The Impact of Globalization on the U.S. Dairy Industry: Threats, Opportunities, and Implications

1. The Impact of Globalizationon the U.S. Dairy Industry:Threats, Opportunities, and Implications Tom Suber

2. Goals for this discussion • Provide an overview of project objectives/approach • Review the expected evolution of the global dairy industry and the implications for U.S. dairy • Discuss strategic options for the U.S. • Recommendations for developing the appropriate option

3. Original project objectives defined by the Task Force Primary: Provide a strategic analysis of the global dairy landscape to provide a common understanding of the challenges, opportunities and threats posed by increasing globalization to the U.S. dairy industry Secondary: From the analysis, determine if there are suitable programs of work at the industry level to address the opportunities and challenges of globalization

4. However, traditional sources of supply will not be able to fully meet growing dairy demand 3 • Global imbalances will create increasingly volatile dairy markets, as processors must compete across borders for milk supplies 4 • Shortage of global supply creates internal and external growth opportunities for the United States 5 • To capture this opportunity, the U.S. Dairy Industry will need to leverage existing capabilities and invest in strengthening specific competitive weaknesses 6 • Inaction will lead to a less competitive U.S. industry 7 8 • Longer term, new low-cost supply (Brazil, Ukraine) will compete for a larger share of the global opportunity, creating a finite window for the U.S. to establish a defensible competitive position Key themes • Globalization of the dairy industry will increase in the coming years, with significant impact on domestic and international trade 1 • Demand for dairy products will grow faster than available supply, driven disproportionately by emerging markets 2

5. Goals for this discussion • Provide an overview of project objectives/approach • Review the expected evolution of the global dairy industry and the implications for U.S. dairy • Discuss strategic options for the U.S. • Recommendations for developing the appropriate option

6. Future world economic and population growth will be driven by emerging markets 2008 population (millions) Dramatic increase in middle-class consumers(~800 million consumers by 2030) Source: US Census Bureau international database

7. High growth from emerging markets Low growth from traditional markets (incl US) As economies create wealth, consumptionof animal protein (and dairy) will increase GDP per capita ($ppp) and animal proteinconsumption (includes fish and dairy) Projected dairy protein consumption growth p.a., 2007-2013 Dairy protein consumption(K MT) Source: “Opportunities for Australian Agriculture” - Australia Farm Institute

8. Chinawill continue to be a significant dairy importer with consumption growing faster than production in the foreseeable future • Dairy demand will be driven by income growth and urbanization, with higher value-added products growing in Tier 1 regions • There is opportunity to continue to develop the northern dairy region, but arable land limits and location, limited infrastructure to support expansion and political need to support the rural masses will limit speed of growth Key importer • SE Asiawill have significant import growth due to growing economies (all countries are far below saturation and growing) and limited ability to develop dairy production due to climate and land • Domestic production only serves ~20% of consumption, with NZ even supplying fluid milk to meet demand • Income levels are <$5,000 per capita in Thailand, Philippines, Vietnam and Indonesia, but expected to grow significantly • Indiais unlikely to emerge as a significant dairy importer: Political and cultural issues will drive the government to limit imports of dairy products • India is projected to have significantly higher demand growth than production due to population and income growth • Government will either have to support increased production or will allow pricing to dampen consumption growth Note: The US and EU are both major importers and exporters of dairy products Most importers have growing dairy demand

9. Russiawill decrease imports over the next five years, but will continue to be a net importer of dairy (mainly from CIS countries) • Demand per capita will continue to grow as the economy expands, but expected population decline will temper consumption growth • Production will continue to grow, but accelerated growth would depend on funding from government programs, thus economic stability from high oil prices Key importer • Japanwill retain import levels through 2013, though will have some product mix shift toward higher value added products • Mexico will grow as an importer with imports continuing to increase across all product categories through 2013 • Consumption will continue to grow an 1.5-2% per year, due to population and income growth • Domestic production is expected to grow more slowly due to low yields per cow • ROWwill be a significant importer with growing needs in the next five years, with the Middle East and N. Africa being the most important regions • Domestic production is limited in many ROW countries and growth prospectsare limited • Economies will continue to develop as globalization continues, suggesting increasing GDP per capita, thus increasing demand for dairy protein Note: The US and EU are both major importers and exporters of dairy products Most importers have growing dairy demand

