation and distribution of dividends coming from the value-added product. To some extent the interests of the two groups may overlap, but not fully16.

Thus, the entrance of non-producing investors has necessitated a more transparent milk price mechanism, about which both farmers and investors could agree. That became the key accelerator behind establishment of the GDT platform – GlobalDairyTrade – which was piloted in 2008 for reasons of improved risk management.

GlobalDairyTrade is an auction-based system for trading dairy commodities, and the first of its kind worldwide. It employs an online trading platform managed by an external entity and creates a market for Fonterra on the one side and buyers on the other. Volumes of products are put up for auction at a starting price, and the price increases through several rounds of bidding until all available volumes are sold. It establishes the market price of the commodities in its most fundamental meaning, the price where the supply is exhausted and where the paying capacity of buyers is exhausted (Appendices 1, 2, 3 for a comprehensive presentation of GDT and Appendix 4 for GDT-index movements in comparison to price fluctuations of major commodities). Paul Grave, general manager of GlobalDairyTrade, explains:

"GlobalDairyTrade sells commodity products which are very undifferentiated, very standardized, and could be produced everywhere in the world. You can find the core-undifferentiated commodity, but if you want something special you have to try another market somewhere else. Some big customers in the consumer brands business do not buy on GDT for instance. They have specifications with vitamin A or D for their brands and cannot find their products here. GDT is the basis, then they pay a premium according to the specifications and services that they bundle to the commodity product. GDT sets the reference price even if you do not buy on GDT."

In 2010, 25% of all Fonterra sales were effected on GDT, but the intention is to expand it further, also allowing other sellers to enter and thus creating an even more refined cash market for dairy and a more efficient, globally recognized mechanism of price discovery.

15 Fonterra was well aware that non-voting shares would not fully exploit the value of the cooperative, but it was a deliberate choice. Manager for Group Strategy and Corporate Finance Abhy Maharaj recalls: "When we looked at non-voting shares, we realized that they would have implied a discount, we knew they would not be traded at the real Fonterra value. There is a discount in place which we could not eliminate through this structure. This is why farmers are not looking for full value. Some of them do, but collectively they do not."

16 Dr Eric Hansen of Fonterra comments on this point: "Farmers have always pressed the coop to move up the value chain into higher value goods. The problem is that it is difficult for them to realize what kind of investment the cooperative would have to plan in order to do so. Farmers tend to think that simply by leveraging the NZ clean/green image a higher milk price could be achieved – they want higher value without putting up the capital to pay for it."



Benefits for Fonterra: • GDT creates a clear benchmark, a reference price that can be used across the world. • It disciplines sales forces also in other channels within the company: Can you beat the

GDT price? • It offers a benchmark also for non-commodity products: the benchmark is set. Each

premium specification that is added through branding or IP adds to that benchmark starting price.

Benefits for the farmers: • GDT adds clarity. Farmers only have to look at GDT price movements to see the

movements of their expected payout.

Benefits for the buyers: • GDT adds clarity, both in prices and in volumes. • Product is always available, even for infrequent, low volume buyers who otherwise may

be marginalized.

The introduction of GDT in 2008 was not an entirely welcome event, but it has won more friends in the meanwhile:

"I was getting some abusive phone calls in the beginning, like what are you doing? GDT is dragging prices down! But it was not GDT, of course; it provided a reflection of the market price. The fact that markets went down during the introduction of GDT helps us now against the reverse suspicion from buyers that GDT is the reason why prices are going up." (Group Director Supplier and External Relations Kelvin Wickham)

"When we started with GDT in 2008, it was the same time when commodity prices started to plummet – many did two plus two and got six, thinking that it was GDT pulling prices down. But if you look at the commodity prices back then, also oil, soybean, maize, for instance, you see that it was a trend then. All commodities prices plummeted, it was not really GDT having an effect on it." (Director of Optimisation, Trading and Sources Ian Palliser)

"GDT came about because we needed a robust milk price, having external investors coming in. It was so that suppliers have always been suspicious about not getting paid enough, and external investors would be suspicious that the farmers would get all the retentions. Now with GDT in place, there is a system to draw the line." (Peter Goss, Ernst & Young partner)

