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Milking Fonterra For All It's Worth

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Investors should be looking at Fonterra Shareholders’ Fund as the BHP of milk, well-placed to supply growing global demand for dairy products, particularly from the emerging middle-class consumers of Asia.

If you can’t beat ‘em, should you join ‘em?

That is the question that Australian investors who would like a global agribusiness exposure, tapped into China, must be asking themselves.

Although Australia’s mineral exports to China dominate that market, on ‘soft’ commodities, we have dropped the ball.

This week, the Global Food Forum, put on by The Australian newspaper and Visy in Sydney, digested the unpalatable news that Australia’s share of China’s food imports has more than halved over the last two decades, to just 3.3% - lost to more aggressive and better-organised competitors.

The Australian Food and Grocery Council told the forum that Australia’s poor food export performance in China was mirrored in “the other growing economies to our north.”

Over the same period, New Zealand - riding a dairy products boom and assisted by a free trade agreement (FTA) it secured with China in 2008 – has increased its share of China’s food imports from less than 2% to 8%. New Zealand is the Saudi Arabia of milk.

And when you're talking about New Zealand’s food export success story, you’re talking about Fonterra, the world’s largest dairy company.

Fonterra was formed in 2001 when the farmer owners of New Zealand’s two leading dairy co-operatives, the New Zealand Co-operative Dairy Company and Kiwi Co-operative Dairies, voted to merge their co-operatives and integrate them with the industry’s separate marketing arm, The New Zealand Dairy Board.

The company exports about 98% of the milk it processes in New Zealand and is responsible for more than one-third of international dairy trade. Fonterra has built up an international brand portfolio across its key markets in Australasia, South East Asia, the Middle East, Latin America and, increasingly, China.

In Australia Fonterra’s major brands are Mainland, Riverina Fresh, Western Star, CalciYum, Bega (licensed from Bega Cheese Limited, of which Fonterra owns 9.1%), Perfect Italiano, and Nestlé Ski in Australia. Fonterra operates ten manufacturing plants in Australia and processes about 1.8 million litres of milk a year, producing 300,000 tonnes of dairy products. It is the second largest milk processor in Australia, behind Murray-Goulburn.

Most of the milk Fonterra processes goes into manufacturing bulk dairy ingredients, such as milk powders, cheese and a range of dairy-based fats and proteins, which are sold to domestic and international customers. In addition to its consumer brand portfolio, Fonterra also sells products straight into the “foodservice” industry, which comprises restaurants, cafes, hotels and catering companies.

Fonterra is owned by more than 11,000 New Zealand farmer shareholders, but in 2012 the company decided to expand its capital base by establishing the Fonterra Shareholders’ Fund (FSF), which it listed on the New Zealand Stock Exchange (NZX) and Australian Securities Exchange (ASX).

FSF allows outside investors - who are not allowed to hold shares in Fonterra - to invest in the company. FSF units are not Fonterra shares: they give their holders access to the ‘economic rights’ that they would receive if they were allowed to own Fonterra shares. But FSF holders do not have voting rights in the company. FSF unit holders earn returns based on the financial performance of Fonterra: distributions made to unit holders reflect the dividends paid on Fonterra shares.

FSF gives Australian investors the opportunity to invest in something they don’t have - a global food leader.

But it is not all milk and honey. There have been a few recent problems for FSF holders.

In August 2013, Fonterra was forced to mount a global recall of some whey-protein concentrate products, which the company said might contain harmful botulism. The recall turned into the biggest food safety scare in New Zealand history. Subsequent testing indicated that the organism was not harmful, but the recall could not help but damage New Zealand’s reputation as a safe supplier of food: it was particularly damaging in China. (Fonterra is being sued by French food giant Danone as a result of the August contamination scare.)

Then, in December, Fonterra was forced to slash its dividend payment in response to what it called “abnormal circumstances," brought about by surging Chinese demand for milk powders, and a corresponding spike in prices. That might sound like a pleasant situation for Fonterra, but for the fact that the price it pays dairy farmers for their milk is based on powder prices.

While about 70% of Fonterra's production is milk powders, the rest of its product mix - which did not see prices rise - was whacked by an inflated cost of milk, which could not be passed on to customers. Fonterra’s margins in products like cheese and casein - usually higher-value products - were hit. Fonterra is required to base the farmgate price for its milk on powder prices, and re-set this every quarter.

Had it conformed to the theoretical calculation formula, the rising powder price would have pushed Fonterra’s farmgate milk price to NZ$9 a kilogram of milk solids (kg/MS), at which the company says it would “not be profitable.” Fonterra decided to keep the 2013-14 farmgate milk price at NZ$8.30 a kg/MS – still a record. (This was lifted to NZ$8.65 a kg/MS in February 2014: in one hit, Fonterra will inject NZ$14 billion (A$13.1 billion) into the New Zealand economy.)

Fonterra said the price gap between powder and non-powder prices had a “negative impact” of $NZ800 million. The company lowered its forecast FY14 earnings before interest and tax (EBIT) from NZ$1 billion to NZ$500 million-$600 million, and cut its FY14 dividend forecast from NZ32 cents to NZ10 cents, to “protect its balance sheet.”

This morning, Fonterra Shareholders’ Fund revealed the full extent of its problems in its interim result. Revenue was a good story, up 21% to NZ$11.4 billion (A$10.7 billion), but interim net profit slumped 53% to NZ$217 million (A$203.4 million) on the back of a record high payout to farmers.

FSF paid an interim dividend of NZ5 cents a share, down from NZ16 cents a year ago. The Fund is expected to pay a full-year FY14 dividend of NZ10 cents a share, barely one-third of the FY13 payout.

Fonterra collected a record supply of milk from its farmer shareholders in the peak October-November period, while overall supplies for the seasons were up 4%. While it processed as much of this milk into the higher-returning milk powder products as it could, one-quarter of production was trapped in cheese and casein products that lost money.

Fonterra said it would accelerate its capital investment plans to improve its production capacity and flexibility, so that it can take better advantage of higher milk prices in future. This will result in additional capital expenditure of NZ$400 million–$500 million (A$375 million–$470 million) over the next three to four years.

Meanwhile, full-year net profit is expected to fall by more than two-thirds from last year’s NZ$751 million. FSF has a bit of work to do to regain its mojo. The Fund is expected to do much better in FY15, but it will not be until FY16 that reported net profit and dividend per share exceed those achieved in FY13.

At $5.84 on the ASX, FSF is trading on a prospective dividend yield (using the current A$/NZ$ exchange rate) of 1.6%. Next year’s prospective yield does not look too alluring either, at 3.4%, using today’s exchange rate. But by FY16, 6% is starting to look a bit more like it.

In the meantime, investors should be looking at Fonterra Shareholders’ Fund as the BHP of milk, well-placed to supply growing global demand for dairy products, particularly from the emerging middle-class consumers of Asia. Sure, the Fund has not set the world on fire: Australian holders are barely 10% to the good since the 2012 listing. The parent company has a way to go to clear up its business-mix and revenue-streams problems, and like BHP, it operates in a commodity price-driven business, but Fonterra Shareholders’ Fund has some pretty sound fundamentals behind its long-term growth prospects.

View More Articles By James Dunn

James was founding editor of Shares magazine, and oversaw one of the most successful magazine launches in Australia. He has also written for BRW, Personal Investor, The Age and Management Today, and was subsequently personal investment editor at The Australian and editor of financial website, investorweb.com.au



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