UPDATE: Fonterra earnings raise concern about base milk price, commission says

UPDATEDFonterra Cooperative Group's [NZX: FCG] earnings have declined since the current milk price calculation was introduced, and are lagging behind that of the regulator's notional producer, raising questions about the setting of the base milk price.

The Commerce Commission wants more comparative information to help build its aggregate assessment of Fonterra's milk price calculation due to a lack of readily available data without substantial investment by the dairy exporter's NZMP ingredients brands unit, the regulator said in its draft report on the 2014/15 milk price.

The regulator expects Fonterra's actual performance to be lower than that of a notional producer due to the product mix, and analysis comparing the dairy company's normalised earnings before interest, tax, depreciation and amortisation per kilogram of milk solids to the capital cost per kgMS shows "Fonterra's Ebitda per kgMS performance has declined since the introduction of the current milk price calculation methodology and that the actual ebitda per kgMS for NZMP is substantially lower than the notional producer is expected to achieve," the report said.

"The question this analysis raises is whether the cost structure of the notional producer that is represented in the base milk price calculation model is lower than practically feasible for an efficient processor and whether the base milk price is consequently set at a level that is too high for an efficient processor," the report said.

The draft report, published today, showed Fonterra's 2014/15 base milk price of $4.40/kgMS was largely in line with the Dairy Industry Restructuring Act's milk price monitoring scheme in ensuring the Auckland-based company has the right incentives to operate efficiently and provide competition in buying milk at the farmgate.

Commission deputy chairwoman Sue Begg told a briefing in Wellington the regulator was "really pleased with the additional information" released by Fonterra. Comparisons between the notional producer's individual cost components with independent processors' views may be a focus for next year.

"We've had a lot of feedback, particularly from the independents, who think we need to look harder at an aggregate assessment, so we've been trying ways of getting better information to make that assessment," Ms Begg said.

Fonterra improved its transparency with the information it provided the regulator, and a number of issues hanging over from the previous season, such as energy and the treatment of fixed asset capital costs, have been resolved, Ms Begg said. Progress has been made on Fonterra's weighted average cost of capital (wacc) but the regulator wants more information to better understand the dairy exporter's asset beta, which measures the company's exposure to market volatility.

"At a high level the wacc rate is within the expected range for a business such as a notional producer, bearing in mind a lot of the commodity risks are not borne by the commodity producer but are borne by the farmer," she said. The regulator hasn't understood how the company's independent expert extrapolated a notional producer would face lower volatility than Fonterra, and "we need more explanation to explain the link between Fonterra's commodity producer and the notional."

The draft report said the independent review notes Fonterra is "exposed to 'stream return' risk for commodities not included in the milk price basket," something the regulator said was unclear whether it was systematic or justified the difference in the asset beta.

"It is also not clear in his report the extent to which any Fonterra board decision [or the ability to make such a decision] to subordinate [that is, reduce]) milk price payments to farmers in favour of the returns to capital providers has been reflected in the asset beta," the commission's draft report said.

Fonterra sets the milk price by reducing operating costs and capital recovery costs from revenue. The regulator's calculation is based on a basket of reference commodity products, made up of whole milk powder, skim milk powder, butter milk powder, butter, and anhydrous milk fat.

"Fonterra takes a five-year view on that – there may be some deviations in the short term but it's Fonterra's view that whole milk powder and skim milk powder are likely to be the most profitable over the next five years," Ms Begg said. "We did review that and it seemed reasonable."

The commission will take submissions on the draft report for the rest of the month, with the final report on Fonterra's milk price calculations due September 15.