"Ten years ago a dairy farmer would not know the relationship between USD and NZD, and no idea what was happening on prices. Now you ask the majority and they can tell you the rate; it is on TV and they track it. We have a GDT event every two weeks. I send them an email every week: very simple, they will just look at one number, whether it is up or down. A fantastic position for the farmers, they know what they get paid is driven by the currency and what is going on in the market." (Sir Henry van der Heyden, chairman of Fonterra)



"Previously, with only bilateral sales efforts, the big customers tended to muscle out the small customers when supply became tight. Small and medium size customers faced the risk of being cut off or at least being capped in the amount of product they could buy. GDT has introduced a change in this dynamic. Now we have a large number of small and medium customers who value GDT, because they know they have equal opportunity to purchase products this way. Big customers, on the contrary, were initially less welcoming because they believed they could get a lower price negotiating on a one-to-one basis with Fonterra. Sales people are always under tremendous pressure to compromise to complete the deal, and because of the relationship. With GDT, they go out there and they think, ‘My job is at risk unless I get at least the same price as GDT does or find some other service or product addition I can sell to the customer.' GDT is bringing about an incredible sales discipline." (CFO Jonathan Mason)

Three Strategies for Being a Global Dairy Partner to the World

"You don't just grow for the sake of growing, you grow for a strategic reason,"

clarifies Mr Ferrier before expanding on the three strategies of Fonterra:

1. Sustainable cooperative performance 2. Grow lasting customer partnerships 3. Build trusted brands in chosen markets

"First, it all starts with sustainable cooperative performance, ensuring that through all our activities, NZ farmers can produce their milk and are able to sell it consistently on the world market for the best sustainable milk price, for generations to come. Our investments in infrastructure, in the supply chain, in the business model, etc. are all to ensure that we can be as efficient a producer and processor as possible. The sheer operational numbers involved are huge: for instance, 15,000 employees operating at 26 locations in some 80 installations, some of them being the largest milk driers in the world. We are closing the doors on a container full of dairy exports every five minutes from one of eleven NZ ports.

Second, we have built on that milk supply a model for growing lasting and often global customer partnerships. We aim to drive value on top of the commodities through bundled services, consistent and high quality supply and secure market access. To global customers it also increasingly matters that we are not a single origin supplier, and are therefore building out global sources of milk. This also includes better leverage of the technologies we have developed. We are probably better at understanding milk proteins than anybody else, but we have not been so good yet to utilize that knowledge for our customers. For instance, we sell 970 configurations of milk ingredients, we are the key suppliers to all five of the world's largest infant formula companies, and we supply the world's top 100 pharmaceutical companies with lactose excipients.



Third, we continue to build our brands in chosen markets. They are three regions: 1. Australia/New Zealand, 2. Asia/Africa/Middle East, 3. Latin America. We do not see that we have a competitive advantage in taking our brands to Europe or North America. But in our chosen markets we have created a well-groomed consumer marketing business which has grown profits of about 20% over each of the past four years and constitutes roughly one third of our overall sales. The growth rates we are achieving are surpassing any of our multinational brand competitors.

In essence, we are looking into each global market segment and making a choice as to whether we will leverage our branding competence, or our technology competence, or our supply competence (or a combination of each) in dairy products, in order to create more value for our NZ farmer members."

Nurturing Value Pools along the Fonterra Value Creation Chain

Another way of looking at these three strategies is to see them as three value pools that "belong" to different stakeholders along the Fonterra value creation chain and to which these have access in different ways.

In the first strategy, the dairy farmers of New Zealand deliver their milk output to the cooperative, and with their collective investments into efficient processing equipment and operating processes they make all of this exportable in the form of commodities to anywhere in the world. The value derived from this milk and its exportability accrues to the cooperative members in the form of the milk price obtained. The value of this obtainable milk price tends to accrue in the value of the land. (Exhibits 21 and 22 on dairy farm working expenses)

In the second strategy, additional value above those commodities is being created in the form of customer relationships, service bundles, technologies and intellectual properties, or global milk sourcing arrangements. These value additions to the commodity price require various investments in R&D, skills and customer relationships, which need to be compensated by the higher prices created. The corporate value created in these investments thus "belongs" to the investors providing the funds – and to some degree to the managers and employees of the company who have created that business with their commitment.

