Dairy Industry Structure Project

1

• Dairy Industry Structure Project
• Presentation to Select Committee
• 10 August 1999

2
Capital Choices
Organisational Choices
Clear Answers
Clear Answers
Integrated Options
Stability / Evolution
Value / Preconditions
Final answer
3
FOUR CAPITAL / OWNERSHIP DESIGN CHOICES
4
FOUR ORGANISATION DESIGN CHOICES
Organisation Design Choices
Multiple marketers
Single Marketer
Multiple manufacturers
Single manufacturer
Vertically aligned
Horizontally aligned
Atomised organisation
Centralised organisation
5
TWO KEY PRINCIPLES

• Maintaining Farmers' control
• Providing Farmers with choice

6
SUPPLY CHAIN STRUCTURE - SIMPLIFIED
Farm
Processor
Merchant
Trading
Ingredients
Consumer
7
ASSESSING BARGAINING POWER
Assessing the market structure
One
High trading risk
Sellers dominate

• Bargaining power
• number of players
• variable supply
• perishable milk
• asset specificity

Few
Number/concentration of sellers
No-one dominates
Buyers dominate
Many
One
Few
Many
Number/concentration of buyers
8
TRANSFER PRICE
Farm
Processor
Merchant
Trading

• Clear internal transfer price

Ingredients

• Clear transfer price

Ingredients slivers
Consumer

• Clear transfer price

Integration is not required for ingredients
slivers and consumer
9
Capital Choices
Organisational Choices
Clear Answers
Clear Answers
Integrated Options
Stability / Evolution
Value / Preconditions
Final answer
10
FOUR CAPITAL / OWNERSHIP DESIGN CHOICES
11
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
12
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
13
FINANCIAL CAPACITY
NZ billions
Total Capital required
12
Less Debt capacity
8
Additional capital required
4
Fair value Share Std
External equity
Retentions
14
RETENTIONS VS FAIR VALUE SHARE STANDARD (FVSS)
Interpretation Provides combination of fair value
share standard and retentions required for a
given external capital level
100
Retentions
0
Nominal Fee
Full market value fee
Fair Value Share Standard (FVSS)
15
AVERAGE RETENTION / PAYOUT VS AVERAGE FVSS BASE
CASE
Retention of Cash Profit
Payout /kg MS
50
3.01 40
40
3.12 30
30
3.23 20
20
10
3.34 10
External Capital of 0
0
3.46 0
2
4
6
8
10
12
-10
3.58 -10
Fair Value Share Standard (FVSS) (/kg MS)
16
QUESTION
Do we need to structure parts of the business to
provide for external equity?
ANSWER

• We should structure the downstream parts of the
  business to provide the option of external equity
  in the future, including
• Consumer
• Ingredients slivers

17
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity
Yes

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
18
CORPORATE VS CO-OPERATIVE
UPSTREAM - Milk processing - Merchant - Trading -
Ingredients

• No transparent transfer prices
• Supplier control required

Co-operative structure to protect/serve farmer
interests

• Transparent transfer prices
• Supplier control not required

DOWNSTREAM - Consumer - Ingredient slivers
Corporate structure to drive performance
19
QUESTION
Should the Industry maintain a co-operative
ownership structure for all of the business?
ANSWER

• Co-operative structure required for
• Manufacturing
• Merchanting
• Trading
• Ingredients
• Corporate structure desired for
• Consumer
• Ingredients slivers

20
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity
Yes

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative
No

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
21
LINKED VS DELINKED

• Avoid dilution of suppliers wealth from increased
  milk supply
• Send correct economic signal for new milk

Required
Rationale

• Avoid uneconomic production
• Total returns (both on and off-farm) remain
  unchanged or increase

Issue

• Debt carrying capacity is an issue to be addressed

22
IMPACT ON FARM ASSETS
Downstream Value
Upstream Value
Current Land Value
Future Land Value
Current
Future
23
QUESTION
Should returns from downstream investments be
delinked from supply?
ANSWER
Returns from downstream investments should be
linked to ownership and not supply to ensure
correct economic signals are sent to suppliers
24
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity
Yes

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative
No

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply
Yes

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
25
DIFFERENTIATED VS UNIFORM PAYOUT
Problem

• A new entrant could cherry pick opportunities and
  pay more than a commodity milk price

• CMP and cost structures must reflect true
  economics of milk
• National farmgate milk price but -
  constitutional changes possible

Required
26
CAPITAL / OWNERSHIP QUESTIONS

• Do we need to structure parts of the business to
  provide for external equity?

External / Internal equity
Yes

• Should the Industry maintain a co-operative
  ownership structure for all parts of the business?

Corporate vs co-operative
No

• Should returns from downstream investments be
  delinked from supply?

Ownership Linked/ Delinked to Supply
Yes

• Should the Industry have the ability to
  differentiate payout?

