California's Turning Point? State faces an uncertain dairy future

In 1993, when California seized title as the nation's No. 1 dairy state, its meteoric rise seemed unstoppable. 

"There's real opportunity for California with increased world demand,” says producer Tony Mendes. "But our dairies have to survive first.”

Over the next 15 years, the Golden State set record after record for milk production, dominating the U.S. dairy scene and coming close to taking over Wisconsin's spot as the top U.S. cheese producer.

The past few years, however, haven't been kind to California's dairy industry. True, the state still leads the nation in milk, with some 20% of U.S. production. In 2008, it set a record of 41.2 billion pounds, almost twice that of No. 2 Wisconsin, and counted farmgate receipts of $6.9 billion.

But the pretty picture stops there. Widespread difficulties have many wondering where this giant is headed.

"Uncertainty about the future is creating consternation among producers,” says Tony Mendes, who milks 1,400 cows near Riverdale, Calif. "We're preoccupied with survival.”

The challenges ahead are many and daunting, Mendes and other California dairy leaders say. Leave out, for a moment, 2009's price downturn, which hurt dairies nationwide. Set aside California's well-publicized water shortages and state budget problems. Consider the plentiful other troubles.

For starters, there's California'sunfriendly business environment and stringent environmental regulations. Mendes estimates his yearly water- and air-quality compliance costs at $35,000 to $40,000. This year, he'll also have to replace the engines on his water wells—at some $35,000 each—because regulators now say the units must be powered by electricity, not natural gas.

"Dairies are spending ridiculously to comply with air- and water-quality regulations,” he says.

Milk processing plants face similar compliance issues, says Alan Pierson, executive vice president and chief operating officer of Land O'Lakes.

"We are under tighter scrutiny at plants for things like energy conservation and air emissions,” Pierson says. "Operating in the San Joaquin Valley, where air quality is so important, we've got to reduce our carbon footprint.”

Pierson believes that the challenge can be turned into opportunity. "The higher [environmental] scrutiny spreading across the country could give California, with its newer infrastructure, a significant advantage,” he says.

Pierson also says it's difficult to build a new plant in California. "The incentives and business climate in other states are more favorable.”

Another major problem is the high cost of feed, much of which comes from the Midwest. That—along with the state's expensive fuel, labor and energy; liability costs; and worker compensation outlays—has bumped up production costs to the $14/cwt. to $15/cwt. range for a 1,400-cow dairy.

"These [costs] are hurting us tremendously,” says Mendes, a third-generation dairy producer with a law degree who also serves as chairman of California Dairies Inc. (CDI). The processing cooperative handles almost 45% of the state's milk supply. 

One day's supply of alfalfa hay at Tony Mendes' Riverdale dairy totals 12 to 14 tons. The high-priced feed costs about $190/ton.

"As efficient as we are, these problems are affecting our competitiveness,” Mendes says. "The golden days of California's expansion and growth are going to stop.”

In fact, California recently saw its largest year-over-year milk production decline since 1956. Between December 2008 and November 2009, the state's dairies produced 3.7% less milk, a cutback of some 1.5 billion pounds. That marked an abrupt turnabout in a state that grew almost nonstop for more than a decade.

While 2009's decrease stemmed from a milk oversupply amid the recession's slowed demand, California also has contracted in another way. Between 2004 and 2008, the state saw a net loss of 255 dairies, leaving 1,852 operations. The California Department of Food and Agriculture had not released 2009 numbers by press time but believes the number of remaining dairies fell sharply last year.

Michael Marsh, CEO of Western United Dairymen, says 150 California dairies might have closed in 2009.

Recovering from 2009's downturn remains a challenge. Financing is tight, and lenders are not only scrutinizing budgets but some are even crafting them for dairies.

"People are in bankruptcy or trying to find a graceful way to exit the industry,” Mendes says. "Most are trying to hold on to what little equity they have left.”

"There is money to lend, though nobody is willing to lend without the fundamentals of credit quality,” says Cornelius Gallagher, global agribusiness executive with Bank of America and chairman of the Agricultural Lending Committee for the California Bankers Association.

"The core problem is that we may see only break-even prices in the next 12 months,” he says. "That's not enough to restore lost equity.” And the likelihood remains for price volatility—"the source of our grief,” Mendes says.

