A value culture for agriculture

Jack J. Dempsey, Ashish A. Kumar, Bernard Loyd, and Loula S. MerkelThe McKinsey Quarterly, 2002 Number 3 Despite the $1.5 trillion a year that agriculture and the activities associated with it bring to the US economy fully 16 percent of GDP much of the industry is destroying value. The problem is not only the agricultural boom-and-bust cycle and the vagaries of the weather but also the performance of one of the industry s traditional business models: agricultural cooperatives. Co-ops, a substantial part of the industry, handle $121 billion annually out of a total of $675 billion (Exhibit 1). With a few notable exceptions, they destroy value nearly $2 billion in 1999 and 2000 and the destruction continues through both the high and low phases of the agricultural cycle (Exhibit 2).¹

Gone are the days when traditional family farms banded together in co-ops for increased market power in buying and selling a wide range of supplies and services. Farms then had similar and fairly basic needs, and co-ops offered their members a valuable service; indeed, they saw themselves as service providers, not as performance-oriented businesses. But while most co-ops have since changed, the world around them has changed even more: farms are bigger and more specialized, and globalization has encouraged many (and often larger) competitors to enter every part of the food industry. In such an environment, many co-ops are destined to fail. Unfocused and inefficient, these institutions ensure that costs are higher than they should be throughout the food chain and serve neither farmers nor food manufacturers at all well.

Yet a few co-ops in the United States and elsewhere have changed the way they operate a development that could, if followed by other reforms, revitalize the US co-op system and its industry. To succeed, co-ops must mirror the changes that have taken place among their customers: farmers and food manufacturers. Besides a new emphasis on the performance of co-ops as businesses, reform will require consolidation and focus.

Down on the farm

The 1922 Capper-Volstead Act granted US farmers an antitrust exemption allowing them to pool their marketing activities in co-ops. Under the act, co-ops must be controlled by members who are agricultural producers. Income is distributed among them according to how much business they conduct through the co-op; those who sell more oranges to it, say, or buy more propane from it get a higher payout. Furthermore, in most co-ops each member has an equal vote in electing the board of directors, whose members are all farmer-owners.

By the late 1920s, modern agricultural co-ops, for marketing and for purchasing supplies, had become a part of the US agriculture industry. Some, such as Sunkist (oranges), Ocean Spray (cranberries), Land O Lakes (dairy products), and Agway, went on to become well-known brand names (Exhibit 3).

Local supply co-ops have a proud tradition of providing farmers with a wide swath of offerings from seeds to crop-inspection services. Local marketing co-ops help farmers get the best price for their crops as well as provide services such as grain storage. Local co-ops have long combined in regional co-ops, which further pool these supply and marketing activities and make larger investments up- or downstream from farms in fertilizer manufacture, say, or wheat milling. Since a wave of consolidation in the 1990s, most of the largest regionals have specialized in a broad area such as meat, feed, or energy; some have also created jointly owned interregional co-ops and limited-liability corporations (LLCs).²As a result, most farmers belong to several co-ops (Exhibit 4).

These attempts to increase scale and focus don t go nearly far enough. Although the number of US co-ops has fallen by half since 1970, to 3,500, most locals remain too small to be efficient. Supply chains are one good example of how inefficiency raises costs. Most supplies pass through three stages: from manufacturer to regional co-op terminal, from regional to local co-op terminal, and then to the farm. Each terminal replicates costs for handling, administration, and insurance. Moreover, inventories usually aren t transparent, so the regional doesn t know how much propane, for example, local depots hold. The system is less than optimal, since many farms are now large and have their own sizable storage facilities, and the trucks used for transportation are bigger too. Lots of farmers could easily bypass their local and buy directly from a regional warehouse, thereby cutting distribution costs by up to half.

Stronger co-ops benefit farmers, agriculture as a whole, and consumers. To begin to create value, local and regional co-ops must double the returns they earned in the year 2000. Co-ops would then gain the ability to increase their aggregate annual patronage to farmers to $1.3 billion, from $670 million. Alternatively, co-ops could invest these resources to create better foods and a safer food system and to raise future returns to farmers.

A doubling of returns is a tall but feasible order. Why have so few co-ops taken up the challenge? The first reason is that farmers tend to stick with co-ops regardless of performance because these organizations, long integral to farm life, have given small farmers market leverage they couldn t wield in any other way and have improved their cost structures. These farmer-owners have made only nominal investments and accepted small returns.³Many regard the investment as merely a cost of doing business.

The second reason is the tradition of independence: local co-ops compete fiercely with one another to survive even when they belong to the same regional co-op and ought to be collabo rating to improve efficiency. The third reason is the co-ops traditional bias for owning hard assets a bias that reflects the desire of farmer-owners to ensure their access to the products and services they need.

