High debt and tight margins have forced Fonterra to pare back its farmgate milk price for the season just ended, and ditch plans for a second-half dividend in a bid to shore up its balance sheet.
In a statement to the NZX, Fonterra said it would cut its 2017-18 milk price forecast by 5c to $6.70 per kg, and won't pay farmers and investors a dividend for the second half of that financial year.
A 5c fall in the milk price it pays to farmers represents a $80 million benefit to Fonterra's earnings for the July 31 year.
Fonterra affirmed its guidance for normalised earnings per share, at 25-30 cents, but indicated that they wer likely to be at or slightly below that range.
The co-op anticipated that no dividends would be paid for the year, beyond the 10c per share interim payment made in April.
Farmgate milk prices are dictated by Fonterra's Milk Price Manual, which was how the original $6.75 forecast was arrived at.
But in just the second time in Fonterra's nearly two-decade history, the company has crimped the milk price - its biggest input cost - in order to benefit earnings.
ASB senior rural economist Nathan Penny said the moves collectively equated to a $150m-$225m hit to 2017-18 farm incomes.
Fonterra's chief financial officer, Marc Rivers, said the decision to revise the milk price was made as the company was finalising its accounts for the July 31 year.
"As we were going through it, we realised that we were coming out at the lower end, or even below, the earnings range that we gave," he said.
Margin pressure was evident across the co-op's global ingredients business, and its consumer and food service businesses, he said.
He said high milk prices made it difficult for Fonterra to capture attractive margins over the fiscal year.
Rivers said the revisions were aimed at curtailing Fonterra's high debt levels, relative to the co-op's earnings.
At the company's first-half result in May, Fonterra said its year-end gearing ratio was likely to be above the 40-45 per cent target range by the end of the 2017-18 financial year.
It said then that the ratio was expected to return to the range over 2018-19.
"Really, it's about having the right level of earnings to sustain the debt level that we have, and to sustain the investment that we need to continue to grow the business," Rivers told the Herald.
S&P Global Ratings said its ratings on Fonterra were not immediately affected by the announcement, but the agency sounded a warning if Fonterra's finances did not improve soon.
"We expect Fonterra's debt to EBITDA will be materially outside our downward threshold of four times for fiscal 2018," it said.
"The rating will come under immediate downward rating pressure unless we believe the group's credit metrics will rapidly improve over fiscal 2019."
A lower dividend and reduced farmgate milk price indicated the group was willing to actively manage its debt levels, S&P said.
As well as tight margins, Fonterra's upcoming result will be hit by the already-announced 105 million euro settlement with Danone and a $405m impairment charge on its investment in Chinese company Beingmate.
Harbour Asset Management senior analyst Oyvinn Rimer said Fonterra's deviation from the Millk Price Manual could have implications for the upcoming review of the legislation governing the co-op.
"You have to wonder as well, whether the comments around balance sheet pressures might trigger a bigger review of the capital structure of the company," he said.
Fonterra's new chairman, John Monaghan, said the revisions had been made with a strong balance sheet in mind.
"It is important for our co-operative to have a strong balance sheet and, as we indicated in May, the higher milk price, which is good for our farmers, has put pressure on Fonterra's earnings, and therefore our balance sheet in a year which was already challenging due to the payment to Danone and the impairment of the co-operative's Beingmate investment," he said.
"You never want to have to reduce the milk price at the season's end, but it is the right thing to do and $6.70 remains a strong milk price," said Monaghan.
Fonterra's NZX-listed units, which allow investors outside the co-op access to its dividend flow, weakened immediately after the news and by late afternoon were down 12c at $4.99.
ASB's Penny said it looked like the $7.00 forecast for the current 2018-19 year was also set for a downward revision - perhaps to $6.50.
The co-operative's full-year results are due on September 13.