Farmers and investors will need to be patient with Fonterra Cooperative Group’s overhaul of its business, which sometime-critic First NZ Capital analyst Arie Dekker says is moving in the right direction. 

The cooperative’s board is working through a review of the business which has seen several assets put on the market to help cut the milk processor’s debt levels, and has signalled more divestments are coming. 

Chair John Monaghan yesterday described the review as pre-empting a fundamental change of the cooperative, with the top priority in achieving top-dollar from New Zealand’s value-add products. The focus will be on the sustainability and provenance throughout Fonterra’s supply chain, qualities that command a premium in markets such as China where food safety is top-of-mind for consumers. 

FNZC analyst Dekker told clients in a note today that the turnaround will take some time and patience is required by holders of Fonterra Shareholders’ Funds units. 

“There are many strategic issues for FSF to address across the right sizing of the asset portfolio, debt and equity capital structure, and the ability to remain competitive for milk supply in NZ given its significant embedded stainless steel capacity and desire to invest further in value-add processing,” he said.

“FSF must be realistic about its capability and ‘DNA’ through this process having seen significant value destruction as it has invested away from its core business without the capital structure to necessarily withstand bumps along the way.”

Once Fonterra figures out the shape of a leaner version of itself, Dekker said it will be in a position to deal with longer-term problems around capital structure and how to position itself in the market. 

“We expect FSF to work out what it looks like before it turns to capital structure considerations in detail and were encouraged by management’s acknowledgement that these issues will need to be progressed and worked on in the lead up to, and beyond, the FY19 result,” he said.

“Being clear on what it means to remain competitive for milk supply in NZ over the longer term should be a key outcome of all this work.”

Dekker has been forthright in his criticism of Fonterra’s inability to convert capital investment into earnings, and at one stage lowered his rating on the Fonterra Shareholders’ Fund to ‘underperform’.

FNZC is restricted in rating the stock at the moment given its investment banking arm is running the sale of Tip-Top. 

Dekker isn’t optimistic that Fonterra will pay a final dividend and is assuming it won’t, citing the uncertain earnings outlook for the rest of the financial year and the company’s need to shore up its balance sheet. 

“While this is a not a good situation for farmers, a robust outlook for the milk price in FY19 should help support this decision if the board finds themselves in that position,” he said. 

The Fonterra Shareholders’ Fund was launched in 2012, giving outside investors exposure to the milk processor’s earnings stream, while preserving the farmer-shareholders’ control of the cooperative. 

The fund was launched in tandem with Fonterra’s Trading Among Farmers scheme, as a means to reduce the redemption risk when farmers either reduce their milk production or exit the cooperative. Fonterra was saddled with a $742 million redemption bill when milk production dropped in the 2007/08 drought.

Some farmers were reluctant to let the fund go ahead, seeing it as a threat to their control of the cooperative and potentially undermining the farmgate milk price. That prompted Fonterra to reduce the size of the fund as a proportion of its stock.

At the time of the offer, it was envisaged that the fund’s units on issue would amount to 7-12 percent of Fonterra’s shares. 

Some $77 million of units were redeemed in the six months ended Jan. 31, while $71 million of new units were issued. After a $40 million negative revaluation of the liability to unitholders, the fund’s net assets attributable to unitholders was $524 million. In the prior period, $122 million of new units were issued and $51 million redeemed. After an $18 million gain on the revaluation, net assets were $852 million. 

The fund had 110.6 million units on issue at Jan. 31, or 6.9 percent of Fonterra’s shares, down from 137.4 million, or 8.5 percent of Fonterra’s stock, a year earlier. 

John Shewan, chair of the fund’s manager, said in its first-half report that he views the strategic review and attempts to deal with Fonterra’s performance as a positive step, albeit one that won’t happen overnight. 

“The commitment in the interim report to take difficult decisions and to a culture of accountability and performance right across the organisation is welcome,” he said. 

The units recently traded at $4.25, having dropped 8.6 percent so far this year. They hit a record low $4.17 on Feb. 28. 

Fonterra chief financial officer Marc Rivers told reporters yesterday that the fund is still fit for purpose, and that the focus on improving performance will be key in turning that around.  

“The route that we have to improve comes back to performance – that’s the focus of the strategic review,” he said. “If we do that then the share price will be reflective.”

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