Comment

Rod Oram: How Fonterra hit the wall in China

Rod Oram has followed a trail of bad management decisions and poor governance to discover why Fonterra is staring down the barrel of a massive writedown on its investment in Beingmate. He raises questions about the role of Fonterra's auditor, PwC, and a stifled culture of debate on its board.

The evidence is clear: Fonterra is well on the way to racking up its second disastrous investment in China in a decade.

The first was Sanlu. The co-op bought a 43 percent stake in the Chinese milk processor in 2005. Three years later, Sanlu was the main culprit in China's scandal of melamine-tainted infant formula. Sanlu was prosecuted and bankrupted. Fonterra lost its entire $250m investment in the company.

The second is Beingmate Baby and Child Food. Fonterra paid $755m for its 18.8 percent stake in March 2015. Yet, the company has comprehensively failed to meet every forecast it has made since Fonterra announced its decision to invest in August 2014. Beingmate's latest bad news: it expects to report a loss of up to 1bn yuan ($214m) for its year ended December 2017.

Fonterra says it remains confident that Beingmate will come right, thanks to the leadership of the "Co-operation Committee" consisting of Theo Spierings, Fonterra's chief executive, and Xie Hong, Beingmate's founder, which the two set up in 2015 when Fonterra invested.

Is a turn round plausible? Over recent weeks, I've asked that question to a range of people with knowledge of Fonterra's investment in, and subsequent relationship, with Beingmate.

Speaking on condition of anonymity, they have described how the investment and relationship were bad from the start and keep getting worse.

Informed by this knowledge, I put a long list of questions to Fonterra. Its answers were brief and largely non-specific.

Key themes have emerged from these investigations:

- Lack of rigour by Fonterra's management and board on their initial decision to invest in Beingmate.

- Failure to regularly review the investment against the strategy and objectives set for it.

- Blaming the market not Beingmate for its failure to deliver on its promises to Fonterra.

- Hoping for the best while failing to prepare for the worst.- Handicapped by its minority stake, Fonterra has failed to exert meaningful change in Beingmate.

These conversations have also shed further light on Fonterra's entrenched governance culture, one which has long worried some shareholders:

- The transfer of risk from Fonterra's balance sheet to its shareholders' balance sheet, as a result of the Trading Among Farmers capital structure implemented in 2012.

This has led, they believe, to inadequate oversight by the board of other under-performing investments, such as its farms in China. This $700m plus investment only finally scraped into profit for the second time last year, thanks in large part to Fonterra's ingredients business buying all the farms' milk at above market prices.

Fonterra argues the premium helps focus the ingredients business on getting the highest value it can for its products in China. No doubt, the co-op's New Zealand farmer-shareholders and other suppliers would be delighted if the co-op offered the same high milk prices and exercised the same value-add disciple here.

- The board "doesn't welcome introspection or outside perspectives," said one person in the financial community who is deeply familiar with the co-op.

- A strong emphasis around the board table on loyalty to strategy, management and collective decisions, which stifles independent debate.

"John [Wilson, the chairman] works with a couple of independent directors and isolates the rest of the board," said a major farmer-shareholder whose time on the board predated the Beingmate deal. "Divide and rule? Take that as gospel."

- Its relationship with its auditors, PWC, meets New Zealand standards -- which allow, for example, auditors to also offer advisory services to the same clients, with some rules around that to prevent conflicts of interest. But it falls short of global best practice. In the US, for example, there is strict separation of such functions.

"The auditors are too close to the company and management," added the Fonterra former director who pre-dated Beingmate but who keeps close tabs on the co-op's management and governance.

While some shareholders have been raising many of these issues over the years since Fonterra was formed in 2001, they say their concerns are taking on a greater urgency because of Beingmate.

There are, for example, persistent rumours among some well-connected, major shareholders that one or more directors declined to sign off last September on Fonterra's fiscal 2017 accounts.

In response to this writer's question on the sign off, Fonterra replied:

"It's important that boards of directors retain the ability to have open and frank discussions. To avoid compromising the robustness of this process, the details of board meetings are not disclosed. Accordingly, we're not able to publicly share the details of the specific discussions that have taken place in Fonterra board meetings."

To understand how Fonterra has got to this point in its history, it's important to consider the context in which Fonterra made its decision in August 2014 to invest in Beingmate.

In August 2013, the co-op was hit by the possibility that botulism had tainted some of its shipments of whey protein concentrate, a key ingredient in infant formula. This triggered a large, worldwide product recall, which was made fraught and chaotic by Fonterra's inadequate systems, as the government's subsequent investigations reported.

