Keith Woodford sees volatility being a permanent part of Fonterra's future in most markets, but impovements in the things it can control should reduce the swings

By Keith Woodford*

Fonterra’s recently announced profit figure for 2015/16 of $834 million is a big step forward from the $506 million of 2014/15. The biggest underlying source of improvement appears to have been the margin for commodity cheese over and above the auction price for whole milk powder (WMP). This is because WMP dominates the milk price calculations whereas cheese margins go straight to profit. A second major improvement has been Australian operations where unprofitable operations have been sold and the EBIT (earnings before interest and tax) are now running positive.

Several factors will determine whether or not Fonterra can maintain its profit in 2016/17, with perhaps the biggest being whether there is a margin between cheese and WMP. Another key issue will be whether or not Fonterra can achieve success from its relationship with Beingmate in China.

Currently, the Beingmate relationship looks wobbly, with Beingmate having lost considerable market share over the last 18 months for its own infant formula. For Fonterra, with its 18.8 percent share in Beingmate, that loss is worrying. But more worrying is whether Beingmate has the supply chain systems to get Fonterra’s own products to market. These next 12 months will be crucial for that relationship in a market where there will continue to be both big winners and big losers.

The two ‘work-ons’ for which Fonterra has direct control of the levers are its Australian operations and its China Farms. Although the negative flow of cash over in Australia has been stemmed, there are still storm clouds on the horizon. In particular, Fonterra has lost market share of raw milk produced in Australia and this is in a market where total production is also in decline. So Fonterra faces the risk of over-capacity in its processing operations and this risk will increase when the new Stanhope cheese factory is commissioned later this financial year. The additional milk will need to come from somewhere, perhaps from additional dissatisfied Murray Goulburn suppliers should that Australian co-operative fail to move forward from its current muddle.

The biggest embarrassment in Fonterra’s latest annual accounts is the ballooning operating losses from its China Farms. These have increased from $44 million to $59 million EBIT.  Most of this will be cash, but there may also be an element of depreciation included. Last year, Fonterra Chairman John Wilson suggested that these farms would be running profitably by now, but it sure has not happened.

Unlike many farmers, I was originally supportive of the notion of Fonterra setting up farms in China. It seemed to have merit if Fonterra wanted to build consumer-based operations using a mix of fresh and powder. But so far it has failed badly. The key question is whether it was the strategy or the implementation that has gone wrong.    

Fonterra’s China Farms got off to a rocky start back in 2007 with the poorly designed Hangu farm, but the rest of the Yutian Hub uses well designed American technology and systems. Until 2014, China farms were meeting their internal financial benchmarks (albeit never publicly disclosed), but then things went astray.

Without access to the detailed data, it is impossible to say where the fundamental problems lie. Reduced milk prices – currently 3.35 RMB per litre- are part of the story but the problem has to lie deeper than that. Even at current prices, Fonterra is receiving the equivalent of about $10 per kg milksolids (MS). Yet this is far from sufficient to cover operating costs let alone make an interest contribution on borrowed capital or contribute to company overheads.

By my calculations, Fonterra would have needed a milk price equivalent to about $NZ14 per kg MS in this last year to make an operating surplus, and about $18 per kg MS to meet a likely internal benchmark of 15 percent on directly invested capital.

This 15 percent internal benchmark may seem high, but it is the sort of return that big companies with big overheads need to achieve from individual business units.  In any case, choosing a lower figure of say 10 percent will only drop the required milk price by about $1.30 per kg MS.

One of the key admissions from Fonterra in its latest report is that the milk from Ying Hub, which is Fonterra’s second hub, some 400 km west of Beijing, is only being sold on the spot market. This is because they have been unable to get long term contracts. So here we have a primitive and dysfunctional supply chain, with no premiums for quality.

Recently, I have heard Fonterra executives say that having the China farms is a necessary cost of doing business in China. But this is palpably incorrect. Yes, the Chinese Government was keen to see Fonterra set up farms, in the mistaken belief that Fonterra had expertise in free-stall barn farming, and that Chinese would learn from this by osmosis. And after the melamine disaster, Fonterra was indeed keen to be seen as a well-behaved investor. But it was Fonterra’s own choice to go there. They actually made that decision before the melamine scandal, and they did so because they thought they could do it profitably.  

There are other foreign groups who have come to farm cows in China, but none of the big processors such as Nestle or Danone have set up their own farms. It was definitely not a requirement for doing business there.

One of the challenges for any external analyst of Fonterra is scratching beneath the surface to get the key numbers. There is a big PR machine skilled in massaging the messages. One can only hope that Fonterra is like a swan paddling in the water; all serenity on top but paddling furiously underneath.

Looking forward to the 2016/17 year which is now underway, Fonterra has expressed confidence that company profits can be maintained, with a likely dividend of 40c per kg MS. Given normal retention rates of 30-35 percent of profit, this implies a profit approaching $1 billion.

On current pricing, with shares valued at close to $6, this gives a pre-tax dividend yield of approximately 6.5percent, which is remarkably high in these times of low yield. That says that the market is somewhat sceptical that Fonterra can maintain its profits long term, and is valuing the shares accordingly. I share that scepticism, with Fonterra’s milk supply likely to drop this year due to declining on-farm production together with ongoing loss of market share to other companies. 

However, the biggest determinant of profit in the coming year is likely to be the price of WMP relative to other products. For non-farmer investors in particular, it has taken a while for them to understand that low WMP prices are good for profits, whereas high WMP prices are bad for profits. Also, when commodity cheese production is more profitable than commodity WMP, that too adds to company profits rather than to the farm-gate price of milk.   

Yet another factor is that Fonterra has tweaked the formula for how it will calculate milk price in the 2016/17 year, and this will shift profits from non-auction WMP across into the milk price. An example is the recent Algerian tender which has been won at prices well above auction prices.

The only thing for sure is that volatility of both milk price and profit will be ongoing, with that being the nature of the beast. All that Fonterra can do is continue to focus on the ‘work-ons’ and take the rest in its stride.

Keith Woodford is Professor of Agri-Food Systems (Honorary) at Lincoln University and a Senior Fellow (Honorary) of the NZ Contemporary China Research Centre. His archived writings are at http://keithwoodford.wordpress.com This article referred to the China Farms EBIT as $69 mln in error. It has been corrected to $59 mln.