"California is in an adjustment phase,” says John Jeter, president and CEO of Hilmar Cheese Company, which handles 12% of California's milk production. "The system was so good for so long, but it needs major change.”

The state simply could not sustain its massive, steady growth of 3% to 4% annually, Jeter says. Its "very controlled” milk pricing system has retarded the change needed for competitive global markets, he adds. And its increased production of commodity products has not positioned the state for emerging demand.

Jeter points to recent adjustments made by the Midwest dairy industry. "They went up the value chain and turned the corner,” he says. "Their milk supply is growing and they're in a good position.”

That's not the case in California, where capacity is often short. The state's processing plants have struggled in recent years to handle the 41-billion-pound supply. Although that changed in 2009, many believe the problem hasn't disappeared.
 

Hector Ochoa oversees California Dairies' processing plant in Visalia, where a recent expansion boosted milk-handling capacity to 10 million pounds a day.

"A year and a half ago, California was in serious trouble with its plant capacity, and it will get there again,” says Richard Cotta, CDI's president and CEO.

CDI just expanded at its seventh and newest plant, in Visalia, Calif. That boosted the site's capacity to 10 million pounds a day, mostly for butter and powder. But Cotta doesn't expect the expansion to end the capacity shortages.

"The dairy industry needs to decide where it wants to go in the long run,” he says. "All the players need to be at the table.”

California has been increasingly cut off from sales to the eastern U.S., says William Van Dam, CEO of the Alliance of Western Milk Producers.

"Texas, New Mexico and Idaho have recently built dairies and big, efficient cheese plants,” he says. "They're 1,000 miles closer to the Eastern market than we are.”

To compete, California would have to sharply reduce its prices, something Van Dam says the state's industry just cannot afford to do.

Despite the difficulties, no one is willing to write off California yet. It still has the advantages of a moderate climate, the San Joaquin Valley's vast flatlands and a well-oiled dairy infrastructure. And all acknowledge the state's best and biggest prospect: exports.

"The shining opportunity in California is the export trade,” Van Dam says.

"The future lies with a hungry world,” Land O'Lakes' Pierson agrees. "California is well positioned to serve the export market. And California itself is a large market that needs to be served. Processing plants are positioned within the state to service that growth. Land O'Lakes is definitely here for the long term.”

Many also are optimistic that California's dairy industry can find ways to readjust its business model.

"We have to find ways to be more efficient and innovative, rather than using economy of scale,” Mendes says.

He foresees more dairy consolidation, perhaps with a family operating not one but several dairies. "They may be more efficient if they're jointly buying feed, raising heifers or paying for transportation,” Mendes says.

"California producers are highly intelligent and their dairies are well run,” Van Dam says. "I have a lot of confidence in their ability to adjust to the circumstances presented to them.”

In a state accustomed to change, the idea that its dairy powerhouse must adjust to new circumstances shouldn't come as a surprise. California's dairy industry transformed itself once before and catapulted to success. The question is: Can it do it again?
 

NOT HEEDING MCKINSEY'S REPORT

California's problems were predicted two years ago in a 20-year strategy study the state's dairy industry developed with McKinsey & Company. Commissioned by the California Milk Advisory Board (CMAB), the study pinpointed three key challenges: rising environmental regu-latory costs, an oversupply of raw milk and lack of investment in innovation and proprietary capacity.

McKinsey advised the industry to address those challenges by:

• minimizing the costs of environmental mitigation;
• continuing investments in promotion and marketing;
• investing more in production efficiency and product innovation;
• suggesting more efficient laws and regulations; and
• refinancing quota.

"In 2007, when prices fell, the industry agreed with McKinsey's findings,” says CMAB's Stan Andre. "But when 2008 brought high milk prices, all that enthusiasm for doing something went out the window. The industry has not yet heeded McKinsey's advice.”
 

Bonus content:

View From the Top: California Dairy Leaders Weigh In

Read Tony Mendes' chairman's letter in the December 2009 issue of the California Dairies, Inc. newsletter

California Dairy Landscape...2009 Reflects Net Loss of 109 Dairies

California Records Net Loss of 109 Dairies For 2009