Differentiated/ Uniform Payout
Current No
Constitutional change required
27
Capital Choices
Organisational Choices
Clear Answers
Clear Answers
Integrated Options
Stability / Evolution
Value / Preconditions
Final answer
28
FOUR ORGANISATION DESIGN CHOICES
Organisation Design Choices
Multiple marketers
Single Marketer
Multiple manufacturers
Single manufacturer
Vertically aligned
Horizontally aligned
Atomised organisation
Centralised organisation
29
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Marketer
Manufacturer

• Should we have single or multiple manufacturers?

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Vertical/ Horizontal
Atomised/ Centralised

• How can we organise to drive performance?

30
THIRTYTWO OPTIONS
Single Marketer
Specialised Marketers
Consumer with Merchant
Ingredients with Merchant
Commodity Competitors
Merchant with Processor
Fully Competing Marketers
Single Manufacturer
No integration
Multiple Manufacturers
31
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Marketer
Manufacturer

• Should we have single or multiple manufacturers?

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Vertical/ Horizontal
Atomised/ Centralised

• How can we organise to drive performance?

32
QUESTION SHOULD WE HAVE SINGLE OR COMPETING
MARKETERS?
Single marketer
Specialised marketers
Fully Competing marketers
Commodity competitors
One marketer

• Specialised marketers
• Consumer
• Ingredients

Competition in all segments of the market

• Specialised marketers
• Consumer
• Ingredients
• Competition in commodities via trader

33
CRITERIA FOR EVALUATING THE OPTIONS
Ability to realise strategy
Impact of marketplace competition
Impact of scale
Impact of performance transparency
34
ANSWER
QUESTION
Will fully competing marketers destroy value?
FINDING

• Fully competing marketers have reduced scale,
  reduced ability to achieve strategy and will
  compete away premiums
• Benefits of competition insufficient to offset
  this value loss

Yes - fully competing marketers will destroy value
35
ANSWER
QUESTION
Will specialised marketers be superior to a
single marketer?
FINDING

• Consumer must be structured separately to allow
  for the introduction of external equity in the
  future
• The positive impact of commodity competition will
  largely offset scale and premium losses

• A single marketer is not feasible given consumer
  needs
• Specialised marketers are feasible, either
• Ingredients and consumer
• Ingredients and consumer, commodity competition

36
SIXTEEN OPTIONS
Single Marketer
Specialised Marketers
Consumer with Merchant
Ingredients with Merchant
Commodity Competitors
Merchant with Processor
Fully Competing Marketers
Single Manufacturer
No integration
Multiple Manufacturers
37
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Yes
Marketer
Yes
Manufacturer

• Should we have single or multiple manufacturers?

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Vertical/ Horizontal
Atomised/ Centralised

• How can we organise to drive performance?

38
ECONOMIES OF SCALE BENEFITS MANUFACTURING
millions annual savings
One Company 50 - 80
Two large companies 35 - 55
Total synergies
Difference between one and two large
manufacturers is 15-25 million pa
39
FINDING
QUESTION
Should we have single or multiple manufacturers?
Performance losses of 0.5 could offset synergy
gains
ANSWER
Not defining
40
SIXTEEN OPTIONS
Consumer with Merchant
Specialised Marketers
Ingredients with Merchant
Commodity Competitors
Merchant with Processor
Single Manufacturer
No integration
Multiple Manufacturers
41
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Yes
Marketer
Yes
Manufacturer

• Should we have single or multiple manufacturers?

Not defining

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Vertical/ Horizontal
Atomised/ Centralised

• How can we organise to drive performance?

42
HOW DO WE INTEGRATE THE DIFFERENT PARTS OF THE
BUSINESS
Vertical integration
Horizontal integration
Consumer customers
Ingredients customers
Merchant
Processor
Ingredients marketer
Consumer and ingredients customers
Consumer marketer
43
ANSWER
QUESTION
Should we integrate merchanting and processing?
FINDINGS

• No intermediate transfer price
• Closely linked business systems

Yes - we should integrate merchanting and
processing
44
FINDINGS
QUESTION

• Should we integrate ingredients and merchanting?

• Risk of destructive competition
• Revisit as market evolves

ANSWER
Yes - we should integrate ingredients and
merchanting
45
FINDINGS
QUESTION
Should we integrate consumer and merchanting?

• Manage complexity/diversity
• Prepare for external equity

ANSWER
No - we should structure consumer so it can be
separated from merchanting
46
FOUR REMAINING OPTIONS
Consumer with Merchant
Specialised Marketers
Ingredients with Merchant
Commodity Competitors
Merchant with Processor
Single Manufacturer
No integration
Multiple Manufacturers
47
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Yes
Marketer
Yes
Manufacturer

• Should we have single or multiple manufacturers?

Not defining

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Yes
Vertical/ Horizontal
Yes
No
Atomised/ Centralised

• How can we organise to drive performance?