10. EU is the largest dairy market in the world, but it is unlikely to grow significantly in the global trade arena • Net exports are forecasted to decline ~6% annually through 2015; cheese consumption will drive dairy growth and production will see marginal increase due to productivity gains • EU policy (phasing out quota in 2015, lowered export subsidies, reduced price floors) and regional market differences will drive a short-term rebalancing, but likely has limited impact on long-term global prospects for the dairy industry • Poland and Romania are best poised for long-term growth, with the Netherlands, Germany and Ireland likely taking share from Italy, Spain, France and the UK during transition period Key exporter • Australia will continue to be a significant dairy exporter with a forecasted 1-3% annual increase in production through 2013, assuming better weather • Production growth is limited by regular droughts that constrain herd size and water availability • Domestic dairy consumption is mature and unlikely to change over the next five years • New Zealand will continue to be the world’s largest dairy exporter, but production growth at current cost structure will begin to be constrained due to land availability from high prices and competing land uses • Most available pasture land is already occupied by dairy, sheep, deer, or beef cattle and trend of transitioning sheep land into dairy has subsided; small number of growth oriented producers have moved to other geographies for expansion opportunities (e.g. Chile, and US) • Moving to feed based dairying (local corn silage or imported grain) will increase their cost structure significantly • Uruguay and Chile will continue to grow as low-cost exporters, but are small markets that likely will not have significant impact on the macro global trade Traditional exporters are slowing, while emerging sources of supply will take time to develop Note: The US and EU are both major importers and exporters of dairy products

11. Key exporter • Brazil has recently become a net exporter and will continue to increase exports due to strong production growth • Brazil likely become a significant global exporter in the long term. However, growth will be limited in speed by their infrastructure, quality issues and credit limits slowing investments • Dairy growth will be different than Beef and Cash Crop growth due to location: West Central region tends toward higher profit cattle ranches and crop farming; Southern region is less suitable to those industries and will be the prime growth area for dairy exports, but has a less developed infrastructure Traditional exporters are slowing, while emerging sources of supply will take time to develop • Ukraine and Belarus could become significant global exporters, but quality issues, lack of infrastructure, a destabilizing economy and currency (Ukraine), and political issues (Belarus) will slow growth on a global scale in the near- to medium-term • Argentina will continue to be a net exporter of dairy products with raw milk production forecasted to increase ~3% annually through 2013, but is unlikely to become a global production leader in the next 10-15 years due to economic, political, and climatic instability • Government policies to maintain dairy supply domestically (e.g. export tariffs on dairy products) have precluded farmers from selling internationally • Droughts, floods and extreme weather conditions have negatively impacted dairy production Note: The US and EU are both major importers and exporters of dairy products

12. How will a globalizing dairy market impact the U.S.? Does it create an opportunity that warrants collective industry action to facilitate? What, if any, is the cost of inaction? Key takeaways – supply / demand factbase • Global import needs will grow significantly, driven by emerging markets that can not support their own demand growth • Traditional suppliers will not be able to meet growing import needs, creating a “latent demand gap”

13. Global trade (indexed to 2007 = 100) 125 100 Latent Demand Gap Import Growth 75 Import Trade Installed Base 50 25 0 6.5-7B lbs. of raw milk …But demand is forecast to exceed supply, creating pressurein the form of a “latent demand gap” that will impact the broaderdairy complex Projected demand with no obvious supply source 14 114 Processors serving internal market consumption 100 All dairy processors connected to global market will see supply- constrained market dynamic Growth where supply sources are predictable Existing trade where U.S. would have to steal share to grow 2007 Global Trade ImportDemand Growth 2013 Global Import Demand 2013 Global Consumption

14. Supply/demand imbalances will drive continued volatility across commodities, including dairy Soybeans, wheat and corn Class III milk Volatility will impact international and domestic players in the U.S. Source: USDA, NASS, World Agricultural Supply

15. Geography NewZealand Australia EU U.S. Cost $560 l a % n t d i s e 0 g o e Quality r 0 C F a 1 M t n e m l % a e 0 l $371 n p i 5 g p t r u l s a a S o M n % t d C i d s e 0 g Commercial capability/ commitment o e e r 0 e C F a 1 F M Product portfolio/ innovation SupplyGrowth Traditional export suppliers are advantaged today, but willface slower growth and higher costs in the coming years Capability comparison Structurallyhigh cost Scalable model Limited abilityto scale Highlyadvantaged Neutral/slight disadvantage Highly disadvantaged *New Zealand’s growth prospects and cost will begin to transition around 2013

16. Any strategy option must also address futurecompetition (emerging low cost-suppliers) Capability comparison Highlyadvantaged Neutral/slight disadvantage Highly disadvantaged Scalable model Emerging,but small

