Fonterra warns of ongoing dairy market volatility

18 November 2008

Fonterra signals ongoing volatility in dairy markets

Fonterra Co-operative Group says there is likely to be more volatility in global dairy prices after a financial year in which prices went on an unprecedented rollercoaster.

In Fonterra’s 2007/08 Annual Review sent to shareholders this week, Chairman Henry van der Heyden said market unpredictability, rising costs, a high currency and financial turmoil made for a challenging business environment in the financial period ended July 31, 2008.

“However, Fonterra worked within this highly volatile environment to bring shareholders the best result since our formation,” said Mr van der Heyden.

“It is clear that 2007/08 has fundamentally changed market dynamics and volatility is more likely to be the norm, rather than the exception, in the medium term.

“With global financial confidence tenuous at best and the inevitable lag between price signals guiding farmer decisions around production, there is every possibility of an imbalance between demand and supply influencing prices.

Average dairy prices achieved by Fonterra during the 14 months to 31 July were US$4,350 per tonne, compared with US$2,673 a tonne in the previous 12 month period. International milkpowder prices peaked at around US$5,000 per tonne in late 2007 but more recently have fallen back to around US$2,600 a tonne.

The Annual Review details how Fonterra achieved its best-ever financial result in 2007/08, generating $9.3 billion for farmer shareholders.

About $9 billion was paid to farmers in the Milk Price component of payout, representing $7.59 per kg of milksolids (kgMS). The Milk Price is driven by Fonterra’s sales of New Zealand dairy products into global markets.

Profits from the company’s global commodity and ingredients businesses and consumer brands businesses generated an additional $364 million, or 31 cents per kgMS, in Value Return for shareholders. Of this Value Return, $277 million (24 cents per kgMS) was retained to strengthen Fonterra’s balance sheet.

Mr van der Heyden said the payout, achieved amid a period of unprecedented volatility in commodity, currency and financial markets, was the highest in 43 years (in inflation adjusted terms) to the Co-operative’s 10,724 suppliers in New Zealand.

However, it was a year in which farmers had been hit by serious drought, farm input costs had risen sharply, and Fonterra’s share price had fallen by 18%. Mr van der Heyden said the year was also marked by the events of raw milk contamination in China, which stretched across the whole Chinese industry.

While the payout was strong, the Fonterra Fair Value Share (FVS) Price had been affected by the increased cost of capital globally and high commodity prices cutting into margins for the ingredients business. The FVS price set at $5.57, within the range determined by an independent valuer, represented a decline of $1.22 from the share price of $6.79 in the 2007/08 season.

The drop in the share price enabled farmers holding excess shares to surrender shares, with a net amount of about $300 million returned to shareholders. The change in share price was a key driver of the TSR (total shareholder return) for the year of negative 13.4%.

Chief Executive, Andrew Ferrier, said Fonterra worked through some of the most demanding and unpredictable business conditions in recent memory to record its highest ever sales revenue and payout in 2007/08.

He said Fonterra achieved a 63% increase in the average commodity sales price realised for the year, to US$4,350 per tonne, which helped offset a 7 cent negative currency impact. Fonterra’s average conversion rate was US74 cents.

Group revenue was NZ$19.5 billion for the 14 month financial year to 31 July 2008, equating to an annual turnover of about NZ$17 billion.

Mr Ferrier said there were significant operational gains and cost reductions during the year in Fonterra’s core business across milk collection, manufacturing and supply chain operations. Many such as energy savings, waste reduction and transport efficiencies delivered a win-win for the business and the environment – delivering on both financial and sustainability goals.

He said Fonterra’s overseas business operations continued to perform well, generating higher returns for shareholders. And despite high commodity prices during the year, Fonterra’s consumer brands businesses performed well, holding up and, in many cases, increasing margins.

In total, segment operating profits (EBIT or earnings before finance costs and tax), were $614 million or 52 cents per kgMS. After deduction of finance costs and tax, the available Value Return (profit) was 31 cents.

Looking across the individual segments, Mr Ferrier said the profit (EBIT) for Fonterra’s Commodities and Ingredients business was $367 million, down from $918 million the previous year. He said in a typical year, Fonterra Ingredients’ value add business achieves healthy margins by using world priced ingredients in its commodities and specialty blended products destined for the higher value markets, such as US, Europe and Japan.

“However, with average commodity prices at record levels, the price differential between global prices and in-market prices fell sharply, putting margins under severe pressure. We are continuing to look for new opportunities to counter these margin pressures.”

Australia and New Zealand's profit was $203 million versus $200 million last year. Mr Ferrier said ANZ's underlying operating performance on a like-for-like basis improved from last year by $53 million.

“This is a very good performance – especially with milk costs at historic highs and a lot of margin and competitive pressure in the market. ANZ has Trans-Tasman leadership positions in cheese and spreads, and leads outright in milk, flavoured milk, dairy desserts and ice cream in NZ.”

He said while there was strong price competition for milk in Australia, a good performance in this market was offset to some degree by performance in the New Zealand market, where margins were squeezed by the high commodity prices.

Fonterra’s Asia/Africa and Middle East business recorded a profit of $90 million before an impairment charge of $139 million relating to the write-down of Fonterra’s investment in San Lu.

The profit for Latin America was up from $58 million last year to $129 million, again as a result of increased margins and volumes in the Latam segment. Fonterra increased its 56.8% shareholding in Soprole to 99.8% in April 2008 buying the Fundacion Isabel Aninant’s 42.6% shareholding for $286 million.

Mr Ferrier said Soprole has been a consistently strong performer for Fonterra over the years, with the company holding over a third of the local fresh dairy market in Chile and was an innovator with new products developed in the last three years accounting for more than 40 per cent of the company’s sales.