Milk and money flowed for Fonterra during 1H13.
EBIT jumped 26% from the prior year and earnings per share (EPS) was up 21%. Both results were c10-15% ahead of market expectations. So then why did the share price only rise by 5.7%? Historically, Fonterra results have been volatile from period to period as the business was buffeted by volatile global commodity prices. While management has taken significant steps to reduce the volatility, it remains, and was highlighted in the 1H13 result. While it was beneficial to investors this time, it could just as well be a head wind in the next period. The expectation of a return to normal conditions was reflected in the EPS guidance provided by Fonterra of 45-50cps (the range tightened from 40-50cps previously). Given that 1H13 EPS was 29cps, this implies a second half of just 16 – 21cps, a 27-45% decline from the strong 1H13 EPS.
The strong performance was driven by NZ Milk Products (NZMP) where EBIT increased to $422m (from $255m, +65%), but $87m of the $167m increase was due to a favourable product mix where Fonterra received more revenue vs what it needed to pay out to farmers. While this provides a short term benefit to shareholders of Fonterra, it could easily be a similar sized head wind in the second half. This is important as the NZMP business has been billed as a ‘low risk’ return type business, but such volatility will erode this picture. It is also disappointing because the volatility overshadows the good progress made by management within the remainder of the division to reduce volatility and improve returns for shareholders.
The strong NZMP result also offset the EBIT decline in the combined Consumer Businesses to $271m (from $297m, -8.7%). The Australia/NZ consumer business significantly underperformed already low market expectations and the Asian consumer business, while demonstrating good growth, also underperformed market expectations. Theo Spierings, the CEO, has a solid plan to streamline the businesses, and accelerate growth in Asia, but these changes will take time and the division will face headwinds from sharply increasing milk prices.
The current drought adds significant risk to Fonterra. A sharp decline in milk collection has resulted in the price for whole milk powder (WMP) jumping 43% over the last month. The drought will have three key impacts on Fonterra.
- Firstly, the product mix in NZMP, which provided the $87m boost in 1H13, has moved out of favour for Fonterra shareholders.
- Secondly, the sharp increases in milk prices will increase the costs within the consumer businesses which may not be able to be passed on to consumers, resulting in lower gross margins and EBIT within those divisions.
- Thirdly, the amount of ‘dry shares’ farmers can sell, to bolster on farm cash flows, will increase which may see an increase in the number of units in the FSF over the next 3 – 6 months.
It was a fantastic first result for Fonterra, but without the storm clouds gathering, the business and industry are coming under increasing pressure.
Senior Equity Analyst
Disclosure of Interest: Milford Funds has had and may in future have an interest in Fonterra Shareholder’s Fund (FSF).