Memorandum submitted by David Wilkinson (DFoB 35)

 

 

Introduction

 

I am submitting this evidence at this eleventh hour because, having viewed the evidence given thus far, I fear there is a danger that the wrong conclusions may be drawn and an opportunity missed for some real progress. I believe much of the evidence has been governed by continued vested interests both commercially (understandably) and politically.

 

I intend to cover the following points

 

1. Board structure and governance

2. Strategy

3. Capital structure of DFB

4. Purchase of ACC

5. Financial reporting of co-ops

6. Development of the liquid business against a changing market

7. Last few months

 

But first a short background

 

 

Background

 

DFB was formed at a time of low milk prices and massive oversupply with UK annual production running well ahead of its current position. A particular issue was the spring flush and the ability to process all the milk in May at all, never mind profitably. Coops at that stage had done little but broker milk and farmers seemed to be at the mercy of the PLC processors who used the oversupply of spring milk to control the price for the rest of the year. In general co-op milk prices lagged the other prices by 0.5-1ppl. There was general agreement that milk prices were unsustainable and that the way foreword was to copy the successful model of the continental co-ops.

 

There are some large figures attached to the collapse of DFB but please keep in mind the size of the prize. Continental farmers have by processing milk and having just a little control of the market achieved better milk prices throughout the last decade. Every 1ppl is potentially worth £140 million per year on farm, across the whole of UK milk.

 

 

Board structure and governance

 

The myth that modern dairy co-ops are run by farmers, who have little experience beyond the farm gate, needs to be put to bed. Modern co-ops recognise these shortcomings and fill the Boardroom with experienced professionals from the food industry. DFB was no exception. At the time of the ACC acquisition the Board consisted of 8 plus 1 advisor. The advisor was Norman Coward ex- head of agricultural banking at HSBC. Of the 8 directors, 3 were non-farmers. Rob Knight was ex-CEO of Masterfoods and main Board director of Mars. Philip Moody is a corporate financier and sat on Boards at Warburton Bread, Bolton Wanderers and the very successful co-ops of Centaur grain and Berry Foods. George Risley was ex CEO of Greencore and had extensive experience at Board level in many food businesses. Of the five farmers, two had considerable Board experience in large non-agricultural organisations. After the ACC acquisition the Board was further enhanced with the addition of Richard Fisher, an industrial production specialist, and David Felwick, ex-CEO of Waitrose and vice -chair of the John Lewis Partnership. David is also a Board member of the £2bn turnover Premier Foods.

 

 

The council took great pride in not only training itself, with all council members going to numerous courses in conjunction with the Plunkett foundation and EFFP but also training future directors. The council had identified the lack of future potential farmer directors and introduced the innovative scholarship scheme which, using DFB and Defra matched funds, trained young people in business skills. The scholars not only met DFB and UK business leaders but also undertook study trips abroad to study the large European Co-ops.

 

Nor did the council take the job of electing the farmers to the Board lightly, employing an outside specialist to chair a selection panel.

 

Board governance was most certainly not taken lightly throughout the 6 years I spent on the Board. I could spend time describing the checks and balances that both the chairmen took a great deal of time to put in place, however I feel this time would be better spent elsewhere.

 

Ultimate company governance lay with the council, and it is my opinion they undertook this well. There is no doubt this is a difficult job relying to a large extent on information fed from the Board. However what is most certainly true is that they were party to more information and more external advice than any individual member, shareholder or shareholder group in a PLC could ever dream of getting. It is for this reason that I believe the council system is the right and proper way for future co-ops to be structured.

 

Those who point to an inexperienced or untrained Board and Council have been lazy in tripping out tired lines. The Board may well have been at fault, but poor structure and governance was not DFBs problem.

