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First NZ Capital grows dark on Fonterra as capital spend fails to spur earnings

Monday 28th May 2018

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First NZ Capital has cut its rating on Fonterra Shareholders' Fund units as the dairy cooperative's seeming inability to convert capital investment into earnings growth and poor track record in adding value raises questions over its ability to retain domestic suppliers. 

Analyst Arie Dekker lowered his rating on the units, which give investors exposure to Fonterra Cooperative Group's earnings, to 'underperform' from neutral, and sliced 17 percent from his target price to $5.09. The units recently rose 0.9 percent to $5.38. 

The research house said its key concerns about Fonterra are the inconsistency between the growth strategy and capital structure which creates an inability to raise equity from farmers or retain earnings; poor track record in adding value from what investment has been made; and an inability to move earnings over 10 years. On top of that, earnings are inherently volatile and neither Fonterra nor the market can predict them.

With "FSF consistently investing $800 million-plus with significant growth capex (and indicating it will continue to) our forecasts have factored in earnings growth that has been elusive and had us questioning whether we have been too positive despite a cautious overall bias," said Dekker in a note to clients. 

He said there is also a range of mounting concerns including what appears to be a negative bias in ingredients earnings; evidence that value-add businesses in Asia, Oceania and China have earnings inversely related to that New Zealand milk price; an increasingly poor proposition for FSF farmers to hold shares which could see FSF continue to lose share to new independent capacity; and mounting concerns about FSF's access to milk in New Zealand with environmental concerns impacting the milk growth outlook. 

Fonterra last week cut its projected dividend payments to a range of 10-to-15 cents per share from a previous forecast of 25-to-30 cents as increased global dairy prices pushed up what it planned to pay to its farmer shareholders. 

FNZC's Dekker said Fonterra has steadily lost market share to independent processors since it was formed and while this has generally been slow, "increasingly the investment proposition in FSF looks like it might be undermining FSF’s ability to retain critical mass in New Zealand milk supply — something that is particularly worrying for FSF if milk supply growth is harder to come by." 

That loss of market share in the South Island triggered a review of the law governing the regulated milk price, and while the previous administration had planned to relax some of the provisions imposed on Fonterra, the new government is holding a deeper investigation into the sector to ensure it's fit for purpose and operating in the long-term interests of Kiwi consumers. 

Dekker said Fonterra has invested significantly in capacity in New Zealand, flexibility in ingredients and new capacity for food services into Asia, but has an increasingly stagnant outlook for milk supply. In the current season, Fonterra's key New Zealand milk supply will be broadly in line with where it sat in 2013 despite the significant investment in capacity. 

He also said Fonterra's poor performance, with variable earnings and low dividends in three of the last six years, makes it increasingly susceptible to market share loss. 

"If FSF was performing better, owning FSF shares might be viewed positively — it is increasingly difficult to see being part of the cooperative positively, creating more opportunity for independent processors in a market environment where milk growth outlook is likely to be more muted," Dekker said. 

He called on the board to address several key questions including whether the growth strategy and the capital structure are consistent, whether Fonterra is too complex to manage and whether the milk price structure is undermining the wider business.

Former Fonterra director Harry Bayliss last week called for John Wilson to relinquish the chair over the cooperative's continued underperformance. 

Dekker said FNZC is reviewing its forecasts but has reduced its forecast for FY18 and FY19 earnings and reduced its long-term outlook for Fonterra's New Zealand milk supply growth from 1.5 percent to 0.5 percent.

FNZC expects FY18 earnings before interest and tax to be $925 million in the year ending July 31, down from its prior forecast of $1.23 billion. In the following financial year, the research house predicts ebit to be $1.4 billion versus a prior forecast of $1.6 billion.


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