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First NZ lifts Fonterra Fund to neutral; ComCom reiterates doubts on milk price asset beta

Friday 14th September 2018

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First New Zealand Capital lifted its rating on the Fonterra Shareholders' Fund to 'neutral' from 'underperform' and said the first signs of a change in approach look encouraging.

Fonterra's full-year loss was disappointing but "with the recent changes in board chair (with annual election of three directors coming up) and CEO (interim) it was encouraging to see FSF take no time in fronting up and acknowledging the issues," analyst Arie Dekker said.

On Thursday, the dairy giant said it is taking stock of its business, prioritising a return on capital and aiming to set realistic forecasts as it looks to turn around the business. It reported a loss attributable to shareholders of $221 million in the year to July 31 versus a profit of $734 million the year before. 

While it is still "rhetoric at this point", Dekker said it was positive that Fonterra sees the need to address transparency and take a hard look at its current positions. The firm also appears willing to "ultimately deal with the big issues" such as lifting performance, retaining farmers and ensuring it focuses on the core NZ co-op and processing assets. Any extension beyond that needs to be matched with capital, capability and openness, he said. 

"We are cautious about what more light on the business will show (may highlight areas of value downside) but see stricter capital discipline and opportunities to streamline as removing barriers to investment and having potential upside," he added. 

Dekker also noted the issues are "complex and will not be easily solved." He said there would be potential benefits to simplifying or reducing what Fonterra does, or bringing in capital and capability to support businesses away from its core.

"FSF is constrained for capital but has a broad range of international businesses which need capital to grow," he said.

He also said Fonterra faces challenges in retaining farmers in an environment where NZ milk price growth is benign and independent processors are successfully adding incremental capacity.

Dekker said that it is likely that Fonterra will have to provide greater flexibility to farmers on the capital they have invested as other companies - such as Synlait and a2 Milk - have demonstrated their ability to match FSF on milk payments while providing farmers with that flexibility on capital. 

Units in the Fonterra Shareholders Fund last traded down 0.4 percent at $4.99 and have fallen 22 percent so far this year. Dekker lowered his 12-month target price to $5.09 from $5.12. 

Separately, the Commerce Commission reiterated its view that the "asset beta"  Fonterra uses to determine the farmgate milk price is "unlikely to be practically feasible". 

Under the Dairy Industry Restructuring Act 2001 (Dira), the commission conducts an annual review of the milk price 'manual' that Fonterra uses to calculate its base milk price each season.

The regime was put in place when Fonterra was created because there wasn't a competitive market for the purchase of farmers’ milk. In this year's review, the regulator has concluded that - except for the asset beta - the manual is largely consistent with its statutory purpose.

The commision said an efficient milk processor with a similar risk exposure to the notional producer is unlikely to have an asset beta as low as Fonterra’s estimate of 0.38. While on balance it felt such as estimate was unlikely to be practically feasible, "we do not consider that we are able to be more conclusive." 

The asset beta is used in calculating the estimated cost of capital of financing milk processing operations, and in turn affects the milk price Fonterra pays its farmers. It reflects the extent to which the assets associated with processing milk are more or less risky than the stock market as a whole. A higher asset beta would put downward pressure on the milk price Fonterra pays its farmers.

The commission also noted that changes to the milk price - once the season is underway - "weaken the incentive on Fonterra to be efficient." On Aug. 10, Fonterra reduced its milk price to $6.70 per kilogram of milk solids from $6.75. 

It also called on Fonterra to provide more transparency in the information it provides about sales outside the Global Dairy Trade platform, as it sells a large proportion of products outside the platform.

While it has met some commitments, the commission wants Fonterra to publish quarterly forecasts of the cents per kgMS impact from the inclusion of off-GDT sales of whole milk powder, skim milk powder and anhydrous milkfat, in the milk price calculation. 

The commission also noted it is the third consecutive season of milk volume decline and said the trend in milk volume collected by Fonterra is something it will monitor ahead of the review of the 2018/19 calculation. 

It will publish the draft report on the 2018/19 manual in October. Assessing how static or declining volumes are factored into the base milk price calculation will be a "key consideration" in next season’s review, it said. 

It noted the government's review of Dira won't impact the 2018/19 manual review as the terms of reference indicate any implementation of outcomes will take place in 2019. 

(BusinessDesk)

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