In due course, no botulism was found and the government declared it a false alarm. But the recall had very badly damaged Fonterra's relationship with major customers, particularly Danone, the French multinational for which Fonterra made large quantities of infant formula under Danone's brands for Danone to sell.

Danone broke off that commercial relationship and sued Fonterra, seeking some $1bn in compensation for costs incurred, sales lost and reputation damaged. Last December, an international arbitration court ordered Fonterra to pay Danone $183m.

To attempt to forestall damage claims from other major customers, Spierings set out in early 2014 on "a global grovel trip", says a person who was one of his senior colleagues at the time.

The enormous and fast-growing Chinese market was the most critical of all. The botulism scare was only the latest of several setbacks there for Fonterra, starting with the Sanlu disaster. These had seriously compromised its efforts, particular in trying to establish its own formula brands in the market.

The key Chinese customer Spierings visited was Beingmate Baby and Child Food, which was founded in 1992 by Xie Hong, a food scientist who calls himself Sam in English.

"When Theo arrived, Sam spotted an opportunity," said Spierings' former colleague. The Chinese government was pushing through major reforms of the infant formula industry to improve its integrity, particularly among its domestic manufacturers and distributors, and build consumer confidence in them.

Beingmate had grown very rapidly as an infant formula manufacturer and seller. Its network of some company owned plus tens of thousands of franchised stores across China made it number one in the market with a share of about 10 percent.

Given the government-driven reforms, though, Xie saw the benefits of closer ties to Fonterra as a source of ingredients for its own formulas and of Fonterra's own brands to sell in its network.

Negotiations began. "The Chinese drove a very hard bargain," Spierings' former colleague said. They knew that Fonterra had to find a major partner to make its Darnum plant in Australia economically viable after the departure of Danone as a customer; Fonterra was eager to overcome its market failure in China with its own infant formula brands; and Fonterra believed it had to show the Chinese government it was serious about investing locally despite all its setbacks.

"Theo kept saying Beingmate was 'a ticket to the game' - investing in farms in China was not enough. One way or another, he was determined to do this deal."

At the August 27, 2014, signing ceremony for the deal, Spierings said it was a "game changer" for the co-op. In addition to the link ups on Darnum and Chinese sales, Fonterra announced other strategic synergies with Beingmate such as R&D and farming in China, UHT milk from NZ, and development by the two companies of integrated global supply chains.

Indeed, Beingmate did belatedly buy a 51 percent stake in the Darnum plant, contracting Fonterra, as the 49 percent holder, to run on behalf of the two of them. Recently, Beingmate has attributed some of its rising losses to Darnum. Fonterra confirmed this week that Beingmate's weak sales in China mean it is struggling to take its share of the plant's output.

And indeed, Beingmate is selling a little of Fonterra's Anmum brand of infant formula in China. But Fonterra finally conceded last September the sales were a tiny fraction of the $100m a year's worth anticipated. Its recent attempts to talk up the sales identify only the number of stores carrying it, not the volume sold.

As for all the other strategic synergies, Beingmate's troubles have caused a "forced ranking" of priorities, to use an internal Fonterra term. All the efforts are going into trying to turn around formula sales and the Darnum relationship. None of the other initiatives have developed.

Meanwhile, Beingmate's performance has been sliding fast since its peak performance in 2013, the year before Fonterra said it was going to take a stake. Heavily dependent on bricks-and-mortar sales channels it is still struggling to catch up with the massive shift to online sales.

Worse, it is failing to capitalise on its advantage of being among the first companies last year to register their infant formula recipes with government regulators.

There are great tensions and conflicts within Beingmate., which have led to turmoil and departures by senior management and board members. One highly contentious issue in the company is whether to sell foreign brands such as Fonterra's.

"You don't want to raise other people's babies," one senior executive told the writers of a Harvard Business School case study. First published in 2002 and most recently updated last March, the study is a far more comprehensive explanation of Beingmate's history, travails and strategic challenges than Fonterra has ever supplied.

My two previous Newsroom columns on Fonterra and Beingmate had traversed these issues at length, on September 30 and January 26.

Reflecting these deep failures in Beingmate, its sales peaked at yuan 6.11bn in 2013, then fell to yuan 5.05bn the following year when Fonterra committed to taking a stake, to yuan 4.55bn in 2015, the year Fonterra bought its stake, and to yuan 2.76bn in 2016. Beingmate has said it suffered further setbacks in sales in 2017, with the results still to be published.

