Fonterra’s innocuously worded ‘Global Dairy Update’, released on the 11th of November, provided another shock to the Unit Holders of the Fonterra Shareholder Fund (FSF). The announcement brought into clear focus the diverging fortunes of two key stakeholders of Fonterra – those of Shareholders (who can only be Farmers) and the Unit Holders of FSF.
The current milk price forecast, at $8.30, would be the highest on record. Unusually, the high prices are also combined with the highest volume of milk production on record, currently up 4.7% year on year. On farm revenues should reach record levels during 2014. However, over the last 6 months, the Units in the FSF have underperformed the NZX50G index by 19%. So why has there been such a divergence?
The ‘Global Dairy Update’ update noted that increased transparency around NZ Milk Products would result in a margin squeeze and a $157 million charge to inventory. In effect, Fonterra has paid a price to Farmer shareholders via the milk price that it will not be able to recover when the product is sold to customers. This decreases the Net Profit After Tax (NPAT) of Fonterra which pays dividends to Unit Holders and Shareholders (Farmers). The impact of these movements has seen two brokers cut their FY14 NPAT forecast for Fonterra by c55%.
There are two key issues for Unit Holders. Firstly, as milk prices increase rapidly the cost of goods sold for Fonterra also increases, putting downward pressure on earnings. The cost of raw milk (paid to farmer shareholders) is the single largest expense of the co-operative. The second issue is the way the milk price manual is constructed, which can result in variations in the prices paid to farmers compared to the prices Fonterra can charge to customers; creating a large amount of volatility in earnings (the variations can be positive or negative). Analysts and Fonterra cannot forecast these differences in what they call ‘stream’ profitability.
There is a silver lining for Unit Holders (at the moment, but this could reverse in the future). With the outlook for on-farm cash flow looking exceptionally strong and the requirement for farmers to ‘share up’ there has been increased buying of shares by farmers, even in the face of the downgraded earnings outlook. The result is the FSF Unit Price fell just 2.9% when FY14 NPAT analyst forecasts were cut by c55%. While this may seem to be a no lose situation for investors, we are wary of financial structures which do not behave in a logical manner for periods of time as they can often quickly and painfully revert when situations change.