Brook Report: A drop (of milk) in the bucket

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With dairy giant Fonterra about to roll out its wide ranging changes to its capital structure, Brook Asset Management portfolio manager Andrew Mortimer looks at the company and assesses its investment prospects. 

Thursday, October 25th 2012, 11:54AM

by Brook Asset Management

A 2010 NZIER study estimated that New Zealand’s dairy sector contributed 2.8% to GDP, which is the equivalent to $5 billion.

While this may not sound that impressive, in context it is greater than the GDP contributions of the fishing, forestry and mining sectors combined, and 10 times the size of New Zealand’s horticultural sector.

New Zealand’s biggest player in the dairy sector is Fonterra Co-operative Group, which generates around $10 billion of export receipts annually, equivalent to one in every four export dollars. Around 75% of this is returned to farmers by way of milk payments, but approximately $1.5 billion is injected back into the economy through salaries, wages and returns to other stakeholders.

The NZIER estimates that the dairy sector may account for as many as 45,000 jobs, directly and indirectly, for an untold amount.

While these statistics are interesting, what lies ahead for the dairy industry is potentially even more exciting.

Global milk production is estimated to be approximately 380 billion litres per annum and Fonterra expects demand to grow by between 27 and 33% during the next eight years. This growth is mainly driven by economic growth, urbanisation and the rising purchasing power of Asia’s middle class.

Most markets are self sufficient; only 50 billion litres (or 13%) is currently traded on a global basis. Global trade of milk is expected to grow by approximately 35 billion litres to 85 billion litres. New Zealand’s contribution to global milk production is estimated to be less than five per cent, however expectations are that domestic production can be increased by 25 per cent, or five billion litres, through improved productivity and land conversion. Therefore, New Zealand can only satisfy approximately four per cent of the total increase in production required over the period.

Capital invested in the domestic diary industry is valued at circa $60 to $50 billion for land and livestock, and $10 billion in stainless steel processing kits. Extrapolating this to the expected growth in demand, an estimate suggests that between $350 and $440 billion of capital needs to be deployed to service this growth.

Fonterra has said it expects to spend around $1 billion per annum on capital items, with depreciation running at around $500 million per annum. Further, growth capital will run at around $500 million per annum or $4 billion in total over the period to 2020. Taking this into account, planned capital expenditure falls short of expected industry growth and Fonterra may be at risk of losing market share during the next eight years.

While few doubt that Fonterra has some competitive advantages in the global market, it does not have the scale to exploit the expected industry growth. At a time when a war-chest should be built to take advantage of opportunities, its 10,500 shareholders are preferring dividends. Dairy farmers have collective mortgages of around $28 billion, or $2.3 million per farmer, and logically a farmer’s priority is to retire farm debt.

Fonterra is in the process of implementing wide-ranging changes to its capital structure, collectively known as Trading Among Farmers (TAF), which will see Fonterra no longer being required to redeem co-operative shares in the event of a supplier reducing or ceasing to supply the co-operative. The main objectives of the capital restructure are to create a permanent capital base and to facilitate trading between farmers, while retaining 100 per cent control and ownership. However, the change is unlikely to increase the company’s ability to raise equity capital, although it is feasible that debt capital maybe more accessible as banks become more comfortable with the equity structure of the co-operation.

Access to a much larger and deeper capital base will be more beneficial to Fonterra than its current capital base. The company has done well to efficiently use scarce capital by entering into partnerships and joint ventures with large players like Nestle and Dairy Farmers of America, but ultimately much more capital will be required for it to truly meet the opportunities that are available.

Ultimately, success in the industry is expected to be determined by the ability to access global milk pools and add value to its brands. Fonterra can buy and develop farms to ensure security of milk supply (i.e. vertical integration) or it can match, or beat, the prices from competitors when bidding for raw milk.

Unfortunately Fonterra does not have the capacity to buy or convert large parcels of dairy land and therefore it is imperative that the company extracts premium margins on product through strong branding and low cost processing facilities. Certainly in New Zealand it has an advantage, given our comparative low cost structure in milk production and the scale of our processing facilities.

Fonterra is no minnow, with assets of $US12.7 billion and equity of $US5.3 billion. Nestle, which is valued at $US200 billion, and Danone, which is valued at $US39 billion, dwarf Fonterra in size. Capital is mobile and companies like Nestle and Danone are much less capital constrained over the next few years, which means they are better positioned to capitalise on growing demand.

Investors may ultimately question the relevance of Fonterra given its current structural strait-jacketed capital structure. Will farmers rue the day they demanded 100% ownership of Fonterra?

It is clear that the story of New Zealand’s dairy industry is still unfolding, along with the opportunities in its path, and I have no doubt that Fonterra’s shareholders, competitors and New Zealand’s farmers will be watching with interest to see how the tale continues.

 

Brook Asset Management Limited ("Brook") is a member of the Macquarie Group. The views and opinions expressed in this article are those of the relevant author and do not necessarily reflect the views or opinions of Brook or any other member of the Macquarie Group. This article is based on information obtained from sources believed to be reliable but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of any information in this article and/or further communication in relation to this article. Brook is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Cth of Australia), and Brook’s obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542. Macquarie Bank Limited does not guarantee or otherwise provide assurance in respect of the obligations of Brook. Macquarie Bank Limited is a company incorporated in Australia and authorised under the Banking Act 1959 (Australia) to conduct banking business in Australia. Neither Macquarie Bank Limited, Brook nor any other member of the Macquarie Group are registered as a registered bank in New Zealand by the Reserve Bank of New Zealand under the Reserve Bank of New Zealand Act 1989 (New Zealand).

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