 

 

Strategy

 

All co-ops brought in business leaders from outsider the Dairy world to identify and hopefully solve the problems, which made the UK dairy farmer the lowest paid in Europe. There were three strands to our strategy

 

 

· Create a foundation of efficient commodity production the ultimate driver in all UK milk prices

· Take out the inefficiencies of the milk transport system which the farmer pays for

· Create a broad based dairy business to create value for the farmer out of a basic raw commodity

 

The lease of Westbury by the three co-ops and the subsequent purchase of all the major cheese plants bar one (Davidstow) delivered the first strand.

 

The joint milk haulage agreements DFB struck with First Milk, Arla and Milk Link started to deliver the second although this has largely unwound with the supermarket specific contracts.

 

To settle for this was never an option for DFB since the majority of its producers were close to chimney pots and expected their milk to go to premium markets and achieve a premium price. Whilst branded products were an aspiration, short-term premium meant getting into the liquid market. Determined not to replicate the mistakes of Westbury and Amelca by building assets with no market for its products. Nor wanting to drive down the market by buying our way in after a super Dairy build as Wiseman has done on several occasions, the Board of DFB looked to buy an existing business. Availability/affordability led us to ACC. Vertical integration was deemed necessary and indeed welcomed by all in government, farming politics and indeed industry commentators. Clearly ACC alone was not meant to be the end game. Consolidation through integration with other more efficient businesses was the goal with farmers being the beneficiaries not the casualties of the process. At that time the availability of those businesses was believed to be a reality.

 

This strategy was spelt out to the membership in a series of meetings held throughout the country in November 2003. The CEO and a director fronted these meetings.

 

Capital structure of DFB

 

To raise funds to enact the strategy all the co-ops retained money from the milk price following a model that had been successful in the Dutch and Danish co-ops. In principal the retained money should have been split at the year-end with part into Company reserves, part into member accounts and part returned to members as a bonus. In practice with little history of this in the UK and the speed of retention needed, this system was "Anglicised" at DFB and all the monies ended up in the members name with the member able to leave with the funds some time after he left the co-operative. This compromise led to an inherent weakness with "investment " from members appearing as debt on balance sheets and leading to three fundamental issues

 

· Debt restructuring issues later with Banks unwilling to accept the co-op model.

· Without the huge general reserves (1 bn euro at Arla) the continental co-ops held (the "dead hand" as they call it) DFB was always going to be in trouble if business plans were not met.

· An inability to sell the business without the debt. This most serious issue meant that without the ex members permission for a debt for equity swap, which the Board failed to get, the company as a whole was too expensive. Even in the last few days DFB had bids on the table for the liquid business. Without the ex-member debt burden a solvent solution was possible.

 

A major obstacle to member investment is the UK tax treatment of co-ops. For help understanding this issue and what can be done about it, I suggest a conversation with EFFP

 

Purchase of ACC

 

The ACC business was purchased for £72.8m.This is an audited fact.

 

It included a 580m litre liquid business, a cheese factory with £18m worth of cheese and a canning factory.

 

Any figures quoted above this figure are unaudited and must include bank fees, legal costs, costs of due diligence, advisor costs etc. As a director I do not recognise the figure quoted by PWC.

 

Much has been made of the price paid. The bid price of £75m (adjusted down at purchase to reflect stock and cash valuations) was arrived at in conjunction with two teams of advisors, Rabobank and Solomon Hare. It was recommended to the Board by a sub group, which contained all the non-farmer directors, the advisors, and one farmer director, which for the record was me.

 

Whilst it seems high now the board were aware that there were other bidders and that those other bidders had considerable synergies and ready funds. Our weakness was our questionable funding.

 

At the time, the going rate for a liquid business was10 pence per litre. Our bid net of the cheese stock was for less than that. Dairy Crest later paid £20m for a 200M-litre business and promptly shut it at a cost of £9m.

 

Again, much has been made about the tired state of the factories. Whilst this is true it is a mistake to believe that all the rest of UK processing was taking place in shiny boxes. In 2004 of the 6 billion litre liquid market less than 2 billion would be going through top class facilities to big supermarkets. The rest, the vast majority, was being processed in lesser facilities and sold through convenience stores or doorstep. In 2009 whilst these sales channels have altered (see later) there still remains some 2 billion litres processed in facilities no better than those DFB have just closed.

