Barber’s Wire: Fonterra’s disappointing performance

Allan BarberFonterra’s interim result announcement contains confirmation of the farmgate milk price forecast of $4.70, but a reduction in the added value dividend, notes meat industry commentator Allan Barber. He says it asks some fundamental questions about calls for the meat industry to adopt a Fonterra-like structure.

The steady milk payout forecast was anticipated, although Global Dairy Trade (GDT) auction results have so far failed to achieve the US$3,500 per tonne average which is estimated to be the minimum needed to underpin the payout. The higher volume being released for auction GDT and likely milk production by competitors such as American and European farmers may actually increase the risk of under-achieving the forecast end of year payout.

But the 5c lower dividend was a bit of a shock, because expectations were for a higher dividend based on lower milk prices. Although this was the case in China and Asia, the milk price in Australia and Chile was actually higher than the previous year and squeezed the margin on value added production. The dividend forecast of 30 cents is the same as it was in 2011, so there has been no improvement at all over the past four years.

The half year result was seriously underwhelming because there were several other factors which were unfavourable, including debt of $1.76 billion or 32.8 percent higher than 12 months earlier, NTA of $1.92 compared with the current share price of $5.50, foreign exchange losses, losses on farming and $264 million of livestock on the balance sheet.

Fonterra’s big problem is its status as a commodity producer. Its much-touted role as a supplier of ingredients to major manufacturers of value-added products and for food service applications does not appear to have made much difference to its earnings. Earnings before interest and taxes (EBIT) for the ingredients division was only $7 million higher than 2013 with profits from non-powder products being largely offset by losses on the disposal of powder at a ‘negative gross margin’, otherwise known as a loss.

Comparisons with global dairy companies such as Danone are revealing and somewhat depressing because in spite of its size (Fonterra is the second largest milk processor in the world) it is way behind those companies in revenue generation from what it processes.

As a commentator on and defender of the meat industry, I have found it hard to argue against the success of Fonterra and the dairy industry in recent years. However, this year’s performance asks some fundamental questions about the constant call for the meat industry to adopt a Fonterra-like industry structure.

Cooperative ownership poses a conflict between the dairy farmers’ expectation of the maximum payout possible and the company’s need to invest in its value added production to lift itself out of the commodity trap. The distinction between farmer shares and shareholder’s fund units may allow farmers to trade shares and outside investors to invest in Fonterra’s business, thus bringing in external capital. But it doesn’t avoid the inherent conflict between cooperative members’ expectations and external investors’ desire for returns on their investment.

The last two seasons have graphically illustrated the commodity nature of the dairy business which Fonterra’s structure has been powerless to avoid. The lifting of the cap on milk production quotas in the EU on 1 April will inevitably result in an increase in global production which raises the question of what impact this will have on dairy trade and price levels.

While nobody denies the need for meat industry restructuring, perhaps there will now be a more realistic assessment of what will and what won’t work.

Allan Barber is a meat industry commentator. He has his own blog Barber’s Meaty Issues and can be contacted by emailing him at allan@barberstrategic.co.nz.

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