Keith Woodford delves into and behind the official Fonterra disclosures for the 2014-15 year and finds some unsettling developments

By Keith Woodford*

The release of Fonterra’s annual report on 24 September coincided for me with a long plane trip back from China. I used the time trying to work out what all the numbers really mean.  It was not an easy task.

Fonterra’s annual report – like most reports from large companies –provides masses of numbers. Some are clearly there for public relations purposes. Others are there to meet the required rules of the International Financial Reporting Standards (IFRS). And then there is another set of numbers which Fonterra constructs according to its own rules. These are called non-GAAP measures; i.e. ‘non-generally accepted accounting measures’. Fonterra itself acknowledges that these measures are not standard between companies, so comparison must be made with caution.

Some might say that none of these sets of numbers are designed to illuminate the true kernel of the situation. So interpretation can be challenging. To get to that kernel, one has to do lots of fossicking.

Along the way one comes across cash and profit measures, pre-finance and post-finance numbers, pre-tax and post-tax profit, and normalised and non-normalised items.  No wonder most people get confused.

To further complicate matters, definitions change throughout the report. For example the term ‘Greater China’ sometimes includes China farming operations and sometimes does not, depending on whether Fonterra is referring to an ‘operating segment’ or a ‘strategic platform’. And the ‘Asia segment’ actually includes Africa and the Middle East but excludes ‘Greater China’.

Borrowing jumps

One notable figure – which is not highlighted - is that borrowings have increased from $4.9 billion at 31 July 2014 to $7.6 billion at 31 July 2015. Clearly, big things have been happening.

Throughout the report, comparisons are made between 2014/15 and the preceding year. This is normal procedure.  However, neither year could be described as a typical year for Fonterra, so the foundation for comparison is wobbly.

In 2013/14, record prices were achieved for both whole and skim milk powder. This made it an excellent year for farmers who are paid the commodity returns minus the cost of processing. But it was a very difficult year for corporate Fonterra.

The key reason why 2013/14 was such a bad year for corporate Fonterra was that high commodity prices squeezed the margins on value-add consumer and food service products.   As a consequence, Fonterra made a profit of only $179 million on assets of $15.5 billion and shareholder equity of $6.5 billion. Indeed Fonterra would have made a loss if farmers had been paid the full milk price using the pricing formulae as set out in the Milk Price Manual.

At the time, both commentators and investors cut Fonterra some slack for the poor performance. The message from Fonterra was that it was just a short term thing and that profits would soar once commodity prices dropped.

In contrast to one year earlier, 2014/15 has been disastrous for milk powder prices. Accordingly, farmers are suffering greatly. In theory, the flip side of this should have been that the 2014/15 year would have been outstanding for Fonterra’s profit from consumer and food service goods. In practice, it has not turned out that way.

The reported after tax profit for 2014/15 is $506 million. Somewhat surprisingly, this is $82 million more than the pre-tax profit.  Yes, that is right: Fonterra is not liable for tax this year and the Profit and Loss Account shows a tax credit of $82 million. Last year there was also a tax credit, but only of $42 million.

Four versions of return on capital

Fonterra provides four different versions of its return on capital: 9 percent, 8.9 percent, 7.5 percent and 6.9 percent.  The 9 percent figure is the one Fonterra highlights, but it is the 6.9 percent figure in fine print that takes all of the equity capital into account. On a per share basis, the return is 29c. Fonterra is committing to pay 25 cents to shareholders leaving 4c for reinvestment.

This retention of 4c per share is consistent with Fonterra’s track record that it typically retains only a small amount of profit. Most companies retain a greater percentage of profits as a growth driver.

Given that Fonterra’s corporate profits are so modest in what should have been a good year, I decided to drill down and see what went well and what went poorly.  To do so, one has to look at the pre-finance and pre-tax numbers which are known as EBIT (earnings before interest and tax). This is because interest is only charged and tax is only calculated at the overall company level and not for individual segments.

This year, Fonterra has made an EBIT profit of $974 million after normalisation. Using the ‘strategic platform’ figures, ingredients and operations contributed $973 million.  In contrast, consumer and food service contributed $408 million.   However, this leaves some $363 million of unallocated costs, plus $44 million of losses from international farming. 