In the third strategy, value is created by building a consumer brands business. The structural investments required to build such consumer brands pay themselves back in the superior margins which consumer brands tend to generate. A brands business also accrues corporate breakup value, as such brands are relatively easy to sell in the global M&A market. In that sense the value pool accruing in the brands business is attached to a particular market presence. Such a brands business often has joint venture owners, as is the case between Fonterra and Nestlé with their Brazilian dairy brands business, Dairy Partners America, thus entering another external stakeholder.

In previous years the dividing lines between these three value pools tended to blend into each other: there was only one ownership group, the NZ farmer members – and only one ultimate valuation tool, the milk price payout.



With the introduction of the new capitalization structure and GDT, the dividing lines will be more complicated. Since GDT sets the price for the commodity, one could argue that all value created up to the prices achievable on GDT "belongs" to the farmer members in the form of their milk payout, while all value created above GDT "belongs" to the Fonterra investors. Eighty percent of the Fonterra investors are also farmers, but 20% may not be, so the investor group must be thought of as a different stakeholder with its own set of interests. GDT draws a similar dividing line in the brands businesses. While the brands business units are barred from buying their supplies from GDT for governance reasons, GDT levels can de facto be the transfer price for their raw materials, with a clear dividing line of value created on top of these in the brand activities.

The consumer brands business entails some essential questions for Fonterra. Compared to an established consumer goods giant, a cooperative has in fact an inherently higher cost of capital, so that the consumer brands business, which has been growing nicely on top of all, might become more valuable to a buyer than to Fonterra itself. What would stop the investors (primarily the farmer members) from selling the brands and taking the cash? After all, thanks to GDT, the sale of the milk would be assured just as before.

Another scenario is described by CFO Jonathan Mason:

"If the value of our non-commodity and brands businesses becomes much higher than the commodity business of accepting and processing milk, then that additional value is reflected in a higher share price above the value obtainable from selling commodity milk. But, if a farmer member wants to sell more milk, he must buy a corresponding amount of shares. So we would be essentially forcing him to become an investor in all that value-added business. He may want that, but he may not. At the moment we are not giving him a choice. Yes, there are solutions to this, but it makes the whole picture a lot more complicated."

Managing Director of Trade and Operations Gary Romano raises a third new question:

"Who and what is our sales force working for? Before, it was in a sense easier: Sell the milk. But now he has to justify himself not only by selling the milk, but also by selling it above GDT price. But GDT does not sell itself automatically either. We still need to attract and generate buyers even for GDT. We need to rethink how to manage our sales force."

Many more ramifications could be imagined, and many questions are not yet settled. Is GDT increasing milk price volatility, or decreasing it, or does it have no influence on volatility? Is the creation of a financial futures market and thus the invitation of financial speculators into the dairy market a good thing or a bad thing, and for whom? Can the investors who are a non-voting, 20% fraction of the ownership of a business really be told to shut-up? Will any of this make farm land prices in New Zealand go higher or lower, and for whom would either move be welcome? Will all of these challenges energize the company to make optimal use of the growth in its markets, or will internal strife over value apportioning slow down the organization? It may be that the overarching question is: Are the two transformational instruments which Fonterra is implementing – GDT and new capital structure – the right and sufficient answers to face the brave new world of global dairy?



And what do the member farmers think? The Chairman, Sir Henry van der Heyden believes:

"Our farmers are pretty busy running their dairy businesses. I doubt that many of them have the time or the interest to think through all the different things that could be happening to their cooperative. However, of one thing I am certain: the farmers will never give up control: First, the chairman must always be a farmer. That is in the constitution: I sit here and I optimize things for my farm. Secondly, the majority of the board will always be farmers. And third: farmers will always have the right to remove the directors."

Farmers are said to have the phone number of the Chairman as a speed dial on their phones – 10,500 members are ready to pick up the phone, should they get the impression that the management of their cooperative is not treating them right.



