Rod Oram delves behind the scenes of Fonterra's Beingmate debacle in this week's column. He finds the board will have to make a momentous decision that has parallels with Fletcher Building's eventual removal of its CEO and retirement of its Chairman.
What's Beingmate Baby and Child Food worth? That's the question gripping Fonterra, its advisers and shareholders.
The simple answer is: a lot less than the $756m Fonterra paid for its 18.8 percent stake in the Chinese infant formula company only three years ago. The greater the write-off Fonterra takes in its half-year results due on March 21, the greater will be the impact on its dividend payout.
The bad news from Beingmate began even as Fonterra committed in 2014 to buying its stake in it; and it has only kept getting worse since.
The latest setback: it confirmed last week that it had lost nearly yuan 1 bn last year ($211m); its independent auditor identified concerns over the level of related party transactions, particularly with its controlling shareholder Beingmate Group; it had high inventories of formula it can't sell under the government's new registration system; and it was at risk of being delisted from the Shenzhen stock exchange because of its dismal financial performance.
The views in China on Beingmate's ability to rebuild itself are not encouraging. Based on a number of interviews I've had in recent weeks, the verdicts range from vaguely hopeful at the best, to no hope for Beingmate at the worst.
The case for vague hope was put by an adviser long familiar with Fonterra's strategy, including its investment in Beingmate. He argues that most companies in China are going through a huge and often difficult transition from entrepreneur-led businesses to well-run corporates.
Beingmate is no different. Beingmate Group's founder Xie Hong is central to Fonterra's relationship with the Beingmate Baby and Child Food subsidiary in which Fonterra has its stake.
John Wilson, Fonterra's chairman, has said repeatedly that a "strategic committee" consisting of Theo Spierings, Fonterra's chief executive, and Xie have been working closely together on turning around the company.
However, Xie's high point with Beingmate was floating its Beingmate Baby and Child Food subsidiary in 2011 at a share price of yuan 42 (it's now yuan 5), while keeping control with a minority interest of some 35 percent through his private holding company, Beingmate Group.
But only three months after the float he left the board of Beingmate Baby and Child on grounds of ill health. He has had no formal role in the company since.
The adviser noted that soon after the float Xie had "driven away" institutional shareholders from the company. This has been noted by Chinese media too, citing investor unhappiness with aspects of the Beingmate's float and its subsequent under-performance.
On a more positive note, the adviser says, Beingmate Baby and Child has "world class plants and formulas". But he concedes its sales and distribution network "is completely broken" and that Xie's ill health has returned. "He is very up and down."
Three factors in the breakdown of the sales network were highlighted by a second interviewee in China familiar with the sector.
First, in 2014 China's anti-monopoly commission fined a number of foreign infant formula companies, including Fonterra, US$100 m for their pricing practices. Those companies then reduced their prices and Beingmate, as a leader among domestic formula companies, followed suit.
However, Beingmate did so by maintaining its wholesale price while forcing sharp reductions in downstream prices charged by its distributors and its tens of thousands of independent retailers around the country. This angered them and damaged their trust n Beingmate.
Second, also in 2014 as Fonterra was committing to a stake in Beingmate, the company was attempting to bring much of its distribution system in-house. This further weakened its relationship with independent distributors and retailers.
Third, Beingmate has responded inadequately to the strong shift in infant formula sales in China from stores to online channels.
On top of those adverse factors, "Beingmate's management is chaotic," marked, for example, by departures of many executives from the highest levels in the company on down.
Consequently, Beingmate's infant formula market share has plunged from 9.3 per cent in 2013 to 2.5 percent last year, according to Eurmonitor. Meanwhile, Fonterra's global arch-rivals have greatly grown their shares. Nestle's is up from 12 percent to 17 percent, Danone's from 7 percent to 10.6 percent and FrieslandCampina's from 4.1 per cent to 7.4 percent.
Moreover, the adviser said, there are a number of laws and culture norms in China that have made it hard for shareholders to get together to sort out troubled companies. In Beingmate's case it has had two great protectors: the mayor of Hangzhou, the city in which it is headquartered, and the Hangzhou branch of China Construction Bank, which is its sixth largest shareholder and a major lender to it.
However, Hangzhou now has a new mayor, and the bank's headquarters in Beijing has finally prevailed over its local branch. This gives the adviser some hope a "China Inc." effort to restructure Beingmate might now be possible. This would take 18 months or so to begin to be effective but, he cautioned, Fonterra might not be part of the solution.
