Brian Gaynor: NZ’s dairy giant deeper in debt

Monday’s announcement of a new $150 million Fonterra retail bond offering has shone the spotlight on the co-operative’s soaring debt levels.

The dairy giant’s total borrowings have swelled from $4.65 billion to $7.56 billion since the end of its July 2011 year while its net positive cash/overdraft position has deteriorated from $762 million to $303 million over the same period.

The new bond issue coincided with Primary Industries Minister Nathan Guy’s statement that dairy farming debt was drifting into a “severe scenario” and he would be urging banks to stand by farmers. The Minister observed that the latest Reserve Bank statistics showed dairy farm debt now stood at $37.9 billion, compared with $30 billion five years ago.

Guy’s comments came a week after a Federated Farmers’ poll showed that 11.1 per cent of dairy farmers were under scrutiny by their banks, compared with 7.6 per cent in November and 6.6 per cent in August.

Fonterra’s announcement early this week also included a first-quarter performance summary.

Unfortunately the three-month summary, which covered the period ended October 31, 2015, had little specific information.

The co-operative reported a revenue decline of 17.6 per cent, to $3.6 billion, compared with the same quarter in the July 2015 year but the gross margin increased from 14.1 per cent to 22.7 per cent. There were no detailed cost numbers or updated debt figures.

Farmer shareholders would probably argue that Fonterra doesn’t have to disclose comprehensive financial data to outsiders. That is a short-sighted view because external sources have provided $7.56 billion of debt funding while farmers have contributed only $5.81 billion of subscribed equity.

Individual dairy farmers and the country’s largest co-op have become extremely dependent on outside borrowings and these lenders may be less willing to roll over maturing debt unless Fonterra becomes more transparent.

Fonterra observes that it has a market value of $8.9 billion, which is well in excess of the largest listed NZX companies. However, its total borrowings of $7.56 billion are also well above the three largest listed companies, which have the following comparative figures:

• Auckland International Airport has a market value of $7.4 billion and borrowings of $1.8 billion.
• Spark has a market value of $6.3 billion and $0.8 billion of debt.
• Meridian Energy’s figures are $6.2 billion and $1.2 billion respectively.

There is a strong argument that infrastructure companies, telcos and electricity generators with relatively stable earnings can have much higher debt levels than commodity producers. However, it is the other way around in New Zealand as Fonterra has much higher debt levels, both in relative and absolute terms, than Auckland International Airport, Spark or Meridian Energy.

The accompanying table shows the composition of Fonterra’s borrowings and its annual net interest costs.

Those net interest costs have risen from $269 million in the July 2013 year to $518 million in the latest period. This $518 million figure comprises $557 million of finance costs minus $39 million of interest received.

Those net interest costs have risen from $269 million in the July 2013 year to $518 million in the latest period. This $518 million figure comprises $557 million of finance costs minus $39 million of interest received.

Fonterra has become increasingly dependent on medium-term notes and bank loans.

These medium-term notes have been issued in New Zealand dollars, Australian dollars, British pounds and Chinese renminbi. They have maturity dates from early next month to 2025. These notes mainly have an “A-” credit rating from Standard & Poor’s.

Bank loans have become increasingly important to Fonterra and now stand at $1.72 billion, compared with $0.49 billion five years ago. All of Fonterra’s debt is unsecured, with the exception of $169 million of financial leases, but it would be naive to suggest that the banks are not at the top of the queue as far as unsecured creditors are concerned.

Fonterra has used a proportion of its additional borrowings to invest in Chinese farms, which are included in the group’s International Farming division. The co-op’s 2015 annual review stated that it had seven farms in China, which have the ability to produce 200 million litres per annum compared with its New Zealand 2015 season uptake of 18.1 billion litres.

The annual review stated that Chinese capital expenditure was $364 million in the July 2015 year, which included the expansion of its two farm hubs, investment in farm effluent treatment systems and livestock purchases.

The co-op’s International Farming division had a loss of $44 million for the July 2015 year. It reported a reduction in its gross margin of 5 per cent in the first quarter 2016, compared with the first three months of the July 2015 year, even though volume increased by 56 per cent.

New Zealand companies have yet to conclusively prove that they can successfully own and operate profitable overseas dairy farms, as demonstrated by the poorly performing, formerly NZX-listed company New Zealand Farming Systems Uruguay.

The Fonterra fixed-rate bond offer, which was announced and closed this week, was for $150 million. These are unsecured, unsubordinated, fixed-rate bonds. The issue essentially replaces a $150 million medium-term note issue which matures next Friday.

Fonterra will have some interest cost saving as the coupon rate on the maturing notes, issued in February 2010, was 6.83 per cent, whereas the new fixed-rate bonds have been issued at 4.42 per cent. The latter have a seven-year term.

This week’s NZX release from Fonterra highlights a number of positive quotes from an October 2015 Standard & Poor’s report which downgraded Fonterra’s long-term rating from “A” to “A-“.

However, the co-operative’s release didn’t mention that S&P’s “A-” rating assumed a milk price of $4.60 per kilogram of milksolids compared with Fonterra’s latest forecast of $4.15 per kilogram.

A number of industry experts believe the $4.15 forecast is still too high.

But the important point is that S&P places a great deal of importance on “the financial flexibility afforded by the co-operative structure, which provides Fonterra with significant discretion over payments to suppliers for milk”.

In other words, the “A-” rating is probably higher than it should be because of Fonterra’s ability to reduce the milk price if commodity prices continue to fall.

Thus, in my opinion the co-op’s high level of debt, and the importance of maintaining an “A-” rating, could have an additional negative impact on farmgate prices.

Standard & Poor’s had this to say about the July 2015 year season: “The group’s financial flexibility late in the season was diminished due to the speed and magnitude of the drop in global dairy product prices, relative to the level of advance rate payments to its supplier shareholders. This also resulted in a material increase in its working capital at balance date, which added to the already elevated debt levels from capital investment and acquisitions during the year.

“In addition, Fonterra’s offer of a loan to suppliers in our view implies there may be limited headroom to lower the payout at the bottom of the global dairy product price cycle. However, we note that loan payments will be phased as savings from the co-operative’s transformation programme are delivered.”

These comments, in my opinion, indicate that Fonterra may be trying to be too many things to too many people. It has the ability to reduce its farmgate milk price to maintain its “A-” credit rating but may be reluctant to do this because it could put some of its loans to farmers at risk.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.