Wednesday 11th July 2018
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Craigs Investment Partners, one of New Zealand's largest investment advisory firms, has dropped the Fonterra Shareholders' Fund from its New Zealand equities portfolio, saying its performance has been "lacklustre at best".
In a strategy note to clients, Craigs research analysts Mohandeep Singh and Roy Davidson said they had removed the Fonterra fund, which gives investors exposure to Fonterra Cooperative Group's earnings, and increased the weightings of milk marketer a2 Milk Co, transport and logistics firm Mainfreight and fast-food operator Restaurant Brands.
"The initial attraction of the Fonterra Shareholders’ Fund (FSF) was the ability to participate in the performance of the largest dairy exporter in the world. However, almost six years after the establishment of the FSF, performance has been lacklustre at best," the analysts said in their report. "Earnings and dividends have been highly volatile, gearing continues to trend higher and major capital investment has not translated into meaningful earnings growth. We no longer believe FSF meets our quality threshold and therefore remove it from our New Zealand equities portfolio."
Craigs isn't the only research house going dark on Fonterra after the country's dominant dairy company in May lowered its earnings guidance, cut its projected dividend payments to unitholders and raised its forecast farmgate milk price for the 2018 and 2019 seasons, saying rising global dairy prices are squeezing margins. Shortly after that announcement, First NZ Capital cut its rating on the Fonterra fund to 'underperform' from 'neutral', citing the inability of the dairy cooperative to convert capital investment into earnings growth, a poor track record in adding value, and questions over its ability to retain domestic suppliers.
Of the four analysts polled by Reuters, one rates the Fonterra units a 'buy,' one a 'hold', one a 'sell', and one a 'strong sell'. The units recently traded at $5.32, and have shed 18 percent of their value so far this year, contrasting with a 7.4 percent gain in the benchmark S&P/NZX 50 Index and 58 percent rally for Synlait Milk. While the Fonterra units appear to offer value at current levels, the weakness is unsurprising and they are unlikely to be re-rated until Fonterra can demonstrate an ability to grow its earnings in a sustainable manner, Craigs said.
"There are a number of key investment characteristics we look for when assessing the quality and appropriateness of any investment opportunity. These include a strong track record of earnings performance, capable management team, clearly articulated strategy, solid balance sheet and strong corporate governance," Craigs said. "Unfortunately, we do not believe that FSF ticks enough of our ‘quality’ boxes, and despite screening as relatively good value at current levels, we have elected to remove it from the New Zealand equities portfolio."
In particular, the Craigs analysts noted that Fonterra had volatile earnings, poor cash generation and limited transparency, faced differing incentives for farmers and unitholders as well as governance concerns, and was moving into a period of increased regulatory scrutiny with a review underway of the Dairy Industry Restructuring Act under which it operates, as well as an emerging view from the Commerce Commission that the cooperative had too low a risk estimate when calculating the cost of financing milk processing operations, resulting in it paying a higher milk price to farmers.
The analysts said that over the past eight years, Fonterra's capital expenditure has averaged $900 million, and despite over $400 million of growth capex per year, amount to a total of more than $3 billion, its earnings growth over this period has been just 4 percent per annum.
"Fonterra has not demonstrated a material uplift in its earnings profile despite meaningful capital expenditure," the Craigs report said.
Given Fonterra’s poor cash generation and high pay-out ratio of about 80 percent, debt has continued to increase, currently sitting at the upper end of the company's target range and expected to exceed the target range in 2018, the analysts said, noting forecast debt of $6 billion in 2018, and gearing of about 48 percent.
"With gearing at elevated levels, milk supply falling (loss of market share), and a lack of evidence that Fonterra has the ability to materially improve earnings, it is difficult to have conviction in a scenario where shareholders begin to see consistent growth in dividend and earnings over time," they said.
While Fonterra had invested to add value to its products and not simply process commodities, returns had not materially improved over the past eight years, despite relatively favourable drivers such as rising Asian demand, Craigs said, noting the cooperative's returns fell short of those generated by peers such as Synlait Milk, and were "disappointing".
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