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Fonterra units sink back to issue price as product squeeze hurts dividend, earnings outlook

Fonterra Shareholders' Fund [NZX: FSF] units retreated to last year's issue price after the dairy giant slashed its forecast dividend payments by two thirds and halved its earnings forecast, saying high milk powder prices haven't been matched by cheese and casein.

The units, which are entitled to dividends from Fonterra's shares, dropped as low as $5.49, below last year's $5.50 issue price. They recently traded at $5.50. Craigs Investment Partners analyst Arie Dekker yesterday cut the units to 'sell' and lowered his 12-month price target to $5.51, citing the price squeeze.

The world's biggest dairy exporter cut its dividend forecast to 10 cents a share from 32 cents while keeping the milk price at $8.30 a kilogram of milk solids. Fonterra's board said it had used its discretion to keep the forecast price below the level implied by the Milk Price Manual calculation, which would have seen it lift to $9 per kgMS.

Chief executive Theo Spierings said while it is still early in the season, Fonterra has to ask itself whether the record gap between prices for milk powder compared to cheese and casein is partly a structural change in demand that will continue for longer and how it should respond.

"It is really strange, when you look at the last 20-30 years of dairy for milk protein in cheese to be worth so much less than milk protein in milk powder," Spierings told BusinessDesk. It can be at least partly explained by demand in China, he said.

"China's demand for milk powder is very high, while for cheese and casein it is not so high," he said. China's taste for cheese isn't likely to grow from direct sales to consumers because that nation "has no cheese culture." Where it can grow is in cheese as an ingredient in food manufacturing and from fast-food chains.

Provided the milk price forecast remains at $8.30, Fonterra doesn't expect to have to add to the $157 million provision against inventory of specialised ingredients and branded consumer products produced by its largest NZ Milk Products division that it announced last month, Spierings said.

Fonterra is limited by its plant configuration on how much milk powder it can produce. Currently 70 percent of production capacity is for milk powder and the rest of its plant makes cheese and casein, whose prices haven't kept up with milk powder.

Spierings said currently the ideal ratio would be 100 percent milk powder production and over time Fonterra probably needs to change its production mix across its various global milk pools. That could see New Zealand, which is handy to China, become the specialist producer of milk powder, while the company would use milk pools in Europe and the US for cheese and casein production, for which those markets were better suited, he said.

As part of a strategy to lift milk powder production, Fonterra today announced it had approved spending of $235 million for a third powder drier at Pahiatua in the Lower North Island, which will have a capacity of 2.2 million litres a day and is scheduled to be ready in August 2015.

Today Fonterra forecast 2014 earnings before interest and tax of $500 million to $600 million, down from normalised EBIT of $1 billion in 2013.

Asked whether unitholders in the Shareholders' Fund were effectively second class citizens to farmers in Fonterra's hierarchy, Spierings said no. The drop in the units today "was an instant reaction" to figures announced today being bigger than was expected.

"The decisions we've taken are to protect the co-op," he said. "Investors will appreciate a strong balance sheet. They see we are driving long-term value."

Matt Goodson, who holds the units as managing director at Salt Funds Management, said Fonterra is in "a slightly difficult position where they have to balance the interests of farmers with the interests of investors in the Fonterra shareholders fund."

"The price had a tremendous run since IPO and it seemed to be almost a slight misunderstanding of exactly what the shareholders fund was, some people seem to think it was a just pure play on overall milk prices or overall milk industry health but as we have seen today it is a little different to that," he said.

Comments and questions

Only a matter of time before the conflicted directors (Board majority) started favouring farmers over shareholders.

Only mugs will hold these shares from now on.

Correct. A ludicrous & entirely misunderstood (until today perhaps) structure. A veritable melting pot of uncertainty, conflict & absence of advocacy. Smart investors avoided this 'stock' in the same way they avoided CDO's. Another black mark for NZ capital markets.

The smart farmers who sold can now buy in again at the issue after a healthy profit (taxable ???)

Lower demand for 30% of your product causes a missed target whilst 70% of your product is commanding higher than normal prices?

Something very wrong here.

"Something very wrong here."

Yes of course. The Fonterra farmers have a statutory monopoly.
Yes , Fonterra must sell milk to other processors , under DIRA, until there is competition i.e. forever, because , by design , there will never be competition.
As long as the Milk Price Manual is blatant fraud , and emerging prcessors can be undercut and weakened by Fonterra , to the point where startups are "rescued" by overseas (lost to NZ
ownership)interests, then Fonterra remains perfectly happy to sell raw milk , because the price under DIRA is a jackup.
What's the problem?
Only the fact that the US dairy lobby is adamant that there is no free trade in dairy products while DIRA is on the statute books.
We can live with that can't we?

Think about it. The raw milk which ended up as "added-value" land fill was worth how much?
That's right. It was worth just as much as any other litre of raw milk that Fonterra collected.

And people are supposed to believe that there is a transparent market for raw milk under DIRA. Yeah right!

My understanding is that no raw milk was dumped; only low value buttermilk. Not having to process that meant that plant could be utilised processing higher value products. But then, as a "Farmer" you would know that already.

Isn't the milk price mandated in DIRA.
If Fonterra decide to undercut this and pay out less to farmers... they are using farmers as a bank to fund their under performance. That's a wee bit unfair on the farmer suppliers..... so who else out there wants their milk????

"Isn't the milk price mandated in DIRA."
What on earth makes you think that?
The Commerce Commission hasn't got the guts or , more importantly the wherewithal to fight the blatant manipulation that Fonterra practises in relation to '"added value" ; commodity milk ; raw milk value; and dividends.

If there was competition for raw milk we might have some transparency, but DIRA guarantees that competition will never happen. That is the reason for having DIRA ; so that there will be no competition , and the Commerce Commission is essentially powerless.

Nothing wrong with the Fonterra fund, but you have to understand how it works. The higher the price paid to farmers the greater margin is squeezed and the lower dividends through the fund. Hence a lower price. Why the margin squeeze? Because Fonterra can't ratchet up prices at the retail end of the business as fast as it's costs rise. Hopefully the units will have a price starting with a 4 and then it will be time to look at buying again, sold out totally some months ago, but that does not mean the units won't do well again.

So the Milk Price manual is not set in concrete ; Fonterra used '"its discretion".

" that does not mean the units won't do well again."

What makes you think that there is a new supply of turkeys out there in the market Chris?

As soon as Christmas is over it is safe to be a turkey for another year.

Joking aside people have short memories and will make the same mistake over and over again. That is good for those who buy low and sell high to the next crop, aka rafter of turkeys.

Looks like Fonterra is putting a bit away for the up coming lawsuits from the botulism scare.

The farcical nature of Fonterra's raw milk pricing is revealed by the fact that Fonterra offers quarterly contracts for raw milk supply bought outside of the DIRA regs. The price for such contract milk in the middle of winter is nearly double the price of milk at the peak of the season.

But hey!
That's what it means to be a "cooperative" right?
A farmer who owns expensive land adjacent to the factory , receives , in the middle of winter , the same raw milk price as someone hundreds of miles away from the factory , on cheap land, producing at the peak of the season when milk is being dumped into landfills.

It's entirely logical!! The Milk Price Manual says so.