Questions and Answers on GDTAppendix 1

1. What is GDT?GDT, GlobalDairyTrade, is the Fonterra developed on-line trading system for dairy commodity products to manage volatility and discover the price market. It is the first of its kind worldwide. It can be accessed on www.globaldairytrade.info. (Figure 1)

2. Who can participate? Who participates?Participants are vetted before registration. Products purchased have to be used for the bidders' own purposes only, unless Fonterra agrees otherwise to allow a distributor to resell the product. None of the bidders can be a Fonterra related party. In June 2011 there were 338 registered bidders from nearly 60 markets, including: Bahrain, Bangladesh, Cameroon, China, Canada, Costa Rica, Djibouti, Egypt, El Salvador, Guatemala, Honduras, Hong Kong, India, Indonesia, Jamaica, Jordan, Kuwait, Lebanon, Libya, Malaysia, Mauritius, Mexico, Mongolia, Myanmar, Netherlands, Nigeria, Oman, Pakistan, Peru, Philippines, Saudi Arabia, Senegal, Seychelles, Singapore, Sri Lanka, Syria, Taiwan, Thailand, UAE, Vietnam, Yemen, Zambia, Zimbabwe.

3. How does the bidding mechanism work?The process is an ascending price clock auction. The trading event is managed by an independent trading manager – Fonterra is not involved in running the event itself. Bidders bid through volumes, not price. Fonterra offers a certain amount of product at a pre-specified starting price (always 15% below the closing price of the previous event) and customers start bidding, round after round. In the beginning, the volumes customers would like to purchase at the starting price will be much higher than what Fonterra is putting on sale. In the following rounds, the trading manager increases the price, and customers can bid again for a certain amount of product at the new price. All bidders bid at the same price. During the event, prices increase and volume demand decreases. The event finishes when the amount bidders want to purchase equals the amount Fonterra wants to sell. All bidders pay the final price.

4. Which products are offered?On GDT only dairy commodity products can be bought: whole milk powder, skim milk powder, anhydrous milk fat, butter milk powder, rennet casein, milk powder concentrate, and cheddar cheese. All products are very undifferentiated. Fonterra publishes a 12-month forecast of how much product will be offered at each event, and the forecast is confirmed five days before each event. (Appendices 2 and 3)

5. How often does GDT run trading events?Trading events are run twice a month, to allow for significant liquidity of the market and to ensure a more regular and transparent price signal by eliminating mid-month uncertainty.

6. What determines which volumes are sold on GDT each time? The quantities of each product group (e.g. WMP, whole milk powder) placed on sale are determined by the quantities the seller offered to sell. However, within each product group there are a number of product specifications (e.g. Regular WMP, Instant WMP, UHT WMP). The quantities sold of these specifications are determined by the pattern of bidding demand subject to the rule that total quantity across the specifications must not exceed the product group quantity.

7. Usually, how much does the actual offer differ from the forecast offer you publish some months in advance? The offer quantity in a trading event is generally within 10–15% of the quantity forecast at the previous event. But the root mean square error on forecasts three months ahead is around 20–25%.

8. On what contracts and delivery agreements can bidders buy?Sales are all on FAS basis – Fonterra Arranges Shipping. When bidders buy, they can choose among three different contracts: for the product to be delivered in 3, 6 or 9 months. Customers can bid on any or all of the contract periods.



Questions and Answers on GDT, continuedAppendix 1

Figure 1. Bid submission page on GlobalDairyTrade website

Source: Fonterra materials; the image is property of CRA International, Charles River Associates – all rights reserved



Forecast offer quantities for selected GDT productsAppendix 2

Anhydrous milk fat (AMF)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT

Contract 1 Contract 2 Contract 3

Butter milk powder (BMP)

0100200300400500600700800900

1,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT

Skim milk powder (SMP)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12


Whole milk powder (WMP)

0

5,000

10,000

15,000

20,000

25,000

30,000

MT



Forecast offer quantities for selected GDT products, continued

Appendix 2

Anhydrous milk fat (AMF)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT


Butter milk powder (BMP)

0100200300400500600700800900

1,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT

Skim milk powder (SMP)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12

MT

Apr-1

1

May-11

Jun-1

1Ju

l-11

Aug-1

1

Sep-1

1Oct-

11

Nov-11

Dec-11

Jan-1

2

Feb-1

2

Mar-12


Whole milk powder (WMP)

0

5,000

10,000

15,000

20,000

25,000

30,000

MT

All forecast offer quantities in MT (metric tons)

