Keith Woodford says Fonterra’s half-year results are solid but it is not all plain sailing ahead

By Keith Woodford*

Fonterra has produced a solid set of results for the first half of the 2016/17 season, with after-tax profit up two percent to $418 million.

Results were broadly in line with market expectations. Prices for Fonterra units had been drifting down on the NZX in the weeks prior to the announcement from a high of $6.39 to $6.20 and lost another five cents over the following two days down to $6.15.

As always, the half-yearly and annual reports from Fonterra are a masterful exercise in communication. It takes effort to scratch beneath the surface to figure out what the numbers are really telling us.

One big message is that Fonterra is making slow but steady progress with food service and consumer products, with a nine percent increase in the amount of milk being marketed that way compared to the same period last year. This still comprises only 23 percent of the total milk volume.

Nearly all of the progress in food service and consumer products relates to Asia, and most was in food service (up 17 percent) rather than consumer products (up 4 percent). Overall, Fonterra remains a commodity producer, with more than 75 percent of the milk still sold that way.

Fonterra has been making sound margins of 30 percent on its food service and consumer products. This is a good achievement during a period when the base cost of the milk has been rising. However, Fonterra has dropped its estimate of overall profit for the full year by five cents to a range of 45 to 55 cents per share. This represents an overall drop of about $80 million, compared to previous estimates made earlier in the year.

Fonterra’s plans at this stage are to pay dividends of 40 cents per share, with the first 20 cents being paid in April. This implies they will only be retaining about 10 cents per share, or somewhere around $160 million, for reinvestment.   As a comparison, FrieslandCampina, one of Fonterra’s big international competitor co-operatives, typically retains about 55 percent of profits for reinvestment.

This low retention demonstrates that the primary focus is on getting money out to farmers, many of whom are cash strapped after two preceding bad years, rather than building the co-op for the future.

One figure that could be regarded as surprising is that Fonterra has reduced its net interest-bearing debt by $793 million compared to the same time last year. How has this happened?

There would seem to be two parts to the answer.

First, at the end of January, Fonterra had $2.3 billion of payments due to its non-milk suppliers of goods and services, up $193 million since the same time last year. Readers may recall the controversy over the last year about Fonterra increasing the payment terms to its suppliers of goods and services, in some cases up to 90 days. Although these invoices waiting for payment are liabilities, they are not classed by Fonterra as debt because they incur no interest.  Hence, interest-bearing debt has dropped.

Second, Fonterra owed its farmers $2.4 billion at the end of January, which was $1.1 billion more than at the same time last year. These variations from year to year are part of the swings and roundabouts of the payments system comprising advance payments, top-ups and residuals. By the end of Fonterra’s financial year (31 July), most of the milk price will have been paid and so Fonterra’s debt will increase accordingly.

There is also a counteracting factor with more than $500 million worth of additional inventory on hand compared to the same time last year. Total inventory is valued at $4.5 billion. The extent to which the increase represents a valuation issue versus physical product remains unclear, but the overall level of $4.5 billion does suggest there is plenty of product waiting to be sold. It also helps explain why Fonterra has found it necessary to put more product onto the global dairy trade auctions during recent weeks.

Fonterra reports its gearing ratio as 46.6 percent. However, I have always found their unique method of calculation, using only interest-bearing debt, to be misleading. The simple gearing ratio of total liabilities to total assets is $12.2 billion divided by $19.3 billion, or 63%. Conversely, equity makes up only 37% of total assets. The ‘bottom line’ is that Fonterra has limited ability to borrow for further large-scale capital expenditure, and this will constrain the value-add journey.

One figure I always look for is to see how Fonterra’s China Farms are progressing. These last six months, production was 160 million litres compared to 100 million in the corresponding period last year. Despite the production increase, they have made a loss of $24 million before allowance for any interest or tax (EBIT). For the same period last year, the loss was $29 million.  On a per litre basis, the EBIT loss has dropped from 29 cents  to 15 cents, but something there is still not right.

The prospects for Fonterra’s investment in Chinese company Beingmate, and the associated joint venture out of Darnum Park in Australia, remain opaque. The publicly-listed Beingmate stock price is currently up about 15 percent on the same time last year, but still down about 22 percent from when Fonterra made its investment.

An interesting quirk in the notes to the accounts is that Fonterra re-classified some of its UHT milk (presumably from Waitoa) as ingredients. That suggests something went wrong and the milk was subsequently converted to powder. Fonterra is not the only company to have found the Chinese UHT market to be very challenging in the last six months.

The biggest Fonterra-related issue for its farmer suppliers over the next six months will be what happens to commodity prices. Currently, the prices for butter and anhydrous milk fat (AMF) are remarkably high, the price for cheese is modest, the price of whole-milk powder (WMP) is poor, and the price of skim-milk powder (SMP) is awful. But nothing ever stays the same for long in the commodity game.

*Keith Woodford is an independent consultant who holds honorary positions as Professor of Agri-Food Systems at Lincoln University and Senior Research Fellow at the Contemporary China Research Centre at Victoria University.  His articles are archived at http://keithwoodford.wordpress.com