48
ANSWER
QUESTION
How can we organise to drive performance?

• Performance management within specialised
  marketers or a single milk processor will
  require
• replication of external markets within the
  organisation
• breaking the organisation into a large number of
  transparent (but connected) performance units

49
ORGANISATION QUESTIONS

• Will fully competing marketers destroy value?
• Will specialised marketers be superior to a
  single marketer?

Yes
Marketer
Yes
Manufacturer

• Should we have single or multiple manufacturers?

Not defining

• Should we integrate merchanting and processing?
• Should we integrate ingredients and merchanting?
• Should we integrate consumer and merchanting?

Yes
Vertical/ Horizontal
Yes
No
Atomised/ Centralised

• How can we organise to drive performance?

Atomised
50
FOUR REMAINING OPTIONS
Specialised Marketers
Commodity Competitors
Ingredients with Merchant
Merchant with Processor
Single Manufacturer
Multiple Manufacturers
51
Capital Choices
Organisational Choices
Clear Answers
Clear Answers
Integrated Options
Stability / Evolution
Value / Preconditions
Final answer
52
ORGANISATIONAL OPTIONS
Option 6
Option 2
Specialised Marketers
Option 3
Commodity competitors
Single Manufacturer
Multiple Manufacturer
53
OPTION 2 IS CONSIDERED UNSTABLE
Option 6
Option 4A
Option 2
Full competition
Join up
Option 3
Compete in commodity
54
REMAINING OPTIONS OPTION 4A
Fully integrated competing companies -
competition in both consumer and ingredients
55
Capital Choices
Organisational Choices
Clear Answers
Clear Answers
Integrated Options
Stability / Evolution
Value / Preconditions
Final answer
56
CRITERIA FOR EVALUATING THE OPTIONS
Impact Of Marketplace Competition
Ability To Realise Strategy
Impact Of Scale
Impact Of Performance Transparency
Fragmentation Competition
Manufacturing Marketing
Premium above commodity New Zealand umbrella
brand Destructive competition
External performance pressure Impact on
x- inefficiency
57
COMPARISON VS OPTION 6
billions
-1.6
-0.4
6

0
-2.0
Strategy
6
-1.0
-0.2
0
Scale
-2.0
6
-0.5
-0.2
Marketplace Competition
0
-2.0
6
-0.8
0
-3.1
Total
58
OVERALL COMPARISON VS OPTION 6
billions
0.0
Total of strategy, scale and competition
-0.8
6
-3.1
1.1
Performance Transparency

6
1.1
-3.1
0.3
-2.0
6
-3.1
1.1
Overall
0.0
59
DOWNSIDE OF OPTION 3 IS HUGE
billions
0.3
0.0
-2.0
-3.1
1.1
Overall
6
60
SUMMARY

• Option 6 is preferable to a pure Option 3 by 800
  million if x-inefficiency can be eliminated
• Otherwise a pure Option 3 is preferable to Option
  6 by 300 million if breakdown of Option 3 can be
  prevented

We believe that the x-inefficiency can be managed
under Option 6
61
THE VALUE OF THE STRATEGY IS DRIVING THE STRUCTURE
millions pa
Status Quo
Option 6
Option 3
Option 4A
Equivalent annual NPV of total strategy, scale
and competition
0 ?
350
270
40
62
MAKING OPTION 6 WORK
Governance
Making Option 6 work

Performance Management
63
GOVERNANCE MEASURES TO DELIVER ON OPTION 6
Governance Measures Clearly defined
strategy Targets aligned to strategy Measures
aligned to value creation Independent
Directors Active farmer reviews Consequences
for non- performance

• Rationale
• Enable farmers to judge performance
• Hardwire in strategic goals
• Tangible wealth creation
• Improved Board performance
• Farmers custodians of performance
• Critical to any performance system

64
EFFECTIVE PERFORMANCE MANAGEMENT
Challenges
Principles
Solution

• Single independently administered NZ milk price
• Arms length based transfer prices

• No transparent milk price
• Administered product prices

• Replicate the market

• Provide farmer choice
• Organise around small performance cells

• Separate off areas of business specalisation
• Accountable, autonomous performance cells
• Aggressive targets

• Big company
• Diverse and complex

65
EFFECTIVE ORGANISATIONAL DESIGN

• Key Features
• Flat
• Lean
• Autonomous
• Accountable
• Co-ordinated

• How is it different?
• More transparency
• More accountability
• More autonomy

66
ILLUSTRATIVE BUSINESS/OPERATIONS STRUCTURE
Service Cell
Milks
Corporate Services
Manufacturing Cell
Yellow Fat
Manufacturing Merchanting
Consumer CEO
CEO
Ingredients
Cheese
Recombined Milks
Global Sliver 1
Cultured / CME
Global Sliver 2
Cheese Ingredients
Nutritional
Shared service cells
Performance cells
67
OPTION 6
Consumer separate subsidiary. Single company for
processing, merchanting and ingredients