Keith Woodford: Uncovering the story behind Fonterra's spin

Fonterra has been quick within its annual report to congratulate itself for overall value-add performance.
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Fonterra has been quick within its annual report to congratulate itself for overall value-add performance.

ANALYSIS: Fonterra's 2017 financial performance was a solid result, despite profits dropping 11 per cent to $745 million.

The main cause of the drop was the higher farm-gate price of milk supplied by its farmers, which is a cost to corporate Fonterra.

This farm-gate price is based on commodity returns and is largely beyond the control of Fonterra. The decline in profit would have been much greater if it were not for a 6 per cent reduction in operating costs.

It is these operating cost-savings that have fuelled the more than $5 million bonus payments this year to chief executive Theo Spiering. These savings can be directly attributed to the so-called V3 strategy, which was Spiering's baby.

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The V3 strategy caused stress and heartburn among many Fonterra employees, including considerable numbers of staff who were made redundant back in 2015. But this year, the results of this have come through into the bottom line.

Fonterra has an enviable position as a commodity producer with cost leadership. This is driven by large-scale modern plants, an ability to switch between commodities as prices fluctuate, sophisticated logistics, and tough internal disciplines.

A worker prepares to milk cows on a 40-hectare farm managed by Fonterra in Yutian County, Hebei Province. Fonterra's ...

A worker prepares to milk cows on a 40-hectare farm managed by Fonterra in Yutian County, Hebei Province. Fonterra's performance in China needs ongoing scrutiny, Keith Woodford says.

With approximately 75 per cent of milk going into these commodities, it is the commodity processing that is the big earner for corporate Fonterra. This is because corporate Fonterra gets a guaranteed processing margin before passing on the rest to farmers.

Fonterra has made good progress this year in Australia after many years of tribulation. Until now, Fonterra's Australian operations have been an ongoing running sore with some major losses going right back to New Zealand Dairy Board decisions before Fonterra's formation.

Fonterra has recently been aided in Australia by managerial and governance incompetence of the Murray Goulburn Co-operative. This has resulted in a flow of suppliers to Fonterra at precisely the time Fonterra needed new suppliers for its new Stanhope cheese factory, replacing the old Stanhope factory destroyed by fire in December 2014.

A key foodservice product where Fonterra is currently excelling is mozzarella cheese.

A key foodservice product where Fonterra is currently excelling is mozzarella cheese.

Murray Goulburn has been the largest Australian milk processor for many years, with about 30 per cent of the market.

However, the consequences of an undisciplined entrepreneurial chief executive, combined with a board that failed to scratch below the surface of the massaged information flow they were receiving, are now changing the fabric of the Australian industry.

This year, it looks like Fonterra will be the 'No 1' processor in Australia.

BRANCHING OUT

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Fonterra has been quick within its annual report to congratulate itself for overall value-add performance. The public relations machine is expert at steering around any messaging speed bumps that might otherwise have spoiled the story.

Fonterra reports it has increased the amount of milk allocated to consumer products by 3 per cent and foodservice by 27 per cent. The combined total is now 5.5 billion litres of liquid milk equivalent (LME), comprising 24 per cent of its global production. Fonterra says it is on track to reach 10 billion LME allocated to consumer and foodservice by 2025, but the journey to this has not been laid out.

It is not easy to decipher the amount of New Zealand milk sold in these value-add products, versus how much is Australian and South American-sourced milk. My reckoning is that more than half of the consumer products come from milk sourced outside New Zealand, with those products sold mainly in the home regions of production. In contrast, most of the foodservice products are sourced from New Zealand. But within the report itself, one will not find answers to these questions.

A key foodservice product where Fonterra is currently excelling is mozzarella cheese. Fonterra has unique technology-based intellectual property which gives it cost-leadership for mozzarella. Fonterra claims more than 50 per cent market share of pizza cheese in China.

To retain its position in the growing mozzarella market, Fonterra will need a growing 12-month milk supply to match its growing mozzarella processing capacity. This will be challenging to achieve within New Zealand's dominant seasonal-production system.

The other more general foodservice challenge is that success is based on cost-leadership combined with tangible product-quality attributes. Market positioning is more easily defended than with basic commodities, but it is arguably less easily defended than a competitive position based on consumer brands.

