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Fitch gives Fonterra thumbs up over unchanged farmgate payout, dividend cut

Wednesday 18th December 2013

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Fitch Ratings has praised Fonterra Cooperative Group's decision to hold the forecast payout to farmers and slashing its dividend by two-thirds amid a growing gap in prices between milk powders and its cheese and casein products.

The Auckland-based company's decision is "characteristic of the fiscal discipline that underscores its credit rating," Fitch said in a statement. Fonterra has an AA rating. Earlier this month the cooperative surprised analysts by holding the forecast payout for this season at a record $8.30 per kilogram of milk solids and cutting its expected dividend to 10 cents from 32 cents.

The board used its discretionary power to keep the milk price unchanged, as the rising price of milk powder meant it should have hiked it to $9/kgMS under the regulated rules of its Farmgate Milk Price Manual.

"Fonterra has used its leadership position in the New Zealand dairy industry to regulate production and protect the long-term fortunes of farmers," Fitch analysts Johann Kenny and Vicky Melbourne said in a note. "The lower milk price will act as a deflator to New Zealand milk production and protect the industry from adding capacity on cyclical extremes."

Prices for rennet casein rose 7.3 percent and cheese 1 percent in today's Fonterra-run GlobalDairyTrade auction, while whole milk powder prices fell 1.5 percent. About 70 percent of Fonterra's production capacity is for milk powder, with the rest of its plant making casein and cheese.

Units in the Fonterra Shareholders' Fund slumped below their $5.50 offer price for the first time after the dividend was cut, and have since come back closing at $5.78 yesterday.

At the time, Australian fund manager Perpetual, the fund's biggest unitholder, backed Fonterra's decision saying it supports the dairy group's long term strategy and was prepared to wear short-term pain.

Fitch's Kenny and Melbourne today said Fonterra's bigger raw milk collection and a spike in prices for global milk powder without the same gains for non-powder products led to bigger gaps between the theoretical and realised returns the dairy company can make.

"The decoupling of returns has the potential to reduce the free cash flow of the cooperative by allowing the inflation of the cost of its inputs," they said.

By holding the farmgate price and cutting the dividend, Fonterra "maintains financial headroom under Fitch's negative rating guideline of debt to pre-subordination EBITDA below 2.5x on a sustained and projected basis while also ensuring that the cooperative remains free cash flow positive and financially flexible," they said.

The lower farmgate price will also reduce incentives for farmers to produce more than the "long-run optimal level of milk," which should support deleveraging of their balance sheets.

Last month, the Reserve Bank reiterated earlier warnings that high levels of agricultural debt, primarily in dairy, posed a threat to the nation's financial stability if farmers chose to lift their borrowing on the assumption high commodity prices will persist.

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