Source: GlobalDairyTrade



Forecast annual supply – all GDT products

Price movements for major commodities

Appendix 3

Appendix 4

–

50

100

150

200

250

300

Jan-0

8

Mar-08

May-08

Jul-0

8Se

p-08

Nov-08

Jan-0

9Mar-

09

May-09

Jul-0

9Se

p-09

Nov-09

Jan-1

0

Mar-10

May-10

Jul-1

0

Sep-1

0

Nov-10

Jan-1

1

Pric

e in

dex

0

200

400

600

800

1,000

1,200

1,400

1,600

GD

T-TW

I ind

ex

Commodity food price index Crude oil (petroleum), Brent Soybean mealSugar and cocoa, free market Wheat GDT-TWI index

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000Ju

l-08

Sep-

08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep-

09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

1-Se

p-10

5-O

ct-1

0

2-N

ov-1

0

1-De

c-10

4-Ja

n-11

1-Fe

b-11

1-M

ar-1

1

5-Ap

r-11

MT*

WMP AMF SMP BMP MPC RenCas

3 WMPproducts

*AU WMPintroduced

AMFintroduced

SMPintroduced BMP

introduced

Twicemonthlyevents

Commodity food price index 2005 = 100; includes cereals, vegetable oils, meat, seafood, sugar, bananas, and orange price indicesCrude oil (petroleum); dated Brent, USD per barrelSoybean meal, Chicago soybean meal futures (first contract forward), minimum 48 percent protein, USD per metric tonSugar, free Market, Coffee Sugar and Cocoa Exchange (CSCE) contract no.11 nearest future position, US cents per poundWheat, No.1 Hard Red Winter, ordinary protein, FOB Gulf of Mexico, USD per metric tonGDT-TWI index (Global Dairy Trade Trade Weighted Index): percentage changes in prices discovered in a GDT trading event, weighted on the basis of total international dairy product trade flows

Source: GlobalDairyTrade for GDT-TWI index, IMF for commodity prices indices

* metric tons** AustraliaWMP: whole milk powder; AMF: anhydrous milk fat; SMP: skim milk powder; BMP: butter milk powder; MPC: milk protein concentrate; RenCas: rennet casein

Source: GlobalDairyTrade



Key financials for Fonterra 2006 to 2010Exhibit 1

12

mon

ths

to

12 m

onth

s to

14

mon

ths

to

12 m

onth

s to

12

mon

ths

to

12 m

onth

s to

31 M

ay 2

006

31 M

ay 2

007

31 J

uly

2008

31

Jul

y 20

09

31 J

uly

2010

31

Jul

y 20

10

(mill

ion

NZ

D)

(mill

ion

NZ

D)

(mill

ion

NZ

D)

(mill

ion

NZ

D)

(mill

ion

NZ

D)

(mill

ion

EU

R)*

Rev

enue

fro

m s

ale

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oods

13

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19

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16

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16

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9,

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C

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0

Sour

ce: F

onte

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annu

al r

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ts 20

06–2

010



Fonterra business portfolioExhibit 2

Margins

Dairy Ingredients

WMP1, SMP2, butter, cheese, etc.

CheddarPlusTM,C213

Anchor, Bega, CalciYum, Fresh ‘n’ Fruity, Mainland, Perfect Italiano, SKI, etc.

Dairy Partners America (DPA)

Trade & Operations

Global Ingredients & Foodservices

Australia/New Zealand

Asia, Africa/ Middle East

Latin America

Consumer*

Anlene, Anmum, Anchor, Fernleaf, Mainland, etc.

Sofrole, Nestlé brands etc.

Specialty*

DMV-Fonterra Excipients,4 Clear Proteins, etc.

Referred to as

Commodity &

Ingredients for

reporting purposes

* In some cases margins on high value consumer products are equivalent or greater to margins earned on specialty products.