Finally, change must be financed, and members are reluctant to invest further even for growth s sake. The difficulty of redeeming investments is one deterrent: most co-ops have no mechanism for trading equity among members, and programs for returning members equity are generally based on revolving first-in, first-out systems that take an average of 16 years. Although the rules governing the transfer of ownership stakes can be changed, few co-ops have tried to do so. Moreover, with increasing indebtedness among co-ops, debt capital is harder to obtain. Inflexible ownership and governance structures, combined with less than stellar financial performance, make it difficult to raise equity capital externally. Even Farmland Industries, the largest US co-op by revenue, did not focus sufficiently on returns to stave off the cash-flow crisis that led it to declare bankruptcy in late May 2002.

Plowing ahead

To survive, co-ops must change. Some already have done so and consequently enjoy high levels of performance and good returns. Outside the United States, a number of co-ops have become global operators (seesidebar, ”

Global co-ops“). Within it, some “new-generation” co-ops have begun to show promising results, though none is yet large enough to compete globally.

To enter the new generation, a co-op needs both a commitment from its members that it should operate as a high-performing business and an attractive business plan that encourages investment from members or elsewhere. The plan must be based on the two other key elements of success: consolidation and focus.

Sort out the economics

Before choosing a strategy, co-ops must understand the economic underpinnings of their existing businesses a considerable change for organizations that have never really determined what it costs to serve their farmer-owners or, in marketing co-ops, their buyers. Co-ops can then work out which of their offerings and customers do and do not create value and assess their capabilities and their opportunities to improve performance.

Only by presenting a clear strategy and by providing real options for redeeming investments will co-ops persuade their members to invest more. The strategy could be to concentrate on an offering or customer segment that now creates value, though a co-op may be able to transform a weak offering so much that it can serve hitherto unprofitable customers and perhaps new ones. A co-op might even see that it had the ability and the opportunity to develop an entirely new business.

Dakota Growers Pasta shows what can be done. Wheat growers in North and South Dakota, Minnesota, and Montana established this new-generation co-op in 1992 to take advantage of efficiencies from integrated milling and pasta manufacture and from serving a well-defined customer base of retailers and restaurants.⁴With the promise of a 15 percent return, farmers invested an average of $12,000 each, for a total of $12.5 million. All members are committed to delivering a quantity of wheat corresponding to their share ownership, an arrangement that helps make Dakota s operations predictable.

Given the tight alignment between the interests of the farmers and the co-op, the traditional governance structure works well for Dakota, which has benefited from the consumer s increased acceptance of store brands to become the third-largest US pasta manufacturer despite a decline of 1.6 percent a year in total retail pasta sales since 1996. From 1996 to 2000, Dakota created over $14 million in value (Exhibit 5) while returning $24 million in patronage to growers and enjoying significant increases in the value of its stock, which, along with the associated delivery obligations, is traded among producers.

Even Dakota faces some of the challenges troubling other co-ops: the industry has been in overall decline, and it isn t easy to supply an increasingly national market from a single plant with limited capacity. Dakota destroyed substantial value in 2001. Despite its success as a co-op, in May 2002, Dakota announced its conversion to public ownership to improve its access to the capital needed to strengthen its position and resume its expansion.

In general, a co-op that has a strong plan and uses alternative governance structures such as the LLC will find it easier to raise capital from both farmers (who are willing to invest in strong plans) and outside sources (which are now put off by the convoluted governance of most large co-ops).

Size matters

Too often, five or six competing co-ops in an area offer the same services, so one obvious element of most co-op plans should be improved operational efficiency through consolidation. In northwestern Wisconsin, one regional and two local co-ops created a joint venture on the LLC model to replace a network of ten fertilizer-blend plants, each having a capacity of 2,000 to 3,000 tons, with a single 6,000-ton plant supported by two of the older plants operating seasonally. The rationalized network improved usage and cut overheads and operating costs. Over three years, the venture has achieved operating margins of 3 percent (versus the 1 percent of the stand-alone plants) in a difficult market that eroded gross margins to 24 percent, from 27 percent. These improved returns are distributed among the membership. Together with spare capacity at the new plant, they are fueling the co-op s ambition to acquire the fertilizer operations of neighboring co-ops.

Similar opportunities for consolidation exist in the manufacture and distri-bution of other supplies and in food processing. Furthermore, most co-ops continue to maintain their own resources for back-office functions (including the purchase of supplies and equipment, auditing, and human resources), so scope for consolidation exists here too. Such a development would put co-ops on an equal footing with investor-owned companies that have crafted efficient franchiselike arrangements to provide support services.

What is your market?

Most co-ops have too broad a focus. Today, the largest 3 percent of agricultural producers account for more than half of all agricultural output in the United States. Big farms are often more mechanized and specialized than smaller ones, yet producers, large and small, usually have equal votes at co-ops, and their bias toward treating all members equally results in uniform business approaches and pricing policies; big farms, for example, can t expect a big discount for buying larger volumes. Thus no segment of producers is served well, and co-ops are increasingly susceptible to competition from focused (and often investor-owned) competitors. The more and more prevalent business-oriented producers take advantage of the best deals from any source.