Its net profits peaked at yuan 721m in 2013, fell to yuan 68.9m in 2014, improved to yuan 103.6m in 2015, then turned into a loss of yuan 780.7m in 2016, and the company has forecast a loss of up to yuan 1bn for 2017. Its market share has plunged during the three years of Fonterra's investment.

Over this period, its balance sheet has deteriorated badly. It has paid no dividends since Fonterra bought in. The co-op said the deal would be earnings positive from the outset, in part because of some $16m of dividends a year from its Beingmate shares. But it has received no dividends.

Fonterra said it was getting a good deal buying its 18.8% stake in Beingmate in March 2015 at yuan 18 per share. Even though Beingmate had reported a 90% drop in net profits for 2014 only weeks before Fonterra made its purchase, "due consideration" was given to the bad results, said Lukas Paravicini, who was then Fonterra's chief financial officer. He is currently its chief operating officer, Global Consumer and Foodservice.

Ever since Fonterra declared its intention to invest in Beingmate in 2014, Spierings and Wilson, the co-op's chief executive and chairman, have constantly expressed their faith in Xie, Beingmate's founder, and in the strength of Spierings' relationship with him. Wilson has reiterated that message in recent days on radio here.

Clearly, Xie is a talented scientist and entrepreneur. Today he is enjoying a far bigger success with BGI Genomics, a Chinese listed biotech company, than he did with Beingmate. His high point with Beingmate was floating its Beingmate Baby and Child Food subsidiary in 2011 at a share price of yuan 42, while keeping control through a minority interest of some 35% through his private holding company, Beingmate Group.

But only three months after the float he left the board of Beingmate Baby and Child. He has had no formal role in the company since, though he remains its largest shareholder.

If Xie has the talent and desire as an active owner to bring order and purpose to Beingmate, to renew its strategic drive and restore its profitability, he has shown no signs of achieving any of that in the three years Spierings and he formed their "Co-operation Committee" to lead the company.

As recently as the middle of last year Xie visited Fonterra in Auckland, the co-op says. It declined to comment on the view of Beingmate he gave the co-op.

But barely two months after Xie's visit, Beingmate forecast in July it would fall into loss. By early September Fonterra was working with its advisers on revaluing its stake in Beingmate in order to finalise the co-op's 2017 accounts.

They used "a fair value methodology" - that was, "an estimate of what a market participant would pay for a similar stake in Beingmate under current market conditions," according to the note on page 7 of Fonterra's 2017 Financial Results.

On that basis, Fonterra took only a $35m impairment loss on its investment. PWC, its auditor, subsequently gave the accounts their unqualified approval.

Since then, Beingmate's fortunes have fallen far faster and deeper. After the company forecast in January of a loss of up to yuan 1bn for 2017, Fonterra made its first public rebuke of Beingmate and aspects of its governance. Up to then, Fonterra kept blaming the market conditions in China for the company's slide.

And yet Fonterra's faith in Xie endures, despite Beingmate missing every forecast it has made over the three years of Fonterra's involvement with it, and Xie has shown no ability to have any impact on reversing its declining fortunes.

In part, Fonterra has only itself to blame by taking a minority stake in a complex and opaque Chinese company. Even with two directors on the board, its ability to understand and influence the company are highly limited. This was a fundamental lesson it should have learnt, at great cost, from Sanlu.

The two directors are Christina Zhu, currently Fonterra's head of Greater China, who is Chinese with an international business background, and Johan Priem, her predecessor in that role who is currently a consultant in China.

Priem was a colleague of Spierings at the Dutch dairy co-op Royal FrieslandCampina before they joined Fonterra. He does not speak or read Mandarin, and is supported in Beingmate board meetings by a Mandarin interpreter, Fonterra says.

Fonterra says it is further hobbled by disclosure laws. It says that Zhu and Priem can only tell it what Beingmate says publicly. They cannot share with it anything they learn from within Beingmate. Presumably, that must also significantly constrain any conversations Spierings has with Xie.

Consequently, Fonterra says it has to seek information on Beingmate from other sources.

How did Fonterra get into this mess?

The picture built up my recent conversations with knowledgeable people includes these key elements:

- Fonterra felt under great pressure to make a big strategic investment in China to rectify its own failures in the market, and to assuage what it believed were the desires of the Chinese government.

- Beingmate took advantage of Fonterra's weak bargaining position to drive a hard bargain.

