Examination of Witnesses (Questions 300
- 319)
WEDNESDAY 21 OCTOBER 2009
LORD GRANTCHESTER
AND MR
GERRY SMITH
Q300 Mr Drew:
Mr Smith, you were about to leap into action and we will be pleased
to hear what you have got to say to back up the Chairman's perspective.
Mr Smith: I think it depends what
you want to cover, Mr Drew. Do you want to cover in my view the
reasons for the demise of Dairy Farmers?
Q301 Mr Drew:
Do, please.
Mr Smith: I suppose I was fortunate
that I joined the business in November 2004 following the acquisition
of ACC so I was not part of the due diligence exercise but, in
my view, there was no doubt that we paid too much for that business.
We acquired old assets and I would argue that they were the oldest
assets in the dairy industry. Those assets required significant
investment to bring them up to standard. You read the PwC report,
£20 million was invested in those dairies following the acquisition
of ACC. I think it took us some time to understand what we had
actually purchased. I would argue—
Q302 Mr Drew:
Could I interrupt you at that. Why? ACC were a fairly transparent
organisation. I will declare an interest, I am a Co-operative
member. I know a bit about ACC. It was not the reason I did not
take part in cross-examining them, but there would have been some
nervousness on my part because of what I have known previously.
It was known that there were some difficulties just in terms of
capacity, competitiveness and effectiveness in the market place,
so why was it such a shock when things started to appear in terms
of future evaluation that you did not quite buy what you thought
you bought?
Mr Smith: I did not get involved
in the liquid side of the business until around about the summer
of 2005. I was asked by the Board to go and investigate, together
with some colleagues, the performance of that business, so we
had actually had the business from August 2004 and a black hole
was discovered in the summer of 2005. We analysed the business
in some detail in the summer of 2005 and personally I came to
the conclusion that we had not made any profit in that business
since we acquired it. I think it was not until we appointed—
Q303 Mr Drew:
Your predecessor had not picked this up?
Mr Smith: No-one had picked that
up until the summer of 2005.
Lord Grantchester: To interject
there a minute, we did not find that the company had the mechanisms
to help us find the answers as to what was going on. We had to
go in to analyse the business that we had purchased ourselves
as to where in the supply chain what was the cost of going through
one dairy, as opposed to another. These things were not readily
available in the company, we had to go about setting up all those
knowledge bases and trying to understand how the supply chain
worked, we had to do that. That is why to a certain extent it
was not there, that it took that amount of time to set up to enable
Gerry's team to then be able to have the tools to analyse the
business.
Q304 Mr Drew:
That is a fairly fundamental weakness. If you do not know whether
you are a making a profit or loss, most businesses would be in
some difficulty.
Mr Smith: I would suggest that
it was not until we appointed a new finance director to look after
the liquid side of our business that we discovered we had an issue.
You have to remember that we acquired the business in August 2004
and our financial year was March 2005. When you acquire a business
sometimes you acquire a very strong balance sheet with it, so
the true performance of the business sometimes is not known until
you prepare your own budget.
Q305 Mr Drew:
I know that neither of you was around but who did the due diligence
on the actual takeover of ACC?
Lord Grantchester: KPMG.
Q306 Mr Drew:
What action have you taken against KPMG in the sense that at least
you could question them whether their due diligence was suitably
rigorous?
Lord Grantchester: As I said in
my earlier comments, we did wonder ourselves and we did formulate
a claim against ACC.
Q307 Mr Drew:
I know that, but that is the formal thing. There must have been
an informal reckoning that this was not what you thought it was.
Lord Grantchester: Correct.
Q308 Mr Drew:
That is for the record, yes?
Lord Grantchester: Correct.
Q309 Mr Drew:
Could we move on because I am aware that we have got to try and
get to the end of this session. Just so that we are absolutely
clear, the membership of the new organisation got to vote on a
number of key parts of the creation of the business and, in particular,
obviously the takeover of ACC was ratified by a vote of the membership.
