Fonterra loses while A2, Synlait soar
Nikki Mandow contrasts Fonterra's massive loss with record profits from A2 and Synlait. She finds Fonterra stuck in commodity-processing mode.
The contrast between Synlait Milk's record first-half profit and Fonterra Cooperative Group's interim loss suggest the world's largest dairy exporter hasn't just got trouble with Beingmate Baby & Child Food, but has a long-running inability to move away from commodity production.
This week milk powder and infant formula maker Synlait Milk posted a first-half profit of $40.7 million, four times more than it earned a year earlier as sales jumped 50 percent to $439 million. And Synlait isn’t the only NZ dairy company on a stellar track. Earlier this month, its key customer a2 Milk reported a 150 percent gain in first-half profit as sales surged 70 percent.
Fonterra posted a first-half loss of $348 million for the six months ended January 31, after writing down its 18.8 percent stake in Beingmate, its Chinese infant formula distributor, and paying $183 million in a settlement to Danone over the 2013 whey protein contamination scare. But even before the one-time charges, Fonterra’s was a less than spectacular performance. Volumes fell 11 percent, margins contracted by 6 percent and earnings before interest and tax dropped by 25 percent.
Comparisons between Synlait/a2 Milk and Fonterra aren’t simple. Fonterra is a complex business. Its cooperative structure, its vertical integration, its sheer size in the market, the fact it’s reliant on not one but several commodity price structures, all come together to make the company, as Harbour Asset Management senior research analyst Oyvinn Rimer says, “like a machine with a million moving parts”.
But still, it’s a puzzle why Synlait and a2 Milk can deliver such strong financial results while Fonterra can't. After all, the weather’s the same for everyone’s cows, they eat more or less the same stuff, and basic milk prices are the same.
So what’s different?
There is one thing that stands out strongly from the two sets of financial results: value-added production. Making and selling innovative, higher-margin products.
It isn't a new idea at Fonterra - the company even has a name for its moving-up-the-value-chain strategy: V3 ("Driving more Volume into higher Value at Velocity"). As chief executive Theo Spierings said in 2017's full-year results presentation: "V3 is at the heart of our ambition and provides the foundation for us to fund and drive innovation and sustainable value creation." Fonterra's "V3 strength" had enabled the company to deliver "solid earnings in an environment of rapidly increasing milk prices", Spierings said.
That was last year. But search back through previous financial results and Fonterra’s performance appears disappointing when it comes to driving more volume into higher value, let alone with any velocity. The company has three different categories of sales which fall into the “value added” basket: "consumer" (branded products for households - Anchor butter, Anlene adult milk powder, Anmum baby formula etc); "food service" (specialist Anchor branded products for restaurants, hotels, cafes etc); and "advanced ingredients" (clever stuff like pharmaceutical ingredients and designer proteins).
Those three categories combined made up 43 percent of Fonterra's total volume in the latest half, up from 42 percent last year. Fonterra has changed the way it categorises its business units and only split out advanced ingredients as a separate item last year, making earlier comparisons tricky.
But consumer products made up 12 percent of Fonterra's sales in 2014 and that hasn't changed since. Fonterra argues that total volumes increased over that time, so even though the percentage hasn't increased, the amount of value added product has. Still, it seems Fonterra didn’t manage to transform any of its commodity sales to consumer value added.
Even in the first half of this year, when Fonterra’s total milk volumes fell 11 percent, which should have given the company an opportunity to increase the proportion of value-added sales compared to the total, the percentage in the consumer category only rose fractionally - to 13 percent.
No advance in advanced ingredients
Meanwhile, in the "advanced ingredients" category, the percentage hasn’t moved from 19 percent over the last two results, even with the lower overall volumes this year.
In food service, the company has managed an increase, with the percentage of sales creeping up every year from 6 percent in 2014 to 11 percent in 2018. The company announced last year that food service had reached $2 billion in revenue. At the time, chief operating officer Lukas Paravacini said that if the category was a standalone company, it would be New Zealand's sixth-largest export business.
Still, putting the higher value-added consumer and food service categories together, Fonterra’s financial performance was disappointing in the first-half result. Gross margin fell to 23.6 percent, with Fonterra attributing the decline to the impact of rising butter prices that deterred consumers. Normalised earnings (ebit) fell almost 40 percent, and the result was even worse in Asia.
In its presentations, Fonterra uses a wheel-like pie chart to illustrate the change from commodity dairy and base ingredients to value added. Marc Rivers, who started as CFO this month, says the wheel is turning, as the company moves more milk (measured in liquid milk equivalent, or LME), into consumer and food service.
“Sometimes the wheel turns faster than other times. The reason we saw it slow down in the first half of this year is because our overall volumes were down 11 percent for the half year versus the same period last year. In consumer and foodservice we had another dynamic play out which was as customers responded to higher prices, especially for butter, we saw our product mix move away from butter towards cream, which uses less LME.”
Rivers says the company added an additional 380 million LME into consumer & foodservice in 2016, a further 576 million LME in 2017, "and this year we’re aiming to add another 400 million LME".
He puts a positive spin on the financial performance. “We aren’t capturing as much margin as before, but it’s still incremental margin we are collecting, because otherwise, it would have been a bulk ingredient sale. In absolute terms, it’s incremental profit and value.”
A surprising high point in China
Surprisingly, given the problems with Beingmate, China is a high point in the Fonterra value-added picture for the first half of 2018, with volume in the consumer and foodservice segments up marginally and normalised ebit only fractionally down.
Analyst Oyvinn Rimer sees Fonterra’s food service business in China as the “crown jewel” in value-add.
“They are the number one player in China in that space with cream, butter, cheese and in quick service restaurants, like Starbucks and Domino Pizza,” Rimer says. “The Chinese don’t eat much cheese