Australia | Mar 19 2020
This story features FONTERRA SHAREHOLDERS FUND. For more info SHARE ANALYSIS: FSF
While several risks remain, Fonterra has emerged from the first stage of its restructure with a positive earnings outlook for FY20.
-Improved ingredients returns in NZ and recovery in China's foodservice
-Pricing pressure in UHT cream and cheese in NZ
-Knots in capital structure still to be ironed out
By Eva Brocklehurst
One of the more positive news items in the current environment has come from Fonterra Shareholders Fund ((FSF)), which has signalled the first stage of its earnings recovery has been achieved. The company reported first half net profit of NZ$293m and normalised earnings of NZ584m, ahead of broker forecasts.
While no interim dividend was declared Fonterra aims to pay a final dividend. While there is still a risk around the drought and higher milk prices as well as the impact of coronavirus on foodservice volumes, the company has maintained guidance for earnings per share of NZ15-25c.
After several challenging years, Credit Suisse observes the balance sheet is on track for substantial reductions in debt, which could underpin a resumption of dividends in the second half. UBS also notes growing confidence in the ability for earnings to reach the top end of the forecast range in FY20, despite some modest demand risks stemming from coronavirus.
Evidence for this comes from improved ingredients returns in New Zealand and a recovery occurring in China's foodservice demand. The pace of an earnings recovery from FY21 could be slower, nevertheless, as the company confronts margin pressure from higher milk costs and the task of downsizing.
The first half normalised earnings (EBIT) lifted to NZ$570m, ahead of UBS estimates. This was driven by stronger gross margins in foodservice and reduced losses in Australian ingredients. Australian ingredients sales volumes fell by -24% because of reduced milk supply.
UBS retains a Neutral rating and NZ$3.95 target. The main area that disappointed the broker was lower gross margins in NZ, amid pricing pressure in UHT cream and cheese because of greater competition. Macquarie also was disappointed with gross margins.
Guidance has revealed some earnings risk in the second half from reduced foodservice sales initially in China and throughout Asia as virus containment measures affected restaurants. Moreover, early in 2020 there was unrest in Hong Kong and Chile which is expected to have influenced dairy demand.
Fonterra is still progressing divestments of the China Farms and DPA Brazil and Credit Suisse welcomes the exit of the former. Still, the broker assesses the investment case remains difficult and current earnings need to grow to support the valuation and maintains a Neutral rating and NZ$3.97 target.
The company completed the sale of DFE and foodspring during the half year, making NZ$401m and NZ$68m in gains on sale respectively.
No update was provided on the review of the capital structure except that Fonterra will remain as a co-op. The exit of phase 1 of the restructure has removed the risk to the balance sheet and the board and management is working with farmers regarding the future of the co-op in 2020.
Credit Suisse expects this next phase will be difficult and achieving consensus will take time, believing investors should wait for more detail on the capital structure plans and the size and scope of the co-op.
The broker points out retention of lower growth and non-NZ milk pool businesses need to be tested against what it means for supporting more capital flexibility for farmers and improve sustainable returns.
Macquarie asserts the current structure works against unit holders and the company's policies appear to be about maximising costs and investing in working capital to favour farmers. Macquarie has an Underperform rating and NZ$3.50 target and assesses the volatility in the business makes forecasting a challenge.
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