17. Identified U.S. strengths • Low enough cost • Highest capacity to grow supply • High quality products • Diverse supply base • Relatively low seasonality Customers view the U.S. as well positioned tosucceed in global dairy… “The U.S. is positioned to play a bigger role globally… Former head of China dairy procurement, top 5 CPG “The U.S. has the technology and ability to grow faster than the rest of the global markets.” European-based director of global equipment manufacturer “The U.S. market has promise, but has some issues to address too…” Head of procurement of SE Asia, top 3 dairy CPG “Implicit in our strategy is an effort to develop a diverse global supply base. Relying on supply from a single region doesn’t make sense.” Global dairy buyer, top 5 CPG “The U.S. is the highest growth opportunity we see globally (as a source of supply)” Head of large Asian dairy distributor

18. …but also highlighted some shortcomingswithin U.S. dairy Gaps in capability “The U.S. has hurt themselves…due to lack of consistency, some customers are so used to NZ tastes and quality they are willing to pay $100/ton premium for their product…” Head of large Asian dairy distributor • “In & out” of global trade • Quality not on par with Oceania • Product mix does not align with customer needs • Inconsistent customer service • Volatile pricing/limited contracts “The U.S. will be an important long-term supply base – but the current classified pricing system is confusing and makes it difficult to have price stability for our ingredients.” Head of dairy procurement Global CPG “…they also lack knowledge of documentation and export markets, which can limit delivery consistency” Head of procurement of SE Asia, top 3 dairy CPG • “If I were King of U.S. dairy for a day, I would take advantage of frustration with Fonterra’s position through… • tightening quality • developing customer service • develop confidence in pricing.” • Former head of China dairy procurement top 5 CPG

19. Price Support FMMO/Classified Pricing • Historical policies and programs served an important purpose (e.g. safety net and a means to clear the market) • However, cumulative and combined impact over decades have weakened US competitive position • Government as fall-back customer has limited commercial focus • “In & Out” of export markets impacts credibility in global trade • Safety net distorts investment profile (market risk/reward clouded) • Product portfolio not aligned with customer/consumer needs • Limited innovation within product categories • Increased price volatility as a result of limited development of risk management/hedging practices We need to address the combined and cumulative effect ofdairy policies to improve our competitive position

20. The right dairy strategy will address opportunities andthreats (to domestic and international trade) Opportunities Threats/Risks • Greater share of global trade, and increased growth in domestic market • Improved risk management (less volatility) • Increased use of dairy by CPG companies • Better product innovation • Competitive product portfolio • Increased investment in dairy • Limit growth of low cost supply by meeting emerging demand • Displaced imports ($500M opportunity) • Improved commercial and consumer focus • Underinvestment in value-added production, product innovation and commercial capabilities • Oceania and Europe continue migration to high end of the market • Ukraine and Brazil emerge as capable, low cost sources of supply • Decreased use of dairy in CPG • Increased pressure from imports (depending on trade policy) • Increasing volatility • Growth, with less volatility • Strong domestic market as the basis for increased global trade • Strengthened competitive position • Stagnant growth in domestic andglobal trade • Weak competitive position

21. Window of opportunity 3 4 Low cost, emerging production markets will enter: Brazil in ~10 years, Ukraine/Belarus in ~15 years 2 Traditional supplier growth slows and costs increase Key question for the industry: How can the US takeadvantage of the window of opportunity? Demand will continue to grow, driven by emerging markets 1 Source: “World Trade Trends 2008”, USDEC; FAPRI

22. Goals for this discussion • Provide an overview of project objectives/approach • Review the expected evolution of the global dairy industry and the implications for U.S. dairy • Discuss strategic options for the U.S. • Recommendations for developing the appropriate option

23. What options exist for the US dairy strategy? “Fortress USA” Status Quo Consistent Exporter Global Dairy Player • Complete focus on domestic market • Use of additional tariff and non-tariff barriers to overcome foreign competition • Supply mgt. as a means to balance production and demand, and limit volatility • Attempt to limit effects of globalization • Limited industry efforts to address globalization • Current policies and regulation • Opportunistic participation in global trade as prices allow • Individual companies may choose to develop differentiated export capabilities • Limited effort to manage volatility • Commitment to global opportunities for US milk supply • Broad efforts to improve commercial focus and align product portfolio • Collective effort to reform FMMO and price support • Efforts to improve forward contracts, futures markets • Strong domestic market as a basis for global trade • Joint industry efforts to build insight/ capability • Consistent exporter strategy, plus: • Industry moves to an export focused model that includes milk supply and processing assets outside of US • Commercial and innovation capability development • May include off-shore investment and other significant efforts • Capabilities will support domestic market, though investments may be diverted globally Recommendation by IC Board

