Fonterra Needs To Simplify Its Business

This story features FONTERRA SHAREHOLDERS FUND. For more info SHARE ANALYSIS: FSF

Brokers suggest Fonterra needs to start delivering on earnings expectations to rebuild confidence, while the strategic review is welcomed as an opportunity to simplify the business.

-Late-season increases in farmgate milk and fat prices did not fall back as expected
-Difficult to forecast earnings because of complexity and limited control of costs
-Capital expenditure being reduced to pull gearing back to target
 

By Eva Brocklehurst

While the consumer and food services business has been a success in China, a higher NZ milk price has impacted on momentum for Fonterra Shareholders Fund ((FSF)). Fonterra needs to start delivering on earnings expectations and rebuilding confidence, brokers suggest. FY18 results were below guidance while the outlook for FY19 shows strong growth from a low base.

A larger proportion of volumes went into higher value product in FY18 and this has increased to 45% from 42%. Yet despite the move over the last four years into higher value product, brokers note Fonterra has not yet delivered a sustainable increase in margins.

Gross profit was slightly ahead of UBS estimates, as a weaker NZ price premium and international sales were countered by lower costs through adjusting the milk price. Earnings are expected to increase substantially in FY20, led by a broad recovery in margins and a lower tax rate.

The company has conceded overly optimistic FY18 forecasts, given late-season increases in farmgate milk and fat prices did not reverse as expected. Performance in China nevertheless continues to be strong and the consumer business broke even this year, two years ahead of schedule.

Credit Suisse believes the FY18 result, while disappointing, was well telegraphed at the May and August downgrades. The broker considers guidance is now more conservative and that is a positive, upgrading to Neutral from Underperform.

Yet the company's ability to forecast earnings is made difficult by the complexity of the businesses and limited control on key input costs. Because of this, Credit Suisse suggests serious consideration should be given to simplification around core competencies and capital capacity.

The main concern the broker has centres on the net returns associated with investing in value-added capacity in New Zealand in the absence of supply growth in milk.

Strategic Review

A strategic review of operations is underway, starting with the Beingmate investment, but the company will not be looking at the capital structure or other complex issues such as milk price calculations.

Credit Suisse is encouraged by new management's recognition of the poor performance over the last 6-7 years and the stricter discipline around cost controls and more respect for invested capital that appears to be forthcoming.

Yet, it is time to pick key areas and ensure that the business is well-placed to deliver on the core requirements of the farmer shareholder base, the broker asserts. Some progress is expected over the next 12 months as well confirmation of a permanent CEO.

UBS retains a Neutral rating and cites a long list of issues, including manufacturing constraints, higher milk costs and greater competition with exports. While the strategy to shift towards value-added products is sensible, in the broker's view it is hard to envisage material appreciation in the share price without a better track record on earnings and more moderate regulatory risks.

A lack of visibility on unallocated operating costs and the low overall earnings margin in consumer and food services means Credit Suisse retains questions remain regarding the quality of exposures and investment.

The broker believes it is critical that the company reviews its business interests around the globe and that the capital invested to support volume growth is taken into account when assessing the effectiveness of strategies. The main issue for investors, Macquarie believes, is returns generated from the farm sources and whether these appropriately provide returns versus subsidising farmers.

Gearing

Guidance for FY19 implies 15-30% growth in EBIT, adjusting for the impact of -NZ$75m in milk price reductions in FY18. Gearing has increased to 48.4%, outside the target range of 40-45%.

The company is intent on reducing gearing to within its policy limits over FY19 and part of the plan is to reduce capital expenditure to NZ$650m.This includes limiting additional value-added projects, which may affect future growth in branded volume.

No guidance for dividends was provided and these are expected to be linked to a combination of earnings delivery and objectives regarding debt reduction. In order to reduce gearing back towards the target UBS does not expect dividends in FY19.

The company has indicated that the NZ farmgate milk price is at a premium to the equivalent in the EU and US, which Macquarie notes is good for the farmers but can affect competitiveness in export markets. Meanwhile, in the nutrition segment Fonterra has missed its target to launch a new affordable product over FY18 and will complete development for launch in FY19.

China

Credit Suisse continues to take a positive view on the greater China business, with capacity being added in recent years providing both opportunity and volume growth. A reversion to a more normal milk price would also provide scope for some margin expansion.

China Farms continued to disappoint, with volumes down -19% despite the annualisation of more capacity. Macquarie notes this reflects lower production as changes were made to improve future productivity. Credit Suisse agrees this aspect remains a drag on the business.

Asia and Oceania have earnings that are negatively exposed to the NZ milk price. Yet, against expectations Asia surprised Credit Suisse with good volume growth and some upside is added to forecasts.

Latin America has no exposure to the NZ farmgate milk price and, from the company's perspective, there is upside associated with maintaining positions in the Brazilian and Venezuelan markets.

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