Notably Wilson and Spierings, Fonterra's chairman and chief executive, talk about the need for the co-op's shareholders to be patient over the "medium term" while Beingmate is rebuilt.
But they have never spoken of who their allies are in Beingmate, or even if there is an attempt at a "China Inc." remedy to its failures. Based on Fonterra's past performance in China, little suggests it has the political, cultural and management skills needed to play a constructive role alongside powerful Chinese business and government interests.
In such difficult corporate restructurings the world over, the obvious solution is to sell the good assets rather than try to rebuild the bad ones. In Beingmate's case, that would mean selling its world class plants and recipes for formulas to a company with a strong distribution network.
Should that happen, Fonterra would only have a few cards to play in the negotiations over the sale of Beingmate's assets: its joint venture with Beingmate in their powder plant in Darnum, Australia, and access to Fonterra's other sources of milk powders used in making infant formula.
Interviews with some other knowledgeable Westerners in China, however, describe an even bleaker picture. Over the past decade, Fonterra has suffered three traumas in China:
In 2008, Sanlu, in which Fonterra held a 43 percent stake, went bust because it was the central player in a tainted infant formula scandal that killed six babies and hospitalised tens of thousands of others.
In early 2013, traces of DCD, a nitrogen inhibitor used at the time on some New Zealand farms, were found in some of Fonterra's products. Fonterra's problem was there were no international standards for such residues.
In August 2013, Fonterra recalled some 1,000 tonnes of products worldwide because it suspected botulism might have affected them. It proved to be a false alarm, but by then the damage was done to the confidence of some Chinese consumers in its products.
Now some Chinese people are believing Fonterra "is killing off Beingmate", one of the interviewees said.
We'll know what value Fonterra puts on its Beingmate investment when the co-op reports its half-year results on March 21. To reassure farmer-shareholders and investors in its NZX- listed shareholders' fund that it has a realistic view on Beingmate, Fonterra will have to use a valuation methodology that is credible to them, come up with a plausible revaluation and give a detailed explanation of why and how the co-op believes it can achieve it.
There's no doubt that Fonterra will once again write-down the value of its Beingmate investment, and by much more than its first impairment of only $35m which it made with its year-end results last September.
Then, Fonterra and its auditor, PWC, 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.
But if back then Fonterra had marked its $756m investment in Beingmate to the then share price of around yuan 10, it would have been worth only $420m. Yet, the share price has more than halved in the past six months, valuing the stake at only $200m.
Worse, though, Fonterra has had additional costs to its stake in Beingmate, in particular the interest costs on the bonds and debt financing of the stake, the equity accounting for its share in Beingmate's losses, and the dividend payments it expected from Beingmate of some $16m a year, but which it never received because the company stopped paying dividends as it plunged into losses.
Accounting for these additional costs, Fonterra's total investment in Beingmate to date is close to $1 bn.
In the six months since the previous Beingmate revaluation by Fonterra and PWC, the news from the Chinese company has gotten far worse, and farmer-shareholders' anxiety about their co-op's investment has risen sharply.
This latest revaluation, though, will involve two fresh and experienced people. Bruce Hassall, a former chief executive of PWC, Fonterra's auditor, joined the board last November and immediately took over as chair of its audit and finance committee; and Marc Rivers joined the co-op February 19 as its new chief financial officer. He was previously CFO of the global pharmaceuticals business of Roche, the Swiss company. "He has battle scars from China," said one of the interviewees for this article.
Hassall will also bring to the co-op his recent experience at Fletcher Building. He joined its board in May last year, and took over the chair of its audit and risk committee after its shareholders meeting last October.
To briefly recap Fletcher's recent disasters: its board was remarkably slow over the last few years in picking up on deficiencies in the style and performance of Mark Adamson, the CEO, and the comprehensive failure of people and systems in its Building + Interiors division; when it did act, the board fired the CEO, but it didn't get ruthlessly to the bottom of B+I's problems in a series of escalating loss announcements over the past year.
Only when a new chief executive, Ross Taylor, arrived last November, did the company finally deal with its deep problems. This pushed the forecast B+I losses to almost $1 bn; the company announced it would close down B+I, and it could not afford to pay a half-year dividend; and Sir Ralph Norris said he would retire as chairman before the next annual meeting.
No doubt some farmer-shareholders are considering the strong parallels between the recent performances of Fletcher and Fonterra, and how ripe their co-op is for equally decisive remedies.