Fonterra Cooperative Group needs to make it far clearer to farmers and other investors how its business model operates, says Deutsche Bank after the dairy exporter shored up a slump in half-year profits by intervening in the regulated price it pays for milk at the farm gate.
Deutsche Bank retains its 'sell' rating on Fonterra Shareholders Fund units, with a 12-month target price of $5.64. The units slipped 0.2 per cent by mid-afternoon to $6.08, and have fallen from a closing price of $6.15 on March 26, when the result for the six months to Jan. 31 was declared.
Fonterra posted a 53 per cent fall in first-half net profit to $217 million, a result that would have been far worse if the cooperative had not taken the unprecedented action last December of deciding to reduce the regulated Farm Gate Milk Price (FGMP) to farmer-shareholders by 70 cents per kilogram of milk solids.
That left $519 million on the Fonterra balance sheet that would otherwise have been paid out.
The Commerce Commission will need to approve the decision to pay a price at odds with the regulated manual used to calculate it.
The FGMP decision had highlighted not only the lack of transparency in Fonterra's forward earnings track, but also the difficulties created by Fonterra's existing business model, which limits its range of potential sources of new capital, wrote Arie Decker, a research analyst with Deutsche's local subsidiary, Craigs Investment Partners.
By lowering the FGMP, Fonterra had also created inequities between farmer-shareholders depending on their mix of "dry" and "wet" Fonterra shares, between farmers and sharemilkers, and had created windfall gains for competing producers, who were able to buy milk from Fonterra at lower prices.
"The action of retaining this equity - through adjustment to the FGMP - falls largely on Fonterra's farmer shareholders ... but has wider ramifications also," said Deutsche Bank.
The report acknowledges the decision to withhold part of the FGMP was "an extraordinary event" in response to the fact that demand for dried products such as whole milk powder drove up the FGMP, compromising the margins available from other products, such as cheese.
"Investors should arguably be encouraged by Fonterra's willingness to support earnings and the balance sheet by withholding payment from the FGMP, and in doing so, essentially raising equity from farmers - rather quietly," the research note says.
However, the FGMP was intended to create market certainty. The precedent created by December's action raised the potential, for example, for farmers to be paid higher than the FGMP in years when milk prices were low.
"This action adds an element of uncertainty (i.e., discretion) to a process that is supposed to be very transparent and encourage investment."
Fonterra was also "silent on alternatives - such as suspending dividends, a rights issue or other form of capital raise."
While Deutsche took comfort from the quality of Fonterra's senior management and its commitment to its stated strategy, the cooperative now needed to give much greater detail in fundamental areas.
Among these would be moving to a reporting framework that "can be used to measure performance against some of the key areas of investment being made, thereby supporting increased confidence in implementation as it occurs."
That would also require greater transparency about the amount of capital Fonterra requires for investment to implement known growth initiatives, and information on priorities.
A lack of farmer and equity investor confidence in further investing in Fonterra is the result of the current lack of detail, says Deutsche.
"This lack of desire on farmers' part to invest is a contributor to why Fonterra is currently having to provide options for farmers to grow their production without having to invest capital into the cooperative."