Lord Grantchester: Correct.[10]
Q310 Mr Drew:
What about the dairies at Lincoln and Bridgend that were also
acquired? There was a clear vote on this.
Lord Grantchester: There was no
vote on Lincoln. There was a debate within the Board should there
be a vote on Lincoln. The price paid for Lincoln did not cross
the threshold that needed shareholder approval, but it was gone
through with the Council and explained at great length.
Q311 Mr Drew:
It was referred to the Council. Could the Council have called
for a vote of all the members? Just so I am clear, if they were
either abdicating responsibility or felt the Board was over-egging
the pudding, acting unilaterally, the Council could have said,
"Let's have a vote", but they chose not to.
Lord Grantchester: They chose
not to challenge the decision. It was explained to them that there
was not a formal necessity to have a vote. It was explained to
them.
Q312 Mr Drew:
Finally, moving tack slightly, can you spell out exactly what
this Project 523 is. I think I know what it is but it has come
up on a number of occasions. What was it and what was the impact
of that in terms of the wider remit to change the nature of the
organisation?
Lord Grantchester: Once again,
if I can provide the backcloth to it I am very happy for Gerry
Smith to come in because it was his task to restructure the business.
You will have heard that around 2007 we renegotiated the contract
with the CRTG group successfully. As I have hinted, there were
problems in the relationship from the very start but it was a
successful renegotiation. What I would say is that the negotiation
in 2007 was very prolonged and protracted. It took us a lot of
time, well over the company's accounting year end, and caused
us problems in refinancing and problems for the auditors to sign
off the accounts. The Co-operative were very protracted in their
negotiations. I would like to contrast that with the 2009 negotiations
that were the entire opposite. We re-contracted with ACC during
2007 and we then found problems that ACC in their evidence earlier
highlighted in the supply to the south-east which I would say
was because we did submit different prices as direct to store
or through the RDC network. Thurrock were promised to come on-stream
but Thurrock did not come on-stream at the right time such that
Dairy Farmers of Britain then had to underwrite £6 million
of extra costs that in negotiations were not meant to be our costs.
That was the background to why the south-east was walked away
from because we were being asked to commit to an uncommercial
contract.
Q313 Mr Drew:
There was no tit-for-tat in this inasmuch as the Co-operative
Group had already announced that it was removing you as a key
supplier?
Lord Grantchester: That is 2009.
Q314 Mr Drew:
Yes.
Lord Grantchester: I just want
the Committee to understand what is meant by commercial or not.
You will understand one of the difficulties of learning about
the business that Gerry Smith has alluded to is that it was in
the convenience sector, which was where our customers were, the
Co-operative Group and others in what is called the middle market.
You will recall that the OFT allowed big supermarkets to come
into the convenience sector and the supermarkets restructured
their supply base in 2005 from three suppliers down to two. Those
tenders were not available to us. They were very lucrative contracts
to the big three players. We were in the convenience sector which
they could marginally cost and we could not marginally cost our
core customer. The competitors could marginally cost our customer
against us which made it extremely difficult for us operating
in that market to be able to "compete" because we did
not have behind us other contracts which we could rely on to provide
us with a sustainable price for our members. Our members were
already identifying very severe weaknesses. The co-operative then
came under the pressure of departing members and I have highlighted
to you the crystallisation when that went on our balance sheet
such that it became extremely difficult when the credit crunch
landed in 2008 with the consumer trading down, with major supermarkets
seeing that the trading down resulted in a growth of the discount
sector, to then announce, "We are going to be the biggest
discounter". That was the backcloth to us losing money and
I then identified pressures that came on the business and we had
to part company with our previous chairman by mutual consent.
I was asked to step in and to then quickly have to rationalise
this business, as I said earlier, to keep the customers we had
but to reduce our cost base by delivery through three dairies
rather than five. At this stage I will pass over to Gerry Smith
to clarify this 523 Project.
Q315 Mr Drew:
If you could do that very succinctly, Mr Smith.