- Fonterra's due diligence report on Beingmate, provided by one of its external advisers overseas, was essentially a straight line extrapolation of Beingmate's past growth.

- Beingmate has utterly failed to deliver on those sunny prospects, through a combination of its own failures and of turbulent market conditions.

- Fonterra has doggedly stuck with Beingmate, arguing it is an integral part of its China strategy and it will eventually come right.

But it seems Fonterra has rarely applied basic governance tests such as rigorously and regularly testing its investments in Beingmate and Chinese farms against their original strategic purpose and projections, and current performance.

"Beingmate was outside our capability; we've denied for three years that there was an issue; the only issues were external and short-term ones rather than anything to do with Beingmate," says a person closely involved.

The next big test for the board is how they address Beingmate in time for the co-op's half year results due for release on March 21. The central issue is Beingmate's true value. Today, Beingmate's shares are trading at just over yuan 5, a drop of 72 percent from Fonterra's purchase price, and representing a loss of $545m on its $755m original investment.

Given Beingmate's performance, it's getting harder and at a price far north of its current lowly market price.

On Beingmate's current trajectory it is possible Fonterra's investment might eventually have no redeemable value. Then the total loss on the investment, plus the cost of debt to finance it, plus Fonterra's share of Beingmate's losses could top $1bn.

Clearly, the board will have some deep debates with PWC, its auditors, about the next revaluation before finalising the write-down it will have to take in coming weeks.

A concern some shareholders have expressed is the long-standing relationship between Fonterra and PWC, which has been its auditors since May 2004. There is talk among them of tabling a motion at Fonterra's next annual meeting to require a set term for its audit firm followed by a mandatory change to another.

Moreover, Bruce Hassall, retired in September 2016 after his eight-year stint as PWC's chief executive, then joined the Fonterra board late last year, and immediately took over as chair of its audit and finance committee.

Fonterra says it has board rules in places to ensure there's no possibility of a conflict of interest. The details are in Fonterra's annual report, and repeated in its response to my questions. (link to Fonterra's answers)

Should, though, for example, the board revisit in its latest revaluation of Beingmate the merits of the previous revaluation methodology in September, made while Hassall was still chief executive of PWC, clearly, he would have to recuse himself from the discussion under the rules Fonterra has set itself.

With this escalating range of Beingmate issues, the tide of anger is rising about the co-op's board.

"They love bullshitting farmers," is the verdict of one senior figure involved with the co-op.

Full text of Rod's questions to Fonterra and its answers

Rod Oram

Was the due diligence report on Beingmate which Fonterra used to inform its decision in August 2014 to purchase a stake of up to 20 percent in Beingmate:

- Produced in-house or by an external adviser?

- If external, which adviser provided it?

- Did the due diligence report include forecasts of strong growth in Beingmate’s profits over the following five years? - What was the source of those forecasts?

- How did Fonterra verify them?

Fonterra:

We conducted extensive due diligence prior to our investment in Beingmate, drawing on the expertise of both internal and external advisors. The due diligence outlined a number of significant opportunities – which continue today. It’s important to also view our investment in Beingmate as part of a long-term, strategic plan to grow in the China infant formula market. Our business in China delivered around $3.4bn in revenue last year, enabled by an integrated strategy, comprising Ingredients, Consumer and Foodservice, our China farms and our Beingmate partnership.

Rod Oram

How did Fonterra finance its purchase in March 2015 of its 18.8 percent stake in Beingmate?

- For example, it raised $230m in a 4 percent, 5-year dim sum bond in June 2015, specifically to part finance the deal.

- Which other loans and bonds used to finance the deal are currently outstanding?

- What is the annual cost of servicing them?

- Has Fonterra received any dividends from Beingmate since it has owned shares in the company? If so, how

much?

Fonterra

Beingmate’s acquisition was financed using Renminbi funding. As you’d expect, we have diversified funding sources and draw on the most appropriate of these, depending on the specifics of the transaction. For commercial reasons we do not disclose the terms of our non-public funding, however the total finance cost for Fonterra’s portfolio of debt is available in our Annual Report.

Rod:

Following its purchase of the Beingmate stake, at which subsequent Fonterra board meetings did:

- Directors receive and discuss written reports on Beingmate’s performance and its forecasts for the future? - Directors receive written reports and presentations from senior Beingmate representatives?

- When was the most recent occasion Xie Hong presented to the board?

- Directors assess whether the relationship with Beingmate was meeting the strategic objective Fonterra had set for it? And if not, what remedial action would be taken?