Some of those competitors serve a certain kind of farm. Ag Services of America, for example, is an investor-owned enterprise that uses existing assets (often those of co-ops) to provide comprehensive supplies and financial services to targeted groups of growers with similar needs. It began operation after the US farm crisis of the early 1980s by providing financial products to high-credit-risk growers and, as the crisis su bsided, in the 1990s evolved to serve large growers with an account-management, one-stop-service approach. The company returned 11.1 percent on its invested capital in 2000 well above its cost of capital and from 1990 to 2000 its revenues rose by an average of 29 percent and its income by 40 percent a year. Other such competitors concentrate on investing in innovation, building scale to compete on service and price, and supplying certain goods, such as fertilizer.

On the marketing side, focus has proved a sound strategy in the competition to satisfy more demanding end users. Another investor-owned company, Leprino Foods, has taken 85 percent of the US market for the cheese used in pizzerias by focusing solely on that market. Leprino has pioneered innovations such as cheese that doesn t burn easily in pizza ovens and looks appealing after half an hour in a delivery box. Its revenue has risen at a five-year compound annual growth rate of 14 percent, reaching $1.7 billion in 2001.

To generate value, as Dakota, for example, has done, most co-ops will require a similarly tight focus. In general, they can succeed by creating vertically integrated businesses that fulfill either a single need shared by many farmers or all the needs of a discrete group of customers often customers much closer to the end user than co-ops are used to serving. Both strategies are increasingly viable as IT cuts the cost of coordination.

Concentrating on a specific need can be a particularly powerful approach for supply co-ops. A new venture set up by Garden City Coop, a local based in Kansas, offers an example. Garden City s venture distributes anhydrous ammonia, a highly volatile gas that provides the cheapest form of nitrogen but is difficult and dangerous to transport and store and is generally applied only in two- to three-week periods during the spring and autumn. Like many other local co-ops, Garden City made substantial investments in delivery vehicles and people but generally failed to recoup the investment.

Yet anhydrous ammonia is so crucial to farmers that the co-op decided to transform its delivery process. Garden City now uses specially designed transportation and application vehicles to take the gas from regional terminals and apply it directly to agricultural land, thereby eliminating 85 percent of the expensive and dangerous transfers from trucks to storage tanks. To amortize the cost of the new equipment and to reach more customers, Garden City has created a series of franchiselike partnerships (AgrowLand 1, 2, and 3), all of them LLCs comprising several local co-ops in adjacent counties. Each LLC partnership manages the development of customers in its market and the delivery of anhydrous ammonia. Even in the early stages, the venture has reduced the cost of applying the gas. If the process were applied to all appropriate farms across the United States, the savings would come to some $250 million a year, 21 percent of total expenditures.

Co-ops must create value to survive. Successful co-ops focus on a clear need or a discrete customer group, use scale to deliver their products and services efficiently to their target markets, and hold themselves to high performance targets. Performance management and reformed operations promote a virtuous cycle of value creation. Combined with new-generation approaches to equity trading and a new, competitive mind-set, these measures can ensure that co-ops adapt to and thrive in the changed agribusiness industry.

Change doesn t come easily. Where significant amounts of capital are needed to finance growth or where members need access to their equity, some co-ops might even have to convert to public ownership either by demutualizing or by selling assets to investor-owned companies. Even when a co-op remains a co-op, its customers will probably change. But the co-op system as a whole will still serve a broad cu stomer base, and by doing so more effectively and efficiently it will provide more benefits to farmer-owners than it does today and ensure that the co-op tradition endures.

Notes:

Jack Dempsey is a director in McKinsey s Minneapolis office; Ashish Kumar and Loula Merkel are consultants in the Chicago office, where Bernard Loyd is a principal.

The authors wish to thank their colleagues Jessica Anderson, Agnes Bolwell, Celia Cockfield, Matthew King, Carolyn Pyles, and Salena Whitfield for their contributions to this article and to acknowledge the feedback provided by the following co-op leaders: Donald Cardarelli (Agway), Irvin Clubine (Garden City Coop), Robert Cropp (University of Wisconsin), and Thomas Larson (Cenex Harvest States Cooperatives).

¹The concept of value creation relates a company s return on invested capital (ROIC) to the cost of that capital, defined as the weighted average of the cost of equity and debt:

value created = [ROIC – cost of capital] x invested capital

Companies that create value can provide a fair return to their debt and equity holders, or they can invest those returns for growth. Companies that destroy value can neither provide a reasonable return nor invest to strengthen their market position or future earning power.

²The main difference between traditionally governed co-ops and limited-liability corporations is that LLCs are joint ventures among the co-ops, so in many cases co-op executives rather than farmers sit on LLC boards. This arrangement can give co-ops greater flexibility without eliminating farmer ownership at the base. Some investor-owned companies have even become partners in LLCs.

³Equity in US agricultural co-ops is about $20 billion, 2 percent of the $1 trillion total equity in farming.

⁴
SeeMichael Boland, Christian Freberg, David Barton, and Jeff Katz, “Dakota Growers Pasta,”Case Research Journal, Volume 21, Issue 2, 2001.