Understanding Fonterra gets even harder

Ask anyone with half an eye on the New Zealand economy what's leading its current recovery and they'll tell you two things.

First: the Canterbury rebuild.

And second: the extraordinary boom in both the price and volume of dairy industry exports.

The dairy boom being what it is, you'd think the country's only multi-national company with global scale, Fonterra, would have produced a stonking half-year profit result last week.

Not so.

In fact, if it hadn't been for the co-operative withholding payments of $519 million to its farmer shareholders, Fonterra would have reported a bottom-line loss of about $300m for the six months to January 31 instead of the post-tax profit of $217m it actually announced. That result was a 53 per cent reduction on the same period a year earlier, despite a 21 per cent increase in total revenue for the half-year to $11.3 billion.

How could that be?

The answer lies partly in the absolute silence from the farmers whose incomes were cut.

At a forecast $8.65 per kilogram of milk solids, they're still creaming it with the highest prices they've seen at the farm gate. They are by and large willing to accept that Fonterra needed to hold back a further 70 cents per kg/ms that should, by rights, have been paid to them.

Deutsche Bank analyst Arie Dekker describes this process as "essentially raising equity from farmers - rather quietly". That's typical of the tone throughout a 29-page research note that Dekker produced last week in which he argued, rather quietly, that investors are finding the job of understanding Fonterra increasingly problematic.

For example, he suggests that one thing Fonterra would benefit from is "a reporting framework that is consistent with the strategy . . . and can be used to measure performance against some of the key areas of investment being made".

Read that quickly, and it sounds pretty bland. Stop for a moment and what it says is: "I can't tell what's going on here."

If this were any company other than Fonterra, such a comment would be a serious concern. But this is Fonterra, and Fonterra has always been different.

As a co-operative, its business model is structured around the price of milk paid by Fonterra to the dairy farmers who own and control it.

And as a co-operative with a dominant position in its home market, it is also the creature of regulation. In this case, the regulation that matters most is the farm gate milk price (FGMP).

As a result of the first influence, Fonterra remains quixotically fixated on an input price rather than its profitability, while the second influence has now been shown to have the capacity to play havoc with the input price.

As one seasoned observer of this dynamic puts it: "You are struggling with the contradiction inherent in a company which sometimes acts as an extension of farmer balance sheets and sometimes as a separate balance sheet trying to make profit to cover its own cost of capital.

"The story and strategy change depending on the circumstances."

In the past year, extreme circumstances of very high milk commodity prices have not only prompted Fonterra farmers to pump out as much milk as possible to get the regulated FGMP, but Fonterra's capacity to make the most profitable use of all that milk has fallen short.

Despite a generation of propaganda that New Zealand dairy products need to go up the value chain to be really profitable, the reality this year is that whacking milk in a big stainless steel drier and making it into powder is by far its most valuable use.

Running out of drier capacity and being forced to make products like cheese or casein instead was one of the main reasons for Fonterra's weak first-half performance. Up to $500m of capital expenditure is being fast-tracked to boost drier capacity. Synlait Milk, one of Fonterra's few local competitors, is doing the same thing on a smaller scale.

Both companies need to move fast if Dekker is right and contract milk volumes will "nearly double in the season ahead". That's a lot of extra milk to process. Despite this week's GlobalDairyTrade auction result, where prices slumped 8.9 per cent recent high prices are leading to increased production in other dairy producing markets as well. That may take the heat off the FGMP and improve Fonterra's earnings.

That might mean no need for intervention to allow Fonterra to report a profit while confounding investors who would much rather the FGMP was left right alone. If it can be reduced in a bumper year, who's to say it couldn't be raised in a bad year?

It's hard to escape the suspicion that the FGMP formula is out of whack if it requires this kind of massaging, barely three years since its introduction as a foundation piece of Fonterra's economics.

It certainly doesn't promote the kind of transparent, investable proposition that buyers of Fonterra Shareholders Fund units, whose dividends have been slashed from 32 cents to 10 cents, are looking for.