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Fonterra lifts sales in first-half; profit halves as margins shrink

Fonterra Cooperative Group [NZX: FCG] posted a 53 percent drop in first-half profit as the price of milk ran ahead of prices for products such as cheese and casein, slashing margins at the world's biggest dairy exporter.

Profit fell to $217 million, or 13 cents a share, in the six months ended Jan. 31, from $459 million, or 28 cents, a year earlier, the Auckland-based company said in a statement. Sales climbed 21 percent to $11.3 billion in a period that included record December shipments to China of 110,000 metric tonnes.

Fonterra sees no let-up in the second half, with profit likely to undershoot its first-half result on continued negative impact on product mix margins and higher input costs making it hard to drive growth in its branded and food service businesses, it said today.

The price of whole milk powder, one of the reference commodities used to calculate the farmgate milk price, surged 60 percent in the first half, contributing to a 35 percent increase in revenue from NZ Milk Products, Fonterra's biggest division. But non-reference products - the casein and cheese streams that count milk as their biggest input costs - didn't rise as much, meaning the company couldn't pass on the higher cost of milk.

"Sustained high prices, especially for milk powders, saw revenue increase ... but these also led to higher input costs," Fonterra said. "The increasing pressure on margins was also evident in our consumer and food services businesses. Here the balance needed to be struck between passing on rising costs immediately or continuing to build our market presence and volumes to secure long-term growth."

Fonterra's gross margin in the first half tumbled to 12.5 percent from 18.6 percent.

The company had already telegraphed the issues it has with product mix, where its factories can produce milk powder streams to cheese and casein streams at a ratio of 75 percent to 25 percent. In November it took a $157 million provision against inventory of specialised ingredients and branded consumer products at NZ Milk Products because of the margin squeeze. And in December it slashed its forecast 2014 dividend payment by two thirds, while keeping the farmgate milk price at a record high.

"We processed as much of this milk into the higher returning milk powder product streams as we could," chief executive Theo Spierings said. "However, our current asset footprint meant that around 25 percent had to be processed into cheese, casein and other non-reference commodity products which earned negative returns over the period."

As part of the company's response, it will bring forward planned capital investments including building new capacity to reduce its product mix constraints. That will result in an additional $400 million to $500 million capital spending over the next three to four years.

Fonterra declared a first-half dividend of 5 cents a share and affirmed its forecast for full-year payments of 10 cents.

Units in the Fonterra Shareholders' Fund, which are entitled to dividends on the ordinary shares, were last at $6.22 on the NZX and have fallen 8 percent in the past year while the NZX 50 Index climbed 18 percent. The units are rated a 'hold' based on the consensus of analysts polled by Reuters.

Among the company's other divisions, Oceania reported a 53 percent decline in normalised earnings before interest and tax to $46 million. Sales fell 10 percent to $1.8 billion and its gross margin shrank to 18.8 percent from 21 percent. Oceania includes consumer and 'out of home' food service in Australia and New Zealand, dairy processing in Australia and the RD1 rural supplies chain.

Asia revenue was little changed at $1.05 billion from $1.049 billion while normalised EBIT dropped 68 percent to $32 million. Gross margin shrank to 26.6 percent from 34.5 percent. While volumes grew to China, sales volume to Sri Lanka, where the company was temporarily forced to suspend its market operations, fell 33 percent and had "a significant impact" on first half earnings for the division.

In Latin America, revenue rose 2 percent to $570 million and normalised EBIT climbed 6 percent to $71 million. The gross margin slipped to 26 percent from 26.5 percent.


Comments and questions

Losing money on value added products. Wonder if David Cuniliffe will come to the rescue. Especially given his key role in forming Fonterra.

growing sales and falling margins on something NZ should be well ahead on ..... hmmmmmm

How do you lose money given what the NZ public pays for dairy product................ummmm maybe rest of world doesnt

$11m for legal costs on being sued - Tui billboard. Perhaps dont realise cant go through Small Claims

Big loss leader is the value added NZ Milk that was to make big $ as basis of merger (name at time of merger)(multiple nut under the 3 shells name swaps for confusion) May be better outcome to have 2 big dairy powder companies competing on payout so no cost balloons like now

I have just read the presentation released today after the results and I am curious as to why the business press have not reported on the fundamental failure of this board to demonstrate any evidence that they are executing their strategy.

It seems that their strategy refresh lives on paper but does not create any change in their business performance. Let's look at Fonterra's "Growth Paths"

1. New Zealand Milk - Volumes up (well done farmers) revenues up (well done sales people) EBIT down (well publicised mix challenges causes by an asset base that cannot meet optimal mix through peak) - I didn't see in the previous strategy refresh that there was a concerted effort to increase powder capacity. This revelation in the half year results is either an add on or a knee jerk.

2. Grow Food Service - It seems that Food Service has the same issues as the commodity cannot recover costs in an added value category

3. Grow Consumer Brands - This is the big failing. Australia and NZ seem to be hemorrhaging profit. I understand that the Australian business (despite being restructured last year) still has too large an infrastructure to support the rapidly declining volumes. If you strip out the Australian ingredients numbers, the consumer business is a complete car crash. Asia - dropping margin hand over fist and likewise China.

In addition to this Fonterra paid zero lip service to it's corporate failings..... price fixing in China, botched product recall and subsequent major law suit by a very dogmatic French customer and the sustainability strategy (which is also a strategy driver that does not get any mention)

If I was a wet shareholder I would be seriously questioning the capability of this board. They have a strategy but are making no grounds on executing this.... except on paper.

Some excellent points True Blue. And you have - almost - beat me to it! Please check out our paper tomorrow as I have interviewed Fonterra CFO Lukas Paravicini on these topics, and their impact upon Fonterra's profit.
But I might also add that Fonterra is a cooperative, whose first allegiance is to its farmer shareholders; and the emphasis is on farmer, rather than shareholder.
So, while profit margins leaves a lot to be desired - along with tangible evidence that the board is executing its strategy effectively - in the face of such record farmgate payouts this year, bluntly put, Fonterra is laregly producing the goods for its owners.
However, if the issues you raise are not genuinely addressed by the board in the short to medium term, they have the potential of reverberating more damagingly right back to the farmgate.