Fonterra's latest results are a shock. They show starkly how dependent the co-op is on one commodity product - whole milk powder - and one market for it, China.
OPINION: Clearly, Fonterra is suffering from Dutch Disease.
Normally this afflicts whole economies, as the Dutch discovered in the 1960s.
Booming North Sea gas exports wrought havoc with the rest of their economy. The bonanza sucked capital and resources out of other sectors, drove up the exchange rate and generated excessive optimism and poor decision-making by companies, investors, government and consumers.
But Fonterra is stricken because it's a mini economy. It wants to move up the value chain so it can earn a bigger, more stable and sophisticated living.
But exceptionally high prices for whole milk powder, driven by demand from China, are decimating its strategy. It is investing in becoming more, not less, of a Chinese-dependent commodity producer.
China is fundamentally driving and reshaping global trade in dairy products. The richer its citizens become, the more dairy products they consume. Chinese milk production kept up for the first couple of decades. Imports took only a sliver of the market.
But Chinese milk production has stalled at around 35b litres a year since 2007.
Meanwhile, consumption this year will be well over 45b litres, with imports plugging the gap. This year they will meet some 25 per cent of Chinese demand, a volume fast catching up with New Zealand's entire milk production.
Dairy production in the United States, New Zealand and some other countries is increasing but not fast enough to keep the whole milk powder price in check. For the past year WMP has remained at around US$5000 a tonne, well above the long term trend of around US$3500.
The high WMP price has caused havoc with Fonterra's finances and strategy in three main ways.
First, WMP prices have remained persistently above those of cheese, casein and other more highly processed, and usually more valuable, commodities. But because of its mix of plants Fonterra couldn't switch more milk away from them into WMP so it has missed some of the upside of WMP.
These plant constraints also led to inefficiencies in milk processing at the peak flow of this season. This caused $76m of additional costs in the likes of transporting some North Island milk to the South Island for processing.
Second, the high WMP price seriously distorted the complex financial mechanism by which Fonterra calculates the commodity price for milk it pays its farmers.
Since milk is the main raw material for processed products, Fonterra had to take drastic action to prevent the high price plunging Fonterra's downstream processing and sales activities into a deep loss. On December 11, it announced it had over-ridden the price setting mechanism to cut the milk payment to farmers by 70c per kg of milk solids. On current forecasts, farmers will get $8.65 per kg, instead of $9.35. The lower price is still a record so farmers haven't kicked up much of a fuss.
The cut, though, helped Fonterra mitigate some of the damage to the co-op's finances. This week it reported revenues up 21 per cent at $11.3b but normalised earnings before interest and tax were down 41 per cent at $403 million.
The decimated profits forced a cut in the interim dividend to 5c a share, with a forecast of 10c for the full year compared with 32c last year. But at least the external investors still got something. Fonterra says the drastic switch in return to farmer payout and away from investor dividend, caused by high WMP prices, hasn't yet caused a significant exit of unit holders.
If Fonterra had not cut its milk payment, it would have reported a sizeable loss. It would have been incapable of paying a dividend to farmers and unit holders without borrowing heavily. Even with the cut in milk payment Fonterra's debt still increased by $1 billion.
The third impact of the high WMP price was on its consumer and ingredients businesses, which are supposed to be the drivers of its strategic shift to higher value products. The co-op failed to fully pass on the high raw material cost so profits in consumer products slumped by 53 per cent in Australia and New Zealand and by 68 per cent in Asia.
Asia was doubly disappointing. Sales volume of consumer products rose only 3 per cent despite the rapid growth of markets.
Meanwhile, sales of WMP to China rocketed. The Chinese are getting good at buying Fonterra's commodity powders and turning them into valuable downstream products. Likewise they are ramping up investment in downstream plants here, thereby pulling milk supplies away from Fonterra.
Given all this turmoil, Fonterra revisited its strategy. It concluded the strategy was fine but it needed to accelerate, Theo Spierings, the co-op's chief executive, said at the interim results. In particular, the shift to value-add products was still on track.
But Fonterra's shift in investment focus tells a different story. Six months ago at the year-end results Spierings said the co-op was seeking to invest less in producing commodity powder and more in higher value processed products. This week, though, Fonterra announced an extra $400m-$500m of capex over the next three or so years, equivalent to two new large driers, to give the co-op more flexibility in its plants and thus the ability to produce more powder.
He also said this week that powder was the best NZ investment the co-op could make because its strong cash flow was vital for funding downstream activity; and value added investments here would have to prove their business case.
But there are multiple flaws in this argument. For example, Fonterra only gets a cost-of-capital return on its powder processing assets; high powder prices starve the downstream businesses of financial resources; and its heavy investment in Chinese farms will make Fonterra a big producer of high quality milk, but it will be the Chinese who will process and generate value from it.
These are classic symptoms of Dutch Disease. Given Fonterra's scale here, the symptoms will prove highly infectious across the entire economy.
- Sunday Star Times