Fitch holds its rating because Fonterra has scale, and the defensive characteristics of its ingredients business

Content supplied by Fitch Ratings

Fitch Ratings has affirmed New Zealand's (NZ) Fonterra Co-operative Group Limited's (Fonterra) Long and Short-Term Issuer Default Ratings (IDR) at 'AA-' and 'F1+'.

The Outlook is Stable.

The Long- and Short-Term Senior Unsecured ratings are 'AA-' and 'F1+'. Fitch has also affirmed the ratings of Fonterra's senior unsecured notes at 'AA-', subordinated notes at 'A+', and commercial paper at 'F1+'.

Fonterra's ratings are underpinned by its scale, the defensive characteristics of its ingredients business, the financial flexibility afforded by the effective subordination of its farmer creditors, and the margin protection offered by its fully integrated business model. In a scalable industry, Fonterra is the world's largest processor and largest exporter of dairy products.

KEY RATING DRIVERS

Strong Market Position: Fonterra's ingredients business is the global market leader in dairy exports, commanding 46% of international exports in whole milk powder. Fonterra collects and processes around 87% of the milk in New Zealand from a supplier base of around 10,500 dairy farmers who are also shareholders in the co-operative.

Diversified, Blue-chip Customer base: Fonterra's ingredient's business supplies to global, market leading food companies such as Nestle SA (AA+/Stable). Fonterra's products are used across a range of the reconstituted dairy branded goods sold by these businesses, affording Fonterra both geographic and product level diversification.

Low Cost Producer: Dairy production in New Zealand is one of the lowest on the global average cost curve. New Zealand's cost competitiveness arises from favourable climatic conditions for its grass-fed herd, the depth and breadth of Fonterra's supply chain, and the scale of the company's operations. Both Fonterra and New Zealand's farming industry have re-invested operating cash flows in equipment and infrastructure over the past three years resulting in improvements in marginal cost efficiencies, collection volumes and processed volumes. These investments increased the average cost differential between other dairy exporting nations, giving New Zealand cost advantage in competing for the rapid demand growth in Asia.

Farm Debt Levels Sustainable: Fitch expects the level of borrowing by farmers to the value of milk solids production - a measure of farm leverage, to rise over the rating horizon but for this stock of debt to remain well serviceable. Farm leverage will rise as a result of the falling value of production. The adverse impacts of this rise are mitigated by low interest rates, the low marginal cost of production relative to the price of milk and the high retrospective payments due from Fonterra for the 2014 Milk Season. The improvements in farm capacity and efficiency are the result of increased capital investment in farms funded by the rise in the milk price over the last three years. Fitch expects Fonterra's distributions to farmers to exceed break-even levels over the year despite Fonterra forecasting a drop in the milk price in 2015.

Subordination of Milk Payments: Fonterra's constitution provides for an effective subordination of milk payments to principal and interest obligations (and other costs). In its forecasts, Fitch assumes a minimum 10% of milk supply costs at the end of each financial year (year-end July), to service principal and interest payments, based on Fitch's understanding of the legal framework underpinning the subordination of milk payments, and management's estimates of advance rates.

Investment In Earnings Stability: Fonterra plans to invest in additional plants to increase its production capacity in ingredients whilst retaining its processing capacity in value added products such as cheeses and yogurts. This investment will better align Fonterra's processing footprint with the theoretical production mix that forms the basis of the Farm gate Milk Price manual and thereby reduce future earnings volatility that arises as a result of this basis risk between revenues and costs. Fonterra will invest approximately NZD1bn in capacity increases over FY15 and FY16 - in addition to maintenance capital expenditure in the range of NZD400m to NZD500m. The additional plant is expected to increase Fonterra's processing capacity at the peak by 10% in FY16.

Acquisition Leverage Offsets Stream-Returns: The proposed 100% debt funded acquisition of up to 20% of China's Beingmate Baby & Child Food Co., Ltd, (Beingmate) will offset the positive impact to leverage from a forecast reversion in stream returns. Stream returns were negative in FY14 but prices in these value added dairy products have bounced back in FY15 and Fitch expects positive stream returns to support Fonterra's operating margin. Forecast cash returns related to Beingmate remain four to five years away and are uncertain given the growth focus of this business and the complexities associated with taxation and capital repatriation from businesses in China.

Brands Insulate Profit: Fonterra's brands segments provide farmers with some insulation against a fall in the price of global dairy ingredients. Should dairy ingredients prices fall, Fonterra's brands segment may be able to maintain price points which can underpin gross margins for a temporary period. Fonterra may, at its discretion, pass on this benefit to its shareholders. These factors contribute to the continued viability of New Zealand's dairy industry.

RATING SENSITIVITIES

Positive rating action is considered unlikely over the next three years as Fonterra irons out earnings volatility drivers in its value chain and establishes volumes and margins in its branded goods business.

Negative : Future developments that may, individually or collectively lead to negative rating action include :

- if debt to EBITDA including subordination increases to 2.5x (2.62x in FY13, 1.95x FYE14, 1.86x FYE15) on a sustained basis or;

- overseas milk supply accounts for more than 30% of NZD cost (currently below 12% and expected to fall over the next three years as a result of strong NZ milk volume).