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Fonterra units cut to 'sell'at Craigs on cost squeeze, earnings disconnect

Tuesday 10th December 2013

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Units of Fonterra Shareholders' Fund were cut to 'sell' from 'hold' by brokerage Craigs Investment Partners because of the ongoing squeeze of rising raw material costs and weaker prices for value-added products such as casein and cheese.

Fonterra's 2014 normalised earnings before interest and tax may fall 24 percent to $764 million, Craigs analyst Arie Dekker said in a report. The brokerage, which initiated coverage of New Zealand's largest company in January, expects EBIT to grow longer term, reaching $1.6 billion in full-year 2018.

Last month, Auckland-based Fonterra took a $157 million provision against inventory of specialised ingredients and branded consumer products produced by its largest NZ Milk Products division because rising input costs had squeezed margins.

NZ Milk's sales of reference commodities such as whole milk powder, used to calculate the farmgate milk price, jumped 62 percent to $5.97 billion in the first three months of the year, while non-reference products including casein and cheese rose 22 percent to $6.93 billion. In some cases product had been sold below cost, it said.

Despite Fonterra's position as the largest producer and exporter of traded dairy commodities, as well as favourable dairy demand, the strength of farmer-owned shares and established global positions in value-added products, "translating that and a compelling growth strategy into real earnings growth remains challenging," Dekker said.

He also noted "the disconnect between investment and demonstrated earnings growth."

Since Fonterra announced its provision to write down inventory last month, the gap between cheese and whole milk powder had closed a little "but the pressure continues," he said.

The strength of prices of reference commodities may be underlined this week, with economists betting Fonterra will hike its forecast farmgate milk price to as high as a record $8.70 a kilogram of milk solids for 2014.

Dekker said Fonterra's plant configuration and lack of surplus capacity meant it is "unable to avoid producing product even if that product is expected to realise a loss."

In mature markets like New Zealand, where Fonterra has strong brands, it has the most ability to pass on price increases though it has less flexibility to do so in key Asian markets, he said.

Dekker's biggest earnings downgrade is for NZ Milk, where EBIT is forecast to plunge 41 percent to $290 million. He made no change to his ANZ forecast, steady at $142 million as Fonterra works to turn around its most troubled business.

For Asia, Africa and the Middle East, earnings are forecast to drop 25 percent to $180 million while for Latin America he maintained his existing forecast for EBIT growth of 12 percent to $153 million.

Fonterra units declined 1.3 percent to $6.15 on the NZX today and have fallen 11 percent this year. Dekker cut his 12-month price target to $5.51 from $6.66.

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