Australia | Sep 30 2019
Fonterra Shareholders' Fund is dealing with a raft of problems and brokers take a cautious stance until there is evidence of traction in the proposed solutions.
-Lower contribution from ingredients business flagged for FY20
-Long-term issues surrounding competitiveness in milk
-Move to a debt-related dividend policy
By Eva Brocklehurst
Better outcomes may be ahead but brokers remain frustrated by the slow pace at which NZ dairy co-operative Fonterra Shareholders' Fund ((FSF)) is dealing with its problems.
Credit Suisse highlights the value destruction that has occurred through a series of poor investments which have forced the company to act, although welcomes the direction being taken. Macquarie asserts Fonterra will need to start delivering on several aspects of its strategy before the market regains confidence.
At this stage, the benefits from asset disposals are limited, as funds are required to strengthen the balance sheet. Substantial structural changes are also a possible outcome, brokers note. A capital structure review, including milk prices, has commenced with no set timeframe.
There are long-term issues surrounding the company's competitiveness in milk, which Credit Suisse hopes the review will focus on, as well as its ability to grow the ingredients business given the benign outlook for milk supply growth and surplus capacity.
The broker acknowledges the company's intention to remediate the situation but lacks confidence in the action so far, although recognises it is a complex task. There is too much debt and the number and trajectory of asset sales being undertaken is uncertain.
Guidance for FY20 signals a lower contribution from ingredients in FY20, which UBS assesses reflects the inability to pass on cost increases in price-sensitive markets and categories, as NZ and Australian milk prices are above those in Europe and the US.
Even against a more depressed market valuation, Credit Suisse believes Fonterra needs to generate higher free cash flow, and sustained discipline around expenditure will be a key element in its success.
Any positives? Export competition out of Europe should moderate, as inventory levels are reduced and milk production flattens. Moreover, food service gross margins recovered in the second half of FY19 amid price increases in China and Asia.
There are also positives, brokers note, regarding the planned five-year path to normalised earnings, on a footprint that will mean businesses that have dragged on Fonterra, such as Beingmate and China Farms, will be excluded, although so will positive contributors such as Tip Top and DFE Pharma.
FY20 forecasts earnings (EBIT) of NZ$600-700m compare with NZ$811m in FY19. Macquarie notes this reflects the impact from lower allowable returns under the milk price manual, as well as the sale of DFE Pharma and generally more normal assumptions around returns.
In the second half of FY19 a recovery in prices and a better cost performance allowed margin pressure to moderate. Nevertheless, UBS points out a fall in the regulated returns from milk has impeded profitability for ingredients, which has meant margins have started to decline again.
Credit Suisse is concerned regarding the lack of clarity on a sustainable base level for earnings in the ingredients business, or the investment required over the longer term. Any strategy that will revolve around a reduced footprint and the prices realised for non-core assets will influence valuation outcomes, the broker adds.
Review & Outlook
Brokers assess the decision to focus on NZ-made products and reduce global operations is sensible. The company will focus on five categories: dairy, food service, paediatrics, sports and medical. Market development will be concentrating on the Asia-Pacific in food service and the consumer. South America, particularly, will be downsized.
The company has sold Tip Top, Inlaca, DFE Pharma, foodspring and, its Venezuelan consumer joint venture. This takes sale proceeds to around NZ$1bn. Potential future asset sales include the shareholding in Beingmate, China Farms and Dairy Partner Americas.
Still, the company does not appear unified or committed to singling out specific non-core divestments and Credit Suisse is concerned about the lack of clarity regarding a sustainable base level for earnings in the ingredients business and the investment required over the longer term.
UBS asserts product development and environmental aspirations – Fonterra has introduced environmental targets across greenhouse gas emissions and water use – clash with the desire to reduce capital expenditure to NZ$500m per annum over the next five years.
The company has also moved to a debt-related dividend policy, lowering the pay-out to 40-60% from 65-75%. As Fonterra has flagged further asset sales UBS expects pressure on the balance sheet will be significantly reduced by the end of FY20. A dividend is expected to be reinstated in FY20 albeit at a low level.
While the new policy is more conservative, Macquarie considers it somewhat tax inefficient given the deductibility of distributions paid to farmer shareholders. Macquarie's rating is Underperform with an NZ$3.30 target.
Credit Suisse, while confident debt levels can be reduced to more manageable levels, complains about a lack of supporting detail for how the company will arrive at a sustained turnaround. The broker maintains a Neutral rating and NZ$3.85 target. UBS has a Neutral rating, along with an NZ$3.50 target.
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