 

My point here is that the price paid for ACC was high and no doubt we could have paid less but that was not the reason the business failed. The Board hoped that the Co-op would want to sell to a fellow co-op but could not depend on it. Price paid did affect the amount farmers lost, but it was what we were able to do with the business that caused the failure.

 

The Board and the advisors also had to place a high reliance on the vendor due diligence provided and in some instances appropriate warranties were negotiated into the sale and purchase agreement. Subsequent to the purchase, and the reliance on vendor due diligence, some aspects of the business were not as described and a number of warranty and legal claims were prepared. Legal action dragged until the renegotiation of the CRTG contract in 2007 when unsurprisingly it was dropped.

 

At the time of the purchase the business plan and the funding model including what it meant to the individual farmer was explained in a series of meetings held throughout the country in August 2004. The CEO and a director fronted these meetings. Some members did not like what they saw, put their notice in and left the following April. The money they had invested thus far was returned to them with interest over the next 2 years.

 

 

Financial reporting of co-ops

 

Another red herring!

 

Co-ops have to present an audited set of accounts at the year-end just like any PLC. This is not cheap and involves a large independent team "living" in the business for two weeks every year until they are satisfied all is correct. Anything, which goes in, the annual report, including the chairman's report has to be passed by the auditors.

 

Two years ago the plcs had to swap to using the IFRS set of accounting principles away from UK GAP. Despite there being no requirement to do this until much later, DFB adopted IFRS in 2008, the only co-op to do so.

 

Whilst co-ops do not have to produce half-year figures or trading statements DFB did so (until the change to IFRS made interim accounts cost prohibitive).

 

The directors were available all the time and spoke regularly to members, far more so than in any PLC.

 

There is a fine line between commercial confidence and being open with shareholders.

 

The NFU in their vision document called for more accountability in producer owned businesses with no idea what this means or how it can be done practically. They have persuaded Dairy Co to carry out an exercise that will be futile and will be only as in depth as a normal analysts report, which is in any case carried out from time to time. Any company will be acting against its shareholder interest if it allows access to information not in the public domain, and therefore it will be an analysts report by another name. Potentially farmer members of a weak co-op will be paying through the levy to have their own business abused!

 

Development of the liquid business against a changing market

 

Within the DFB group of companies, the DFB liquid business was a large and complex business employing 2,500 people, delivering many different products through even more different supply channels. The control systems inherited were poor as were many of the contracts. Nevertheless the business had great potential and we should bare in mind the strategic goal of folding it into one of the bigger liquid businesses.

 

Over the next few years the business suffered from several market place changes. These were

 

· The big 4 supermarkets reducing supplier numbers to 1 or 2 (2004/5)

· The competition authorities letting the big 4 onto the high street (2005)

· The NFU vision document encouraged farmer specific pools. These are great for those involved but robbed the co-op members of the benefit of the affect of the income from the best payers, who were and are the big 4. This money trickled throughout the industry and its effect can best be seen by following the price rises companies managed following the series of 2ppl price increases in the early part of this decade. The vision document also spoiled the funding models both the two biggest co-ops had prepared, sowed mistrust of co-op finances and changed the view the PLCs had of their own businesses.

· The growth of the food service industry left our supply chain inefficient with others delivering milk more cheaply on the back of other groceries. This led to competition from larger dairies able to deliver to the regional distribution centres (RDC) of the food service companies. Whilst DFB responded well to this challenge. It meant more competition in this sector, price erosion and costs for our depot rationalisation.

 

The business continued to be developed and grow with the successful addition of the Lincoln dairy. Investment was made but the level has been exaggerated by PWC. Remember capital investment is only real investment when it exceeds the ordinary level of depreciation in any business. Also much investment was made at the cheese factory in North Wales which is now an efficient modern facility, the benefit of which will be felt by farmers for years, through the Milk Link co-op who I am glad to say now own the plant.