1 WMP: whole milk powder2 SMP: skim milk powder3 C21: Fonterra's code name for their product "21st Century Cheese"4 DMV-Fonterra Excipients: short name of the Domo Pharma subsidiary of FrieslandCampina that formed the joint venture with

Fonterra Excipients

Source: Fonterra materials



Global dairy market opportunitiesExhibit 4

Source: USDA, IFCN, James Morrison Consulting analysis

EU25 Other Europe

RussiaIndia/Pakistan

AfricaCentral America

Middle East

North America

0%

1%

2%

3%

4%

5%

6%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Consumption growth (CAGR)

Prod

uctio

n gr

owth

(CAG

R)

Potentially greater exports as supply expands faster than domestic demand

Moderate market opportunity with demand growing faster than supply

Large market opportunity with demand rapidly outstripping supply capacity in areas with high population

Former Soviet Union

South America

Asia

Global net dairy trade 2009Exhibit 3

Source: Goldman Sachs, Farmer fragility despite robust dairy price outlook, thematic report, November 2010

EU27

14.3

OtherEurope

USA

South Korea

Australia

Japan

China

New Zealand

Other Asia

Brazil

Uruguay

Argentina

Mexico

Canada

India

Other LatamOther Africa

Middle EastNorth Africa

0.5

0.3

2.5

2.1

2.9 0.5

1.1

3.0

11.3

2.8 3.6

0.1

7.6

0.9

2.2

3.6

18.4

Net trade deficit

Net trade surplus

Milk equivalents (million MT)



Milk payout and amount of milk processed: historic seriesExhibit 6

* Dairy company payout, adjusted for purchase power parity in New Zealand

Source: New Zealand Dairy Statistics 2009–2010

0

1

2

3

4

5

6

7

8

9

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

DC

pay

out (

NZD

/kg

ms)

*

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Milk

pro

cess

ed (m

illio

n lit

res)

DC payout (NZD/kg ms)* Milk processed (million litres)

Correlation between land price and milk solids priceExhibit 5

Source: New Zealand Dairy Statistics 2009–2010

0

10,000

20,000

30,000

40,000

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

PPP-

adju

sted

pri

ce (N

ZD) p

er h

ecta

re

0

10

20

30

40

50

60

Pric

e (N

ZD) p

er k

g m

ilk s

olid

s

Inflation adjusted average price per hectare Price per kg milk solids



Cost of milk production 2007Exhibit 8

* ECM: energy corrected milk** CEEC: Central and Eastern European Countries

Source: International Dairy Federation

0

20

40

60

80

100

120

Wester

n Euro

pe

North

Ameri

ca

Middle

East

Africa

CEEC**

South

Ameri

ca Asia

Ocean

ia

USD

/100

kg

milk

(EC

M)*

Average

Max - Min

Steady increase in milk solids and milk fat over the yearsExhibit 7

Milk solids and milk fat per hectare in New Zealand

Source: Agribusiness Research and Education Network (AREN), Dairy, the key elements of success and failure in the NZ dairy industry, 2008

0

200

400

600

800

1,000

1992 1994 1996 1998 2000 2002 20041993 1995 1997 1999 2001 2003 2005

kg/h

ecta

re

Milk solids Milkfat



Milk is one of the most volatile commoditiesExhibit 10

* Based on SMP (skim milk powder) and butter** Coefficient of variation = standard deviation of distribution divided by the mean of the respective samples

Source: IFCN Dairy Research Center, 2009

0 10 20 30 40 50

Pork

Cotton

Tea

Beef

Poultry

Cocoa

Coffee

Soybeans

Rice

Milk*

Wheat

Coefficient of variation** in the 10-year period 1998–2008 (%)

Volatility of dairy commodity pricesExhibit 9

* Volatility as ratio of change to absolute value (%)

Source: GlobalDairyTrade, USDA Dairy Market News

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

GD

T-TW

I Ind

ex

0

0.05

0.10

0.15

0.20

0.25

Vol

atili

ty*

(%)

GDT-TWI Rate of monthly change (%)



Model of dairy impact on New Zealand national economyExhibit 11

Exportearnings

• Overall net gains to the national economy• Rural and urban consumers gain from increased incomes• Government spending increases across all regions• Increased investment for future growth

Dir

ect i

mpa

ctFl

ow-o

n ef

fect

sTo

tal e

ffec

t

Current account• Terms of trade

improvement• Reduced foreign debt

and credit risk premium• Lower borrowing costs• Currency appreciation

affects exporters

Government spending• Larger tax revenues and

reduced deficit• Greater national

expenditure on schools, hospitals and police force

Household spending• Higher incomes allow

greater spending• Gains to retailers,

eateries, realtors and consumers

Suppliers• Increased spending on

suppliers• Gains to fertilizer and

agricultural service industries

• Strong regional flow-on effects

Dairy industry

• Increased output• Greater employment• Higher investment

Source: NZIER economic report to Fonterra and DNZ, 2010, p. 38



"Shoulder" pattern of productionExhibit 12

Protein consumption versus GDPExhibit 13

Shoulder pattern of production shown as average of production; each time point on the x-axis represents the average of production values from that calendar day in three production years (2007/08, 2008/09, 2009/2010)


