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.