Fitch Ratings has put Fonterra Cooperative Group on notice over its credit rating, saying its asset sale programme will be critical in getting debt under control. 

The international ratings agency yesterday downgraded the outlook on Fonterra’s ‘A’ long-term issuer default rating to ‘negative’, from a previous ‘stable’ outlook. Fitch said last week’s earnings downgrade indicated that Fonterra is facing structural issues that it needs to deal with if it wants to keep the defensive traits protecting its business profile. 

Fitch said the suspension of the interim dividend and proviso that any final dividend will depend on Fonterra’s end-of-year balance sheet was a positive for bondholders, as was the ongoing strategic review. 

Fonterra’s review includes the divestment of assets no longer deemed core to the wider business, such as the current sale of Tip Top. The Australian newspaper yesterday reported Australian packaging billionaire Raphael Geminder and Kiwi billionaire Graeme Hart are in the mix as potential buyers of the ice cream business, which may fetch about $400 million. 

“The cooperative’s strategic review being undertaken and the successful implementation of actions to resolve these issues over the next 18 to 24 months will be crucial for Fonterra in retaining the defensive traits that have historically underpinned its strong business profile,” analysts Kelly Amato and Leo Park said in their report. 

Fonterra last week hiked its forecast farmgate payout to $6.30-6.60 per kilogram of milk solids in the current season, from its December forecast of $6-6.30/kgMS. At the same time, it scaled back its milk collection forecast by 20 million kg to 1,530 million kgMS. That implies farmers will be paid $9.4-10.1 billion compared to $9.3-9.77 billion.

That increased milk price squeezed Fonterra’s margins, and prompted it to cut earnings guidance to 15-25 cents per share from 25-35 cents per share. That implies annual earnings of between $242-403 million in the year ending July, compared to the earlier projection of $403-564 million.

Fitch said if the asset sale programme achieves the $800 million reduction in Fonterra’s debt, that will lower its debt-to-earnings leverage ratio to a more manageable 2.2 times from about 2.5 times currently by the 2022 financial year. However, if the milk processor doesn’t achieve that, it could be in for a rating downgrade. 

The ratings agency said a key rating driver is for Fonterra to make sure it meets it debt obligations before paying higher prices to its shareholder-suppliers. 

“Nevertheless, adverse business conditions can affect this driver, as highlighted in FY15 when milk payment retention for New Zealand-sourced milk fell to 2 percent after the cooperative decided not to cut its advance-rate milk payments in line with the decline in global dairy prices to assist farmer-shareholder cash flows.”

Fitch’s key assumptions include the farmgate milk price returning to its long-run average $6/kgMS by the 2020 season, sales prices moving in line with changes to the farmgate milk price, capital spending of $650 million a year between 2019 and 2022, and dividend payments being at the lower end of the payout ratio. The ratings agency also assumes the effective subordination of money owed to milk suppliers between 2019 and 2022. 

Fonterra acknowledged the warning, saying its earnings aren’t satisfactory and a fundamental change is needed to boost earnings capacity and quality. 

“We need stronger earnings to deliver a respectable return on the capital invested in the co-op and a strong balance sheet,” chief financial officer Marc Rivers said in a statement. “We are taking a series of proactive steps to make this happen.”

Fonterra noted the steps it’s taking to shore up its balance sheet, including plans to cut operating costs to its 2016/17 levels. That would see it cut about $130 million from selling and marketing, distribution, administration and other operating costs to about $2.37 billion. 

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