Attempts to analyse Fonterra's consumer product performance is somewhat thwarted by Fonterra bundling foodservice and consumer products together. However, they are very different categories.

Scratching below the surface, it is evident that Fonterra is rapidly building strength in foodservice but making slow progress in consumer products. The key consumer-product exceptions are butter from New Zealand, cheese produced and marketed in Australia, and a range of products produced by Fonterra's Chilean company, Soprole. Progress with Fonterra's UHT milk in China is more difficult to assess. Infant formula is struggling.

Fonterra's overall performance in China needs ongoing scrutiny. This includes the China Farms, foodservice, consumer brands, and the troubled Beingmate venture.

The headline result for the China Farms is of a turnaround, with an EBIT profit of $1m compared to a $59m loss last year.

However, scratch hard below the surface and it becomes evident that this profit is based on internal transfer pricing, with the milk then sold for a loss of NZ$38m. So, the overall situation is that the China Farms operations generated a loss of $37m this year even before any allowance for servicing of the $789m capital invested in China Farms. Surely, there is still a long way to go!

Given these outcomes, it is not hard to understand why Fonterra's earlier aspirations for 1 billion litres of China-produced milk have been scaled back to about a third of that amount, plus some additional joint-venture arrangements with Abbott.

The Beingmate venture appears deeply troubled. Fonterra owns 18.8 per cent of this company and the shares were bought in 2015 for NZ$755m (RMB3464m). At the end of Fonterra's 2017 financial year (July 31) they were worth approximately $462m (albeit suspended at the time from trading) and since then have dropped in value to $411m (using sharemarket traded values for September 29 2017).

Fonterra has booked a Beingmate loss of $76m in this year's accounts, comprising $35m of capital value plus a $41m share of Beingmate's operating losses. It did not publicly identify any booking of losses for 2016. This suggests that Beingmate is in the Fonterra balance sheet at approximately $679m, some $268m above current market value.

None of the Beingmate losses are included by Fonterra within the China EBIT profits of $209m. This is because these numbers have been 'normalised' (scrubbed) to remove 'abnormals'.

The ongoing problem with Beingmate is that it seems likely to bleed further in the coming year. Fonterra's farmer shareholders and fund investors will need to keep their fingers crossed on that one.

Chairman John Wilson states in the annual report (P5) that Beingmate's troubles need to be interpreted in the context of overall milk markets in China. He states that, "Beingmate's performance, while very disappointing, is a reflection of China's market conditions, which remain challenging for everyone in the infant formula market due to the impact of regulatory changes."

However, to state that conditions "remain challenging for everyone" is less than accurate. One only needs to look at this year's post-tax profit rise for The a2 Milk Company (ATM) from NZ$30m to NZ$90m. The dominant driver of this has been sales of its Synlait-produced 'a2 Platinum' infant formula to China. Both ATM and Synlait have been soaring on the share market.

The overall infant formula market to China has also been expanding rapidly. So, the Fonterra message has indeed been shaped and polished for public relations purposes. Among the winners and losers, Beingmate and Fonterra have been losers.

In the week following the announcement of Fonterra's results, the share price as determined through the Fonterra Shareholders Fund (FSF) rose from $6.10 to $6.21. So, the overall results were much as expected, with no big surprises.

Fonterra's shares currently provide a dividend return of 6.4 per cent (40 cents on a share valued at $6.21). Unlike ordinary company dividends, these shares are not franked, and shareholders are therefore required to class the payments as taxable income. In the current share environment, this could be considered a high dividend return relative to the price of the shares. This in turn implies that the market is cautious about future profits and future capital gain.

Market caution in regard to future capital gain is no doubt influenced by the low profit-retention figure of only 6 cents per share. It raises questions as to how Fonterra proposes to fund the value-add restructuring that it espouses.

Of all the annual reports that I read, it is Fonterra's that requires the most effort to decipher what is really happening. In part, this is because Fonterra is indeed a complex global company.

But it is also because the Fonterra PR machine is 'hard-wired' towards 'good-news' stories rather than transparency. It should not have to be that way.

- Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington

 - Stuff

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