Analysis of Fonterra's Financial performance

Update on Fonterra's 31st January 2009 interim financial report
The Mega Co-operative Model – an evolutionary dead end?
Performance Assessment of Fonterra
Annual Financial Data from 2002 to 2008

Interim reports to January 2009
Note: When comparing a six month interim report for a seasonal agricultural industry i.e. dairying that differs from the previous report in that two mid winter months (June and July) have been removed and replaced by two mid summer ones (December and January), only balance sheet data will meaningful.

Highlights from Fonterra’s just released interim financials would therefore be:

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

NZX reporting requirements mean information has been presented not traditionally reported by Fonterra. This includes: Total recognized income and expense for the period ($-557 million), Net fair value gains in cash flow hedges ($-1,665 million) and Total Liabilities divided by Equity (373.88%).

Interim balance sheet information for Fonterra between November 2001 and 31st January 2009 are shown in table form:

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

This data is graphed for Assets, Liabilities, Equity and Liabilities to Liabilities plus Equity:

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

This data speaks for itself, and no amount of bullshit or a credit rating can hide the fact that liabilities are excessive, asset values are questionable and equity is disappearing rapidly.

Annual reports to July 2008
While NZ has had a successful dairy industry for over a century, the formation of what was to become Fonterra put the industry on a very different basis to anything that preceeded it.

The issues facing the dairy industry in the late 1990's and the history of the industry to that point must be understood to appreciate how a mega co-operative model could be contemplated. That is a critical task if a model for a sustainable NZ dairy industry is to emerge - but not one to undertake now. At this point it is suffice to say the mega co-op concept emerged from an industry that had largely already achieved the production and efficiency gains possible as low cost commodity suppliers, but still expected ongoing gains, and to defy market principles.

The mega co-operative industry model that emerged was a political construction – an experiment attempting to address issues facing the dairy industry and politicians at the same time. Short term gains were promised, but long term problems known to be inevitable. The experimental model had irreversible flaws - flaws which must not be incorporated into any new model.

Flaws in the mega co-operative industry model include:
1.As a dairy commodiy supplier, the processor is dependent on the availability of a low cost milk supply.
2.Sheer scale dictates a corporate style of goverance, but coprorate goverance and co-operative ownership are uneasy bedfellows. The advantages of co-ops largely disapear.
3.The processor is governed by its suppliers - conflicts of interest abound. The disadvantages of co-ops come to the fore.
4.There is no place for independent industry bodies – the mega co-op is the industry body.
5.Increasing processor and marketing capital effectively requires an increasing milk supply.
6.Being a near monopoly does not lead to innovation, but instead ineffectiveness.
7.The industry has no effective means of controlling short term milk supply in response to demand.

This mega co-op model in NZ has survived so far on the basis of farm asset gains. This bubble has inflated steadily at a rate of around $5.00 per Kg milk solids production per annum since Fonterra's formation was signed off. Farm asset appreciation per Kg of production has exceeded the gross payout from milk over this period. The dairy industry has focused capital almost entirely on farm production to the exclusion of processing and marketing.

This mega co-op model can not continue much longer, but the model's flaws ensure there is no effective means of correction. The experiment can not evolve into a successful one but will rather need to be unwound to a state prior to the formation of Fonterra, before proceding from there. The means for such an unwinding is not provided by the the mega co-operative model either.

Financial Indicators
Financials are retrospective. Fonterra's last accounts are for the period 1st June 2007 to 31st July 2008 – a boom period for dairy products.

Reports for the seven years reported up to July 2008 will though indicate trends. Data below. In brief these trends seem to suggest initial gains in key financial performance metrics followed by a deterioration. Over the seven years milk supply has increased which must have been accompanied by new capital from share purchases, but equity never increased significantly, and is now less that on the formation of Fonterra. Leverage has increased. Liabilities are clear, but the quality of much of the asset base is not. All of these trends developed during a benign economic period with dairy industry growth.

Since the 31st July 2008 there has been a collapse in demand for dairy commodities and world prices have fallen to below long term trends. The price impact has been softened by a falling NZD. NZ dairy production though is very slow to reduce production and dairy commodity supplies are building.

For Fonterra the last 6 months has also been one of marketing debacles. That is if marketing is defined in its correct usage as anything that impacts on a business's long term viability and success. It remains to be adequately explained how a food supplier can over such a short period of time: Seriously upset the Chinese government; Damage its reputation for quality around the world; Become identified in Europe and the US as responsible for forcing world dairy prices down; Develop the belief amongst its highest paying market (NZ fresh products) that they are being milked and; Seriously damage relationships with wholesale traders by enforcing high priced forward contracts in a collapsing market. A retail bond issuance that may turn sour on mum and dad investors could round out Fonterra's reputational battering.

Possible Leading Financial Indicators
World dairy prices and projected payouts
Farm asset prices and costs – farms, cows, supplements
Farm production intentions

Fonterra, consolidated - Financials since inception
2007 and 2008 data are from the 2008 Financial Statements and on a IFRS basis

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Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided

Data Source: Fonterra Annual Reports, Interim Reports, Annual Reviews, and Statutory information provided