- Has the board at any time in the past four years reflected on its learnings from Fonterra’s experience with Sanlu, and in light of them, considered its investment in Beingmate?

Our Board meets regularly to discuss important strategic matters, such as our Beingmate investment, and considers a wide range of information and analysis as part of these discussions. In addition, it is senior management’s highest priority to see this investment on the right track.

Last Wednesday on ZB’s Country programme, Fonterra’s chairman said Fonterra has established a “strategic committee” of Theo Spierings and Xie Hong to oversee the turnaround of Beingmate.

- Given Xie has held no formal role in Beingmate since 2011, what direct role does he play in Beingmate Baby and Child? What role is he playing in the turnaround?

- Given Beingmate has substantially under-performed every forecast it has made since before Fonterra’s purchase of its stake in the company in March 2015, does Spierings personally and Fonterra corporately still have complete confidence in Xie?

Fonterra:

Rod, that’s not correct.

To clarify, there is a Co-operation Committee that involves the largest shareholder, Sam Xie’s Group company and Fonterra as second largest shareholder. It is intended to allow the two shareholders to meet to further common business objectives and resolve any issues in good faith. This Committee was established when we purchased our stake in Beingmate.

Rod:

On ZB last Wednesday, the chairman also said: “We get publicly available information” on Beingmate. This is only the latest of a number of comments by the chairman and chief executive that strongly suggest Fonterra is heavily reliant on such sources of information.

- What types of internal information about itself does Beingmate give Fonterra?

- How many board meetings of Beingmate Baby and Child Food have Fonterra appointees Zhu and Priem attended?

- Have they regularly received board papers from Beingmate about its performance and strategy?

- Have they participated in substantive discussions about Beingmate’s performance and strategy?

- How fluent is Priem in speaking and reading Mandarin?

Fonterra

As an investor in Beingmate, a publicly listed company, we have access to the performance and financial information shared publicly by the company’s board and management. We have total confidence in the judgement of our designated directors, Johan and Christina, and that their actions are in the best interests of Beingmate and its shareholders.

Rod:

In its 2017 accounts, Fonterra wrote down the value of its investment in Beingmate by $35m:

- As a result of the write-down, what is the current value? - Does that include a premium for control?

- How does Fonterra exercise that control to justify the premium?

Fonterra:

Under the basis of preparation of section of our July 2017 financial statements we disclosed the carrying value of Beingmate as $617m.

Rod:

Fonterra says Beingmate says it (Beingmate) is losing money on Darnum? Why is that?

Beingmate has noted it is incurring costs resulting from the Product Purchase Agreement it has with Darnum Dairy Products. Beingmate is not ordering as much product as forecast, which is causing an under-utilisation of the facility and resulting in a subsequent on-cost.

PWC has been Fonterra’s auditor for some years and has performed specific tasks for Fonterra such as advising on the write-down by Fonterra of its investment in Beingmate for the co-op’s 2017 accounts.

Rod:

Given Bruce Hassall was chief executive of PWC for almost 8 years until September 2016, does Fonterra have complete confidence in his independence as chair of the Fonterra board’s audit and finance committee?

Fonterra

The following information is taken directly from the Notice of Meeting document for the 2017 Annual Meeting and shared with farmer shareholders at the time:

In June 2017 the Board announced that Mr Bruce Hassall would be appointed to the Fonterra Co-operative Group Board from the close of the 2017 Annual Meeting. Before joining the Fonterra Board, Mr Hassall served a 12 month stand-down period following his retirement as Chief Executive Officer of PricewaterhouseCoopers. This stand-down period meets International Accounting Standards and Independence rules.

Mr Hassall does not have a conflict of interest as a past Chief Executive Officer of PricewaterhouseCoopers. However, to manage the risk of any perceived conflict of interest, the Board has determined that Mr Hassall will abstain from voting on any resolutions put to the Audit and Finance Committee regarding the appointment of Fonterra’s auditors for the next three years. For those decisions, the other Independent Director sitting on the Audit and Finance Committee will Chair the meeting (currently Mr Scott St John) and the Chair of the Board will join the Committee for the deliberation.

Additional question regarding details of recent Fonterra board discussions about Beingmate:

“It’s important that boards of directors retain the ability to have open and frank discussions. To avoid compromising the robustness of this process, the details of board meetings are not disclosed. Accordingly, we’re not able to publicly share the details of the specific discussions that have taken place in Fonterra board meetings.”