So long, Sanlu

Henry van der Heyden at the ceremony marking Fonterra's contribution to rural maternity programmes. Photo / Supplied

Henry van der Heyden was visibly chuffed when Prime Minister John Key drew the Chinese Premier towards him, making sure Wen Jiabao personally acknowledged him in the lineup at the Great Hall of the People.

As symbolism goes, the Wen handshake was a crucial sign that the Sanlu disaster was about to be put to bed.

The Fonterra chairman had two objectives when he joined the seven-strong business delegation accompanying Key on his first official visit to China.

It was van der Heyden's first trip back since the tainted milk scandal involving Fonterra's Sanlu joint venture became public last August.

He wanted to publicly put the Sanlu affair behind him and use the opportunity to meet President Hu Jintao and Premier Wen, and express Fonterra's long-term commitment to the burgeoning Chinese dairy market.

Just the day before the Wen meeting, the New Zealand Embassy had skilfully changed the protocol order to ensure that van der Heyden was at the top table with Key in his discussions with the Chinese President.

Key had initially wanted to bring the Sanlu affair to a head at last November's Apec meeting and restore Fonterra's position in China. But on that occasion the proposed bilateral meeting with Hu did not come off.

"I knew if you wanted to put a line in the sand with that stuff it essentially had to happen at that top level," says Key. "And those guys endorsed it by saying, 'We see it as a one-off incident. It is behind us now and from our point of view we want to rebuild our agriculture sector and you're part of that."'

"I felt very welcome there," says van der Heyden. "There was nothing on my radar screen to suggest we can't put the past behind us and move forward."

The high-level assurance ended a traumatic nine months for New Zealand's largest exporter. Although 22 Chinese dairy companies were ultimately implicated, Sanlu products posted the highest contamination levels of melamine, an industrial chemical which falsely magnified protein levels in milk and caused widespread kidney damage to the Chinese babies who drank poisoned infant formula.

Van der Heyden was accompanied by Bob Major, who retires from the position as Fonterra managing director, China, at the end of the month. It was Major who sat alongside van der Heyden at a signing ceremony at the Great Hall of the People where the Fonterra chairman symbolically handed over a US$5 million ($8.8 million) "cheque" to the Soong Ching Ling Foundation to support the construction of maternal and infant community hubs in rural areas.

In reality, what was politely publicised as a corporate social responsibility gesture was Fonterra's way of making public amends for the Sanlu failure.

Fonterra had kept Major overseas until any residual litigation risk from the scandal expired with the failure of former Sanlu chairwoman Tian Wenhua's appeal against her life sentence for manufacturing contaminated products. In January, Wenhua's lawyers had tried to implicate Fonterra by claiming she had based her decision to keep producing defective products - well after the contamination was revealed to the Sanlu joint venture board - on a set of EU documents supplied by Patrick Kwok, one of three former Fonterra directors on the board.

While a lawsuit seeking compensation for young children affected by melamine-induced kidney ailments has since been filed against Sanlu, reliable Shanghai sources told the Herald that Fonterra is not expected to face any legal comeback.

Resolution of the legal issues could not have come soon enough for Fonterra.

In Beijing, van der Heyden revealed to the Herald that Fonterra's internal forecasts estimate sales of some 160,000 tonnes of product into China in the 2008-09 financial year that ends on July 31 - a near trebling of the amount sold in the preceding financial year.

At Fonterra's last monthly auction a tonne of milk powder was worth US$2235. At this price, 160,000 tonnes would return $630 million. It is important to note that not all the 160,000 tonnes of expected exports will consist of milk powders.

The Fonterra board was sufficiently comforted by the China sales projections and recent rise in the milk powder price that it this week lifted its forecast shareholder payout by 10c per kilogram of milksolids, to $5.20 for the current season.

The dairy co-op is keen not to be publicly seen as a beneficiary of the fallout from the Sanlu affair. It has already written off $200 million on its 43 per cent stake in the now-defunct joint venture and is sensitive to any suggestion that it may recoup some of that cost through increased sales of "foreign powder" to China as consumers turn to trusted food products.

"The backbone [of the internal estimates] has been the increase in base whole milk powder sales," says Kelvin Wickham, managing director of Fonterra's GlobalTrade. "There has clearly been a flight to quality since the melamine issue.

"But also the world price has dropped and is temporarily below the China price, so Chinese businesses are going for the value option."

Wickham points out that as the Chinese milk price comes down and the world price goes up again, demand for imported product will slacken.

As the table on this page shows, imports of milk powder into China fell away in 2007 as a result of the dramatic increases in commodity prices.

But there is another factor at play in Fonterra's increased exports. Sales of formulated powders such as infant formula have also grown significantly on the back of its supply arrangements with multinational branded players in China - such as Danone, Wyeth Nutrition and Abbott Nutrition - who rely on imports of finished formula and are expanding quickly after the melamine scare.

In Shanghai, Key happily posed for photographs alongside Sam Su, the president of fast food giant Yum! Brands (China division), his chief support officer Joaquin Pelaez, van der Heyden and incoming Fonterra China managing director Phil Turner.

