Fonterra Cooperative Group needs to present a coherent investment case for the surviving business challenged by volatile earnings and limited New Zealand milk supply growth, according to Jarden analysts.

Last month, Fonterra added two wholly-owned farm-hubs in China and its stake in the Dairy Partners Americas (DPA) Brazil joint venture to the asset sale programme it has embarked on in an effort to trim $800 million of debt from its balance sheet.

Jarden research analyst Arie Dekker — who has been critical of Fonterra's unsuccessful strategies — resumed coverage of the Fonterra Shareholders' Fund after a blackout period while the investment banking arm of the firm was engaged in the sale programme.

Dekker said the milk processor needs to provide a detailed outline of the capital demands for the surviving businesses, something he says has been lacking in the past.


"Again, the lack of discipline from Fonterra on disclosure in this area has cost the co-operative dearly in the last five years, with insufficient scrutiny on investment outside of a clearly outlined envelope and little accountability on the outcomes from investment," he said in a note to clients.

"Fonterra has [realised] that an essentially closed-off (to any meaningful outside investment) NZ-farmer-funded co-operative is not well placed to pursue a strategy premised on volume growth and milk pools in international markets," Dekker said.

However, "we would be surprised to see a willingness to bring in outside capital into Fonterra's core business, and we see farmers wanting to retain control over the vertical chain from farm to customer in the core NZ ingredients business — a business that still provides it with opportunities to add value to NZ milk."

As a result, a strong New Zealand co-operative needs to remain a paramount objective, and Fonterra needs a stronger platform to compete for domestic milk, he said.

"We feel Fonterra will stop short of shrinking the co-operative down to a milk collection business and farmers will want to see the core ingredients business retained under co-operative ownership and control."

Dekker said five years of poor investment decisions and 20 years of limited retained earnings have seen Fonterra forced to address the balance sheet through asset sales.

"As Fonterra looks to shrink the capital farmers have invested in Fonterra away from the core co-operative requirements, we expect substantial debt reduction which may ultimately pave the way for some capital return to farmers and a shrinking of the ... equity capital base for competitive reasons," he said.

Against that backdrop, Fonterra needs to be disciplined in its allocation of capital, and Dekker said the co-operative has an opportunity to pause any major capital spending initiative over the next two to three years.


However, Fonterra needs to position itself positively in those areas it chooses to focus on, with advanced nutrition and foods services at the core.

Fonterra is set to provide the market with a full update on its strategy and direction at its full-year result in September. Dekker expects Fonterra to outline areas it will focus on, and areas that may be exited.

Regarding other possible divestments, Dekker said Fonterra has had issues effectively returning cash flow from Soprole in Chile back to New Zealand, which will get more challenging as Fonterra scales back its investment in the region.

"We ... see little reason for Fonterra to hold it for diversity reasons if it can get a fair price for the business."

Fonterra's intention to retain a significant and broad business in Greater China could see strategic rationale for holding on to the China Farms, although it would need to be very clear on any further investment required in downstream assets and the returns from doing so, he said.

Dekker expects to see some visibility on the allocation of costs. "We think it is important for the costs associated with supporting the co-operative to be clearly identified."

Jarden reinstated its "neutral" rating on the stock and set a 12-month target price of $4.39. Fonterra Shareholders' Fund units were recently at $3.91, down 0.3 per cent. The stock, which gives outside investors access to Fonterra's earnings stream, hit a record low $3.89 on Friday, and has slumped almost 16 per cent this year.