 

In 2007 it became clear that the opportunities to merge our business into one of the big 3, for the benefit of farmers had disappeared and DFB quietly started to try to divest itself of its liquid business. Our major problem was our major customer, the Co-op, who took any opportunity to drag its heels on milk price as industry prices had moved over the last 3 years and had opened a competitive tender process for the next contract period.

 

Keen to lower the Co-ops influence DFB entered into an agreement with Tesco to produce 'Local choice' branded milk, Tesco were very enthusiastic about its prospects. They aspired for it to be 20-30% of sales (200-300m litres) in 2 years and were so confident their head of chilled sales and head of dairy products came and spoke to the member council in spring 2008. DFB budgeted for half these figures and had that been met we would still have been trading today.

 

The co-op tender process was the beginning of the end. DFBs competitors, all now with good core well paying supermarket contracts bid low for what would be marginal business for them. DFB was expected to match this and subsidise the direct to store delivery whilst the co-op sorted out its Thurrock RDC in South East England.

 

The effect on our on farm milk price was massive. Whilst the industry was paying 25ppl on farm the fully costed co-op business was worth 20-21ppl. Clearly it dragged our on farm price down at a time when commodities were booming. The Co-op talked about a farmer pool but was not prepared to pay the high cost of segregation let alone a premium price. Claims that DFB were unwilling are false by 2009 we were operating 4 such customer specific pools.

 

In August/ September 2008 the market place changed again. Local, organic, added value was replaced by cheapest and discount. Tesco introduced a discounted milk product and declared itself "Britain's biggest discounter". Sales of local choice suffered, and it was clear that rationalisation of our own business was essential. The "5 to 3" plan was born.

 

Last few months

 

 

Once PWC entered the business in late autumn 2008, from then on the Board were struggling for control. Costs rose as the Board were asked to pay the costs of "advice" the bank were demanding. Whilst Bank borrowing was falling; our ability to borrow fell faster. Covenants were breached to pay the milk cheque and the bank demanded extra fees and punitive interest rates for this. Any suggestion that HSBC lost money out of the collapse of DFB is plainly wrong.

 

The only solvent solution was to sell parts of the business. If a buyer could be found for the liquid business then the rest of the business could have been easily merged with a fellow co-op where there were obvious synergies. Despite several serious discussions a buyer was not found and the bank instructed PWC to put the whole business up for sale in January 2009.

 

In evidence, Gerry Smith (DFB Liquid MD) said that business is about confidence. He is right. The gossipmongers had been peddling half-truths about DFB for 12 months dragging that confidence out of producers, customers and eventually the bank. Perception of DFB was always ahead of reality. But as Gerard Ratner taught us, eventually reality catches up. The "For Sale" sign was confirmation that DFB were in trouble.

 

The "coup de grace" fittingly fell to the Co-op who awarded their contract elsewhere. They will say that they were being commercial and we were inefficient. I would point to one fact that contradicts this and belies their "Fair Trade " tag. For the identical product, delivered in an identical way, Tesco were paying 40 pence per gallon, that's over 8 pence per litre more than the Co-op were prepared to pay in the final contract!

 

 

Summary

 

In 2003 the Dairy industry was in a mess with unsustainable milk prices and oversupply. On farm milk price varied by up to 2ppl. There were great inefficiencies in transport and commodity production. The co-ops brought in industry outsiders to identify the problems and create solutions.

 

In 2009 those people have gone, the problems remain.

 

For 15 to20 % of farmers the supermarket specific pools have delivered sustainable milk prices. For the rest the outlook is less rosy. The on farm price difference is now an unbelievable 7ppl for what is an identical product. Transport inefficiency is worse.

 

DFB consisted of 3000 farmers who instead of protesting or "going cap in hand" to the government set about creating their own solution. A business capable of adding value to milk which at the end of the day is just a basic commodity. Ultimately for whatever reason we failed, and for that I am personally sorry. However what I am certainly not ashamed to have given it a try.

 

 

 

David Wilkinson

October 2009