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Current as of 26/10/16 07:39PM NZST
Jamie Gray is a business reporter for the NZ Herald

The Fonterra paradox: Milk prices down, profits up

Fonterra looks set to report strong annual earnings at its result, due this month.
Fonterra looks set to report strong annual earnings at its result, due this month.

Dairy farmers have endured one of their worst ever years but Fonterra is set to report one of its best yet.

It's the Fonterra paradox.

In times of low milk prices Fonterra's financial performance generally lifts, and when milk prices are high - Fonterra's earnings take a hit.

For Fonterra, a weak milk price means low input costs, giving its manufacturing and dividend-paying side a leg up through improved margins.

Better outlook for dairy farmers
Fonterra result: Eight key things to look for

The co-operative's 10,500 or so farmers are not insulated from big shifts in commodities prices, but a big dividend can help.

Sharply lower input costs over the 2015/16 year and big gains on the value-added side of its business look set to translate into one of Fonterra's strongest financial results - perhaps the strongest - when it reports on September 22.

For the year to July 31, the guidance from the co-operative is for earnings per share of 45c to 55c per share. That translates to net profit after tax of between $720 million and $900m, compared with $506m in 2014/15.

Share market analysts see the result coming in at a record, or close to it, in a range of $783m to $887m, but they say that given its size and scale, the co-op could do better.

After a couple of rough years, which have been marked by low milk prices and a higher-than-normal capital expenditure, the outlook is improving for Fonterra and its farmer shareholders.

With a 2015/16 milk price of $3.90/kg -- the lowest in 10 years -- and a 40c dividend, the total payout is expected to come to $4.30 kg - cold comfort considering Dairy NZ's break even point estimate sits at $5.05/kg.

To soften the impact, Fonterra paid out its final dividend early and in two instalments and last year offered interest-free loans - to the tune of $383m.

The prospects for the current year are looking better, thanks in no small part to an explosive run higher in world dairy prices over the last couple of months and Fonterra's progress in shunting more milk into its value-added businesses.

Whole milk powder prices - which have the greatest bearing on Fonterra's milk price - have rallied by 34 per cent since July to US$2793 a tonne at the last auction on September 7.

Last month, co-operative upgraded its 2016/17 farmgate milk price forecast by 50c to $4.75 per kg and some economists expect to see upward revisions to the milk price - perhaps to as high as $6 a kg - if current trends persist.

The cause of all the pain - world overproduction - appears to be in retreat and the market is showing signs of turning.

As it stands, with an earnings per share range of 50c to 60c, the total payout available to farmers in the current season is forecast to be $5.25 to $5.35/kg.

After a couple of rough years the outlook is improving for Fonterra and its farmer shareholders. Photo / Bloomberg
After a couple of rough years the outlook is improving for Fonterra and its farmer shareholders. Photo / Bloomberg

Harbour Asset Management research analyst Oyvinn Rimer said the biggest influence on Fonterra's result would be the lower cost of inputs - milk - which would give the co-operative a "handsome" margin.

Aside from the extreme volatility the commodities market, much has happened over the year:

Australia cuts

Fonterra has taken a big knife to its loss-making Australian operation - selling assets and reinvesting in new ones.

A milk price reduction from Fonterra's opposite number in Australia, Murray Goulburn, has altered the competitive landscape across the Tasman to Fonterra's advantage.

"The right management decisions seem to have been implemented, so that might bring some earnings upside as well," Rimer said. Fonterra's Australian operation is likely be in back in profit, now that the co-operative is paying a more realistic milk price.

Debt reduction

Over the last three years, Fonterra has spent about $2.1 billion on new plant and $755m on a minority stake in China's Beingmate.

The spend-up didn't go unnoticed by ratings agency, Standard & Poor's, which last year cut its long-term credit rating for Fonterra to A minus while its short-term rating was lowered to A-2 from A-1. Debt reduction will be important part of the result.

This side of the ledger has highlighted the fact that Fonterra, as is common with all co-operatives, faces capital constraints. "It's challenging to be a world-leading company in brands and value add when you have that kind of capital structure," Rimer said.

The China challenge

There have been some real challenges in China. Beingmate's performance has been disappointing.

The co-operative's 18.8 per cent-owned partner in China, Beingmate Baby & Child, anticipates a first half loss of up to 230 million yuan ($48.7m).

The Shenzhen-listed company blamed the downgrade on a fake infant formula scandal, as well as "industry disorder" in the fast-changing Chinese baby-milk sector and new regulations.

The Chinese infant formula market was in a state of "flux" and will take time to settle. On a broader front, the better news for Fonterra is that China - the world's biggest dairy importer - has re-emerged as a significant buyer after maintaining a low profile over the last two seasons.

Governance structure

Fonterra has its detractors, and for many the decision in 2001 to merge the Dairy Board, New Zealand Dairy Group and Kiwi Co-operative Dairies into one has yet to live up to its promise.

In its defence, it remains a relatively new enterprise, compared to its well-established rivals the Swiss multinational Nestle and France's Danone with their 100-year plus track records.

ASB Bank rural economist Nathan Penny said this month's result was unlikely throw any light on whether the current structure was right.

"Will we get a definitive answer at the results that everything is fine and well? No, I don't think so," Penny said.

"We will get one more tick, but several years of ticks need to come before we are confident."

The Nestles and the Danones of this world have got massive balance sheets and a much longer history than their Kiwi competitor.

"Fonterra has a much shorter history and is a smaller consumer business compared to those behemoths - so I think that patience is a virtue in this case."

- NZ Herald

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