Source: FAO, Goldman Sachs commodity research

0

10

20

30

40

50

60

70

80

1-Jun

1-Jul

1-Aug

1-Sep

1-Oct

1-Nov

1-Dec

1-Jan

1-Feb

1-Mar

1-Apr

1-May

mill

ion

litre

s

0

10

20

30

40

50

60

0 5,000 10,000 15,000 20,000 25,000 30,000

Real GDP per capita (USD – year 2000)

Prot

ein

cons

umpt

ion

per

capi

ta (k

g)

China (1961-2003) China 2040 projection

India (1961-2003) India 2050 Projection

Brazil (1961-2003) Brazil 2045 projection

Japan (1961-2003) Korea (1961-2003)



Projected liquid dairy product consumption 2012

Dairy opportunities over the next ten years

Exhibit 14

Exhibit 15


ANZ

China

India

Rest of Africa

EU 27

La�n America

USA/Canada

Middle East & North Africa

Rest of Europe

Milk Consumption 2009 (million MT)(right bar bottom)

Milk Production 2009 (million MT)(left bar bottom)

+42 +45

+8.5 +13

+5.6 +8.0

-0.4+10+11+13

Milk Production Growth to 2019 (million MT)(left bar top)

Milk Consumption Growth to 2019 (million MT)(right bar top)

+35 +36

South East Asia+18+16

+1.5+5.8

+12 +19

+5.8 +6.3

LDP (liquid dairy product) consumption in top 10 dairy markets is projected to reach 186.5 billion litres by 2012

Source: Tetra Pak 2009

-4%

-2%

0%

2%

4%

6%

8%

10%

Japa

n

German

yUK

Mexico

Russ

iaBr

azil

Pakis

tan USA

China

India

0

10

20

30

40

50

60

70

CAGR Volume (billion litres)

approx. 187billion litres in total*

Volu

me

(bill

ion

litre

s)

CAG

R



010203040506070

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Expo

rt s

ubsi

dies

Oth

er m

arke

t sup

port

Coup

led

dire

ct p

aym

ents

Deco

uple

d di

rect

pay

men

tsRu

ral d

evel

opm

ent

CAP

expe

nditu

re a

s sh

are

of E

U G

DP

Share of GDP (%)

CAP expenditures (billion EUR)*Evolution of the EU Common Agricultural Policy support model

Exhibit 16

*200

7 co

nsta

nt p

rice

s

Sour

ce: E

urop

ean

Com

miss

ion,

DG

Agr

icul

ture

and

Rur

al D

evel

opm

ent,

CA

P po

st 20

13, k

ey g

raph

s and

figu

res



Fonterra is the largest global milk processorExhibit 18

Fonterra is the 5th largest global dairy companyExhibit 17

Figures reference period: 2008

Source: International Farm Comparison Network (IFCN), in "Farmer fragility despite robust dairy price outlook", Goldman Sachs thematic report, November 2010

Source: Rabobank, in "Farmer fragility despite robust dairy price outlook", Goldman Sachs thematic report, November 2010

0

5

10

15

20

0

1

2

3

Volume of processed milk (million MT)Processed milk as share of world production (%)

Nestlé

Danon

e

Lacta

lis

Roya

l Frie

sland

Cam

pina

Fonte

rra

Dean F

oods

Dairy F

armers

of Am

erica

Arla

Food

s

Califor

nia D

airies

Inc.

