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A Broker's PreView - Fonterra Backs Farmer Shareholders

Overview: If investors in the Fonterra Shareholders’ Fund (FSF) needed a reminder of their place, they got it last week when the dairy co-operative announced support for share-backed farmers in the form of an interest free loan of 50 cents per kg of Milk Solids. This goes to reiterate to FSF unitholders that their lack of any voting rights means they are merely along for the ride. And what a wild ride it has been.

Pros: Although some unitholders may be unhappy that Fonterra are extending credit to farmers (interest free for 2 years), the reality is that a strong Fonterra relies on the viability of their farmer shareholders. If Fonterra did not step in to support farmers, many could go bust, leading to lower milk volumes and less demand for Fonterra shares from said farmers, putting further downward pressure on the share price.

Along with the emergency lending announced last week, Fonterra also surprised the market with an impressive earnings forecast of 40-50cents per share for the 2015/16 season. This will flow through to a good jump in the dividend, which will please unit holders.

The higher earnings are reflective of the low Farmgate Milk Price (which is essentially a cost of production for Fonterra) and a favourable product mix for the company. The product mix caused issues for Fonterra back in the 2013/14 season, when cheese prices were far lower than whole milk powder and other price setting products. Fervent buying from the Chinese had pushed up prices on some products and pushed up Fonterra’s cost of production, leading to the Board overruling the Milk Price Manual (paying $8.40 per kgMS vs. the manual price of $8.95).

Ironically, this 45 cents underpayment mirrors very closely the 50 cent loan to farmers this season. Both were logical for the long term strength of the Company.

Cons: Working against Fonterra on the global market at the moment is a removal of quotas in Europe and a ramp up of production in the US, both adding supply. This has coincided with a Russian ban on imports and lacklustre Chinese demand. Prices have subsequently plummeted.

This has lead to Standard & Poor’s placing Fonterra’s credit rating on credit watch. The Company’s credit rating remains A, which is still very high. Fonterra’s current gearing is approximately 50 percent. This could be considered high for some companies, but Fonterra’s set up, and ability to tap equity markets has debt holders felling comfortable. In fact one of their debt instruments trades at a yield of just 3.16 percent on the NZX debt market.

Investors should also keep an eye out on the Dairy Industry Restructuring Act (2001) review that started in June. This could lead to deregulation of the industry if there is deemed to be enough competition for Fonterra, meaning that the company could no longer be forced to accept all supply. Having said that, most would argue competition is insufficient to warrant deregulation.

Price performance: The share price jumped 5 percent after the earnings announcement last week, and has been relatively flat since.

Investment outlook: The forward yield is reasonably attractive, but risks abound for unitholders who are merely along for the ride.

Grant Davies
Investment Advisor
Phone: 03 353 0795
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*A Broker's View is written by Grant Davies, Investment Advisor at Hamilton Hindin Greene Limited. This article represents general information provided by Hamilton Hindin Greene, who may hold an interest in the security. It does not constitute investment advice. Disclosure documents are available by request and free of charge.

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