Fonterra's cheese exports to China have increased six-fold between 2002 and 2008, from 2000 tonnes to 13,000 tonnes a year. With Yum! Brands opening a new Pizza Hut outlet in China every three days, the relationship creates a major opportunity for Fonterra to lift those sales even further. "It's going quite nicely," says van der Heyden.

Other growth areas for Fonterra include its food service business, which has boasted a growth rate of 30 to 55 per cent every year from 2004 to 2008. Even with the economic downturn, the 2009 volume is up 20 per cent on last year. Then there are the increased opportunities for specialty dairy ingredients such as whey protein concentrates for nutritional applications.

While in China, van der Heyden also took the opportunity to formally launch Fonterra's 85 per cent-owned dairy farm at Tanghsan in northern Hebei province. Inevitably the question of Sanlu's 15 per cent stake came up and he revealed Fonterra's interest in mopping up the shareholding held by its former joint venture partner.

The high-quality milk from the 3000-cow Tangshan farm was to have been used to manufacture top Fonterra brands like Anlene and Anmum, which provide nutrition for pregnant and nursing women. They will now be produced in New Zealand and launched into the China market mid-year, distributed through a new arrangement with Sims Trading.

Van der Heyden is adamant that ultimately Fonterra must come back into the China market and reinvest in a serious way in its high-growth dairy industry. Right now there is a lot of surplus manufacturing resource around: "We have said no to that," he says.

But before Fonterra re-enters China it has to be sure of two things: first, that it can have confidence in the safety of its milk supply chain; and second, that it has the capital strength to invest in major positions where it is not hostage to an unreliable partner.

Fonterra has learnt some heavy lessons from Sanlu.

An independent audit by Control Risks Group pinpointed weaknesses which Fonterra's top brass say they have since addressed.

Numbered copies of a cut-down version of the Control Risks Group's report were given to members of Fonterra's Shareholders' Council for overnight study under strict confidentiality conditions.

Council chairman Blue Read says his members are happy with the "thoroughness of the review" and are confident the recommendations are being enacted.

"I don't think the board and management have any appetite to go back in and not be sure their supply lines are safe."

For his part, the Prime Minister wants to see Fonterra grab the opportunities that China presents.

Key says that at a private dinner at the New Zealand Ambassador's Beijing residence, a representative from Yili - one of China's two largest dairy companies - gave him the blunt message that Fonterra must further strengthen its linkages or Chinese companies will go elsewhere to source product. Yili - like its ferocious competitor Mengniu - posted huge losses late last year after Chinese consumers boycotted their products when they were revealed to be among the 22 companies
implicated in the melamine scandal.

Yili has invited Key to go up to Inner Mongolia next year and see for himself the scale of China's dairy industry. "I said, have you done JVs with other companies?" Key says. "He said, 'No but we're interested, if you come to Mongolia next year that would be great."'

Van der Heyden's take is that at this stage Yili just wants to keep driving its own strategy and import dairy products from New Zealand.

The Prime Minister says he was surprised at just how much impact the melamine scandal had within China. "Consumers just stopped. They did not trust food quality standards."

Key has directed the Department of Prime Minister and Cabinet to come up with a paper exploring just how New Zealand can take up China's invitation to help it introduce food safety standards across the dairy industry.

"When you think about it, it's very logical what they are doing," Key muses. "They are essentially saying, 'New Zealand is known not only for producing food but high-quality food', so if we get New Zealand to work on safety standards in a market where we know we are going to grow then we get the endorsements.

"It's a little bit like what we're doing with the Greens - you go out there with a home insulation programme. If the Greens say it's a good programme, people then say, 'if the Greens think it's alright - it's alright'. That's what the Chinese are doing - if they say it's New Zealand safety standards then it's good."

Key has also quietly promoted a potential joint venture research programme with China to tackle new technologies in the agriculture sector to combat climate change.

Ultimately, the Prime Minister, like van der Heyden, is excited at the prospect China presents for Fonterra to "scale up". He notes that the economic downturn means there is a lot of spare capacity "sitting about".

But the demographics are compelling. "It's not just that the population is getting bigger, it is that it is getting wealthier.

"We have to essentially orientate ourselves to be part of the Asia growth story because the only other option is we become a Pacific Island story and that's not going to cut it."

Major Chinese investors - such as China's sovereign wealth fund - have also expressed an interest in buying shares in Fonterra if it is ultimately listed. But Key stresses that Fonterra's capital structure is up to its farmer shareholders to decide.

Van der Heyden acknowledges the pressing need for Fonterra to address its capital structure so it can take up international investment opportunities. The co-op is already testing proposals with its Shareholders' Council.

But Key says Fonterra needs to hurry.

"In the end Fonterra's capital structure is going to have to come on to the table.

"They have work out, do they really want to be global - then they really have to 'go hard' because they don't have
that long."

Fran O'Sullivan's flights to China were courtesy of Air New Zealand.