Mr Smith: Just going back to 2005
when we discovered we were losing money, we embarked upon a major
cost-cutting exercise. We took about £15 million of cost
out of the business. We were still facing significant inflation
in this business. When we got to 2008 we were still losing money
despite all the good things we had done. We had improved product
quality, the service levels, and customer confidence at that stage
was pretty good. The 523 Project was a radical rationalisation
of our assets. In the two budgets that we had presented to the
Board in the previous two financial years we had considered reducing
our dairies from five to four or to three. Just to give you the
background: Dairy Farmers of Britain is a sales-led business,
so if we say we are going to sell 800 million litres of milk to
our customers we need to have assets to accommodate that sales
demand. In essence we never sold 800 million litres. We built
up our asset infrastructure to cope with that level of sales and
we were selling 500 million. So we had an asset utilisation, which
is the rate of your sales to your capacity in the five dairies,
which was at 58%. Our competitors were close to 80%. This is a
commodity business, it is all about being a low cost producer,
and you cannot be a low cost producer if you have an asset utilisation
of 58%. We had too many dairies. We put our paper to the Board
and the executive team, which the Board accepted, which was to
radically look at the asset base and reduce our dairies from five
to three. At the same time we were looking to reduce our depot
network significantly. This project was all about taking £28
million of cost out of the business. It reduced our dairies from
five to three, as I have said, and reduced our depot network from
25 to 17. It had a cash cost associated with doing it, and that
was our redundancy costs, of just over £5 million, but what
it did was it took the business from significant loss to being
profitable in the financial year 2009-10. From April 2009 this
business was going to make money. That is it in summary. In essence
we actually delivered that plan. You will have noted on page 27
of PwC's report that they say: "Despite the significant initial
cash outlays primarily relating to redundancies, and delivery
of Project 523 on budget, the planned cash and profitability improvements
did not materialise in the remaining Liquids business".[11]I
have had various discussions with Stephen Oldfield on that comment
and I think he now accepts it is factually incorrect.
Q316 Mr Drew:
Are PwC prepared to reword that?
Mr Smith: They are prepared to
alter that report. The reason I am stressing that, and I think
it is quite important, is in April and May of this year the liquids
part of Dairy Farmers of Britain made a profit of £1.5 million.
Project 523 was a complete success. We had radically transformed
the business from losing money to making money. Unfortunately,
as I said earlier, we lost the confidence of our customers. The
project had been delivered on time and on budget and, in fact,
our cash costs came in at £2 million less than we had forecast.
The confidence had been lost. The project was more than successful.
You asked John what he could have done if he had become Chairman
earlier. If we had carried out the 523 Project 12 months earlier
we may still have been in business.
Q317 Miss McIntosh:
How do you respond to the charge that it was a flawed business
plan?
Mr Smith: The 523 business plan?
Q318 Miss McIntosh:
Your whole business plan.
Mr Smith: I think PwC actually
analysed the 523 business plan on behalf of the bank and they
did their sensitivities. The actual performance during April and
May showed that the plan was not flawed.
Q319 Miss McIntosh:
Obviously I represent a number of farmers who lost access to the
milk market with the demise of DFB. I understand a number of farmers
did place substantial amounts of money with DFB as an investment,
a sort of pension scheme and they will not be refunded obviously.
Have they just lost that money?
Lord Grantchester: We will come
back to this later on. To take you through it step-by-step, the
implementation time of 523 with our financing of it, and so on,
has to be analysed and, as Gerry says, what led to the loss of
confidence. As you rightly say, the collapse then resulted in
losses to unsecured creditors. We can take it now if you like
but at the end I would like to come back to what I could perhaps
suggest to the Committee, to the lines of inquiry they could take
up to mitigate that loss to farmer members. I would like to come
back to that at the end.
10 Subsequent correction by witness that it was a
vote of Council. This was corrected in subsequent evidence supplied,
Ev 55. Back
11
PricewaterhouseCoopers: Receiver's report to creditors, members
and former members, 24 August 2009. Back
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