Kraft

Milk

equ

ival

ent (

mill

ion

MT)

%

0

10

20

30

Dai

ry tu

rnov

er 2

008

(bill

ion

USD

)

Nestlé

Danon

e

Lacta

lis

Roya

l Frie

sland

Cam

pina

Fonte

rra

Dean F

oods

Dairy F

armers

of Am

erica

Arla

Food

s

Unile

ver

Kraft

Food

s



Changing markets for dairy exports from NZExhibit 19

Destination countries of NZ dairy exports, in % of total value

Source: NZIER, Dairy's role in sustaining New Zealand, 2010, p. 39

1989

Western Europe

South AsiaChina

Taiwan

Australia

United Kingdom

Eastern Europe + USSR

Middle East + Africa

MexicoOthers

Japan + Korea

USA

ASEAN (Association of South East Asian

Nations)

2009

United Kingdom

Middle East + Africa

Western Europe

South Asia

ChinaMexico

Taiwan

Japan + Korea

USA

ASEAN (Association of South East Asian

Nations)

Australia

Others

Eastern Europe + USSR



Evolution of New Zealand trading patternsExhibit 20

20 years ago New Zealand was a leading dairy exporter


Today Fonterra is a major multi-origin dairy trader



Dairy farm working expensesExhibit 21

Feed, fertilizer and wages are the largest working expenses on a farm

Source: Dairy NZ, GS&PNZ Research estimates

IrrigationRegrassing

Weed and pest

InsuranceACC Rates

WagesAnimal Health

Stock grazing

Run-off lease

Fertilizer

Vehicles, fuel

Repairs, maintenance

Freight, general

AdministrationBreeding, herd improvement

Farm dairy

Electricity

Net feed made,purchased, cropped



Financial analysis of a "typical" dairy farmExhibit 22

Owner operator dairy farm financial statements

June 2009 June 2010

Physical characteristics

Milking area per herd (ha) 127 134

Peak cows milked 359 372

Stocking rate (cows/milking area) 2.83 2.83

Milk solids produced per herd (kg) 121,350 123,731

Milk solids per hectare 956 924

Milk solids per cow 338 333

PAYOUT RECEIVED (NZD/kg milk solids) 5.21 6.37

Dairy cash income

Milk sales (net of dairy levies) 632,202 788,167

Net livestock sales (sales - purchases) 42,134 35,468

Other dairy cash income 5,119 5,798

Net dairy cash income 679,455 829,433

Cash farm working expenses -468,201 -540,734

EBITDA 211,254 288,699

Depreciation -54,779 -53,332

Other non-cash adjustments -170,943 -165,866

Operating EBIT 95,090 176,165

Interest -192,746 -167,450

Tax -22,126 -7,471

NPAT -119,782 1,244

"Adjusted" NPAT* -58,397 60,447

Net drawings -76,557 -76,557

"Adjusted" NPAT less net drawings (retained earnings) -134,954 -16,110

Cash flow

EBITDA 211,254 288,699

Interest -192,746 -167,450

Tax -22,126 -7,471

Rent (excl, run-off ) -14,567 -10,710

Other income 16,082 20,736

Introduced funds 9,231 18,645

Income equalization 1,528 0

Operating cash flow 8,656 142,449

Net capital transactions -258,664 -41,472

Net drawings -76,557 -76,557

Decrease/Increase in net debt -326,565 24,421

* Adjusted NPAT excludes some non-cash adjustments



Total assets 6,058,785 5,925,749

Net capital transactions 258,664 41,472

% of cash income 38.1% 5.0%

Depreciation 54,779 53,332

% of total assets 0.9% 0.9%

Change in asset valuation -450,136 -121,176

% of total assets -7.1% -2.0%

Total liabilities 2,441,217 2,576,148

Interest 192,746 167,450

Effective interest rate (%) 7.9% 6.5%

Debt/EBITDA 12.25 8.88

Debt/Assets (%) 42.7% 43.3%

Interest % of dairy cash income 28.4% 20.2%

NZD per milk solids produced

Dairy cash income 5.60 6.70

Cash farm working expenses -3.86 -4.37

EBITDA 1.74 2.33

Interest -1.59 -1.35

Depreciation -0.45 -0.43

Tax -0.18 -0.06

"Adjusted" NPAT* -0.48 0.49

Net drawings -0.63 -0.62

"Adjusted" NPAT less net drawings (retained earnings) -1.11 -0.13

TOTAL ASSETS 49.93 47.89

TOTAL LIABILITIES 20.12 20.82

* Adjusted NPAT excludes some non-cash adjustments

Source: Goldman Sachs, Farmer fragility despite robust dairy price outlook, thematic report, November 2010

Financial analysis of a "typical" dairy farm, continuedExhibit 22



Dairy farm in New ZealandExhibit 23


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