24. Short-term benefits of Fortress USA are unlikely, and long-term implications are disastrous Short-term capture of profits is uncertain at best Negative implications of Fortress USA: • Lack of growth • Falling consumption • Dairy substitution • Limited product innovation Road-blocks will limit implementation • Isolation of the industry is critical to successful • “F-USA” implementation • Increasing tariffs difficult due to WTO implications • Broad changes will face opposition by industry participants looking to take advantage of export opportunities • Very difficult to line up industry constituents. High risk of loss of control in the process • Rising Costs • Less focus on costand productivity • Increased over-sight/regulation • Less investment Supply management may not deliver lower volatility • Weak Industry • Does not benefit broader industry • Weak position if barriers reduced • Leads to industry stagnation • Unsuccessful attempts have been made in the past • Import / export variation has significant impact on ability to manage price • Forecasting is imperfect in the dairy industry While Fortress USA could theoretically be attractive to producers if price increases were feasible… … the negative implications of a closed market strategy make it a highly risky strategy, leading to stagnation an decline

25. Latent demand gap will result in someprice recovery • However, price volatility will continue to whip-saw domestic market • Food processors start to limit dairy usage due to high/volatile prices • Sporadic investment in technology and product innovation • Static product portfolio • Opportunistic development of commercial capability • Limited policy/regulation reform • Limited growth opportunities • Slowing domestic growth • Export growth less than demand • Limited import substitution • High volatility will persist, impacting market growth and stability • Peaks will drive higher substitution • Troughs will be painful and may reduce market investment • US as marginal player will add volatility • Erosion of U.S. competitiveness • Lag industry leaders (Oceania) in innovation and commercial capabilities • Higher cost than emerging market supply with no differentiation • Less investment in capital, talent, innovation • Lack of U.S. ability to meet emerging demand will increase speed of entry of low-cost competition • Risk of flat or even declining domestic market (and diminished international trade) Inaction in a period of changing market dynamics is a questionable industry strategy Maintaining the status quo will likely resultin a weakened U.S. dairy industry Short term (5-10 years) Long term (10-25 years)

26. Processors CPGs Retailers/Consumers Near-term Long-term Near-term Long-term Near-term Long-term In summary, each option affects playerin the value chain in different ways Producers Near-term Long-term FortressUSA Status quo Consistent explorer Global dairy player Positive impact Neutral impact Negative impact Depends on US ability to move up-market to value-added products

27. In summary, the U.S. should pursue a focused set of company and industry actions to benefit from a future of increased globalization • Globalization has and will impact domestic and export trade – the trends that create the “global demand gap” run deeper than the business cycle, and broader than U.S. dairy policy • The U.S. industry should take action to leverage strengths and bolster shortcomings to benefit from globalization – a “do-nothing” strategy is insufficient and dangerous • A strategy of becoming a “consistent exporter” will create growth and profit opportunities in both internal and external markets • Key enablers of a future strategy must address pricing policies, and enhance tools to mitigate forward market risk • As an industry, we should mobilize against a focused set of activities to build capability and create the needed change • In parallel, U.S. dairy companies should utilize the insights from the globalization study and ongoing industry resources to strengthen their competitive position

28. To achieve the “Consistent Exporter” strategy, both industry and company specific actions are required Priority Reform regulated milk pricing systems (Federal and State) and price support Development of mechanisms for risk management / reduction of volatility High Continue pursuit of trade treaties that provide net export benefits Investment in cross-border commercial capabilities/ partnerships Development ofsales / marketing capabilities Develop ability to deliver customer product specifications Develop capabilities to package/manufacture high value-added products to meet internationalstandards Build on existing food safety assurances and traceability as a competitive strength Product & technology innovation (possible with financial incentives) Cost and productivity Export Marketing Board Company specific Collective industry Low

29. Thank youQuestions OR Comments? Tom Suber, U.S. Dairy Export Council tsuber@usdec.org

30. Appendix

31. Accommodating Globalization – Internally & Externally Globalization Operating Committee Toland, Glanbia (Chair) Nobis, MMPA Carey, Darigold Ruiz-Funes, LOL Clauss, Hilmar Shelley, Schreiber Cotta, CDI Taylor, Leprino Kaneb, Hood Waldvogel, DFA Murfield, UDA Stakeholder Coordination Tipton, IDFA Kozak, NMPF Gallagher, DMI Toland , GOC Staff & Support Quality, Safety, Traceability Carey, Darigold (Chair) Volatility Management Shelley, Schreiber (Chair) Pricing Reform Trade Treaties Standards & Specifications Pre-competitive Sales & Marketing Programs Science & Innovation