Using the ‘operating segment’ information, ingredients and operations contributed $699 million of the $974 million total EBIT. But this is clearly an underestimate given that not all ingredients are included in the ingredients segment.

All we can say for sure in relation to ingredients (essentially commodities) and operations, is that they contributed something more than $699 million to EBIT. In contrast, the rest of the business (including consumer goods, food service and international farming) contributed something less than $275 million to EBIT. 

When interpreting these figures, it is important to remember that finance costs totalling $517 million have still to be deducted.

Remarkable

On the surface, the profit dominance of ingredients and operations is remarkable. Recall that earlier I said that corporate Fonterra is expected to do well when commodities are low in price, but that is because of the increased margins on consumer and food service goods. But here we are seeing excellent profits from the commodities themselves. There are two reasons for this.

The first reason is that Fonterra calculates the returns to its farmers from five reference products. These are whole milk powder, skim milk powder, butter, buttermilk, and anhydrous milk fat. Fonterra then deducts processing costs from the sale prices for these products, and pays its farmers on the assumption that all milk was converted to these products. However, the reality can be quite different, and Fonterra also produces other commodity and ingredient products called non-reference products.

This year Fonterra has done well from these non-reference products, including cheese and casein. The prices have not been good, but they have been better than the prices for milk powders. And for corporate Fonterra, in contrast to the farmers, it is this relativity that matters. Fonterra has also been buying lactose cheaply from overseas, which it adds to the milk powder and thereby increases its margins.

The second reason is that the processing charges that Fonterra deducts from the market price of the reference products include an allowance for return on capital. Therefore, Fonterra makes considerable profit each year simply by toll-charging for processing of commodities. By definition, this part of the business is very low risk, given the commitment to supply by farmers, and the automatic charging of a return on capital.

Struggling overseas

There are two business segments where Fonterra is struggling badly. One is Australia. The other is international farming.

In Australia, Fonterra purchases about 19 percent of Australia’s milk. To do this, it has to pay market prices as its Australian farmers are not bound to the company like New Zealand farmers. Quite simply, Fonterra is making a loss on these operations. Given the way Fonterra bundles NZ and Australian operations together, it is impossible to be precise, but it is probably of the order of $200 million for 2014/15 once ‘one-offs’ are included.

The Australian operations have been problematic ever since Fonterra was formed. Fonterra took over poor quality Australian assets from the NZ Dairy Board, and then compounded those problems with further strategic errors.

Fonterra’s international farming operations are almost totally in China. Two years ago, things looked rosy, but somehow the wheels have fallen off since then.  This last year the losses are $44 million EBIT. Once interest on borrowed capital is added in, the losses become much greater.

In this last year, Fonterra’s farms in China produced about 160 million litres of milk and 12 million kg milksolids from 25,000 milking cows. Those production figures would be good if they were from New Zealand pastoral style farming, but from intensive housed free-stall farms they are awful.

Chinese farmers are currently receiving about 3.4 RMB per litre for milk of about 3.5 percent fat and 3 percent protein. This equates to about $NZ 0.85 per litre.

Fonterra’s China farms will be getting paid more than this. My estimate is that they will be getting at least $NZ1 per litre for milk of about 7.5 percent milksolids. So they are getting about $13 or a little more per kg milksolids. Yet they have still made a loss of $3.67 per kg milksolids, with interest still to be accounted for. 

Plenty to worry about

The overall message from Fonterra’s accounts is that once one scratches below the surface there is plenty to worry about.  The operating returns at the corporate level have depended on an imbalance between powder prices relative to cheese and casein. Purchasing cheap lactose has also helped. Australian operations remain a worry with much still to be sorted out. And the China farms are bleeding profusely.

Another issue of note is the extent to which Fonterra is building inventory. The accounts show that in 2013/14, Fonterra’s NZ operations produced 138,000 tonnes more product than were sold. And in 2014/15 Fonterra produced 126,000 more tonnes of NZ product than were sold. This suggests that at 31 July 2015 there were 264,000 tonnes of additional inventory compared to the same date two years earlier.

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Keith Woodford is Honorary Professor of Agri-Food Systems at Lincoln University. He combines this with project and consulting work in agri-food systems. His archived writings are available at http://keithwoodford.wordpress.com