Fonterra’s 2013-14 year result was the biggest business and economic event of the week.

The dairy co-operative is our largest and most important company by a wide margin. It had total revenue of $22.3 billion in the latest year, 2.7 times Fletcher Building’s $8.4 billion revenue. Dairy accounts for 31.1 per cent of the country’s total exports while the rural community has been transformed from sheep and cattle farms to dairying.

We now have 6.5 million dairy cows, compared with just 3.1 million three decades ago. Sheep numbers have fallen from 70.2 million to 30.8 million and beef cattle numbers from 4.5 million to 3.7 million over the same period.

Fonterra; Rising income but falling earnings

However, Fonterra’s earnings have not kept pace with the growth in the dairy sector. The co-op had ebit (earnings before interest and tax) of $503 million for the year ending July 31, 2014 compared with $937 million for the 2012-13 year. (Fletcher Building reported ebit of $592 million for its June 2014 year.)

•Why has Fonterra’s ebit fallen for four consecutive years and what is the company’s future strategy?

Fonterra’s key variables are the revenue and expenses columns in the accompanying table.

Fonterra’s main expense item is New Zealand-sourced milk. This has risen by 66.6 per cent, from $7.9 billion to $13.2 billion, since 2009-10. The huge increase has been because of a 37.7 per cent rise in the farmgate milk price, from $6.10 to $8.40 per kg of milk solids, and a 21.6 per cent increase in milk volume.

The company has a limited ability to influence the farmgate price because it is determined after taking into account the principles set out in the Farmgate Milk Price Manual, which is independently audited.

The purchase of non-New Zealand milk has remained fairly static, in Kiwi dollar terms, and the other net costs include a number of non-operating income items.

The most interesting aspect of Fonterra’s finance statements are its external revenue figures, which are made up of New Zealand Milk Products (NZMP) and consumer products.

NZMP represents commodities and ingredients sold to other companies, such as Nestle.

The consumer products section contains a large number of well known brands including Anchor, Fresh ‘n Fruity, Kapiti, Mainland, Tip Top and many, many more. The co-op sells consumer products throughout the world with the number one market position in Sri Lanka, Malaysia and Chile, as well as New Zealand.

The problem with Fonterra is that it is not making much progress in becoming less dependent on commodities and ingredients by expanding its consumer products activities.

Consumer products now represent 28 per cent of total group revenue, compared with 33 per cent four years ago, while earnings and margins from these operations have dropped dramatically in recent years.

Consumer products ebit has fallen from $582 million to just $234 million over the past four years and the ebit margin has plunged from 10.6 per cent to 3.8 per cent. This is partly through higher farmgate milk prices.

Ironically, the returns from its Australasian consumer products operation were particularly poor in the 2013-14 year, as illustrated by the following figures:

• Australasian consumer products’ ebit has dived from $299 million in the July 2010 year to just $31 million in the latest period.

• The return on the co-op’s Australasian consumer products assets has shrunk to just 1.3 per cent.

• The ebit margin has plunged from 7.9 per cent to 0.8 per cent over the same four-year period.

Fonterra said the poor Australia and New Zealand results were primarily because of margin pressure in the consumer brand market. Australian ebit was $37 million lower than 2012-13 and New Zealand ebit fell 61 per cent.

The New Zealand result was particularly disappointing because RD1, which is included in the NZ consumer products division, “delivered a strong performance”.

A strong consumer products operation is important because it provides a buffer against market price volatility experienced by commodity and ingredient products.

This stability is important for farmers, particularly those who are highly geared. It is also crucial for the country as a whole because just over 60 per cent of exports are in dairy, meat, wood, fruit, wool, fish and vegetable products, mostly commodities, and this makes the domestic economy extremely vulnerable to volatile commodity prices.

Chief executive Theo Spierings is upbeat about Fonterra’s opportunities in the consumer products area but the co-op has a long, long way to go. For example, Nestle has a 15 per cent ebit margin on its consumer products – some of which are based on milk powder ingredients bought from Fonterra – while the co-op has an ebit margin of less than 4 per cent on its total consumer products operations.

Kerry Group, the former Irish co-op which is now a listed limited liability company, has made huge progress with its consumer products. These branded products, which represent 27 per cent of Kerry Group’s turnover, reported an ebit margin of 8 per cent for the December 2013 year compared with 7.7 per cent the previous year.

Royal FrieslandCampina, Theo Spierings’ former Dutch dairy co-op employer, achieved an ebit margin of 9.2 per cent on its European, Middle East, African and Asian consumer products operations in the December 2013 year.

Fonterra is expecting a much better 2014-15 year, based on its forward-looking statement, but the outlook for farmer suppliers is far less rosy.

Broker analysts are forecasting group ebit of around $1 billion for the 2014-15 year, compared with $503 million last year, with the consumer products division expected to report ebit of around $500 million compared with $234 million last year.

However, most of this will be at the expense of farmers as the milk price is forecast to fall from $8.40 per kg of milk solids in 2013-14 to $5.30 this year. On the basis of a 3 per cent lift in production and a $5.30 milk price, Fonterra farmer milk income will decline from $13.2 billion in 2013-14 to $8.6 billion this year.

The dairy co-op has an extremely aggressive growth strategy over the next decade. It is aiming to have total revenue of $35 billion by 2025, compared with $22.3 billion last year, and to source about one-third of its milk supply from abroad. It also aims to be the market leader in Australia, Brazil, China and Indonesia.

But the biggest challenge facing Fonterra is its consumer products division. Dairy farmers and the economy will continue to be buffeted by volatile commodity prices unless Fonterra is far more successful in this area.


Brian Gaynor

Portfolio Manager

Disclosure of interests: Milford Asset Management holds securities in Fonterra Shareholders’ Fund on behalf of clients.