32. Executive summary of scenario modeling • We ran our analysis across five main scenarios: 1. Fortress USA, 2. Status quo with a 5% increase in price by 2013, 3. Status quo with flat prices, 4. Consistent exporter with 50% of latent demand capture, 5. Global player with 75% of latent demand capture as well as 5% share capture of EU exports • Even though Fortress USA theoretically appears attractive in the near term, there are both short-term and long-term concerns with this strategy. We believe this strategy would detrimental to the US dairy industry • In the near-term, the feasibility of successfully implementing a Fortress USA strategy is extremely low • It will be extremely difficult to put in place a supply management system that would effectively address volatility in the industry and adequately anticipate new market demands • True Fortress USA would include increasing tariffs and otherbarriers to limit the impact of imports / exports, which would face strong resistance due to the ramifications on other agriculture industries (due to WTO restrictions) • Longer-term, this strategy will have drastic implications on the dairy industry • Higher cost structure due to creeping inefficiencies, depressing producer margins, pushing prices even higher • Negative impact on dairy consumption at the consumer level • Substitution of dairy for other ingredients by CPG companies • Complete lack of investment, innovation and growth  leading to stagnation • Vulnerability to imports as inevitable loopholes are exploited or if the trade barriers are ever taken down • Highly unfeasible given the required change in overall trade policy and agreements in place • The IC Board has agreed that Fortress USA should not be pursued • On a base case, Consistent Exporterappears to be most attractive with PV of ~$29B compared to status quo (5% price increase assumed; $26B) or status quo with flat prices assumed ($21B), while Global Player has also been deemed as an premature industry strategy at this point by the board

33. Risk adjusted, Fortress USA does not create value over the Status Quo Theoretical PV of industry profits: $60B 40 ~30 ~26 20 0 Theoretical Fortress USA (20% price increase due to supply mgt.) Status Quo (5% price increase due to latent demand) Fortress USA (Risk Adjusted)

34. Base case: Consistent exporter provides better industry value than Status quo PRELIMINARY Base case Options studied in detail Option deemed infeasible at industry level Price increase No price increase

35. “Fortress USA” might be attractive only for producers in the near term Producers Processors CPGs Retailers/ Consumers Requires significant gov’t oversight and intervention and fundamental change in trade policy counter to current trade agreements Positive impact Neutral impact Negative impact

36. “Status Quo” would lead to neutral to negative impact in the long run Producers Processors CPGs Retailers/ Consumers Note: If we consider the missed opportunity for dairy innovation and trading up the dairy category, this could be considered a negative impact for consumers and retailers Positive impact Neutral impact Negative impact

37. “Consistent Exporter” would help US in global and domestic markets; positive long term outlook Retailers/ Consumers Producers Processors CPGs Efforts to manage volatility as a priority strategy benefit entire value chain Positive impact Neutral impact Negative impact

38. Global dairy player requires significant advancement; deemed premature as an industry strategy Producers Processors CPGs Retailers/ Consumers Efforts to manage volatility as a priority strategy benefit entire value chain Positive impact Neutral impact Negative impact

39. Approach for estimating the “size of the prize” 2 Volume impact Price impact Revenue opportunity in 2013 (separate for each scenario) Growth in exports (vol) Impact of price (direct impact for producer market, partial impact for processor/CPG market Growth in domestic market (includes impact of imports) + X = Impact of demand elasticity to price (will affect volume based on price assumptions) Margin opportunity in 2013 (separate for each scenario) Revenue opportunity in 2013 (separate for each scenario) Impact of change in margin % (price – costs) [Taking into account the difference in size and profitability of producer, processor/CPG markets] = X Note: We have kept most of the assumptions constant from 2013 to 2025

40. Assumptions for the DCF model – Base case Assumption Fortress USA Status Quo (5% price increase) Status Quo (flat price) Consistent Exporter Global Player

41. Assuming full potential scenarios,Consistent Exporter yields ~30% higher PV than SQ Lower volatility, higher exports, improved domestic growth, and moderate price increase lead to ~30% additional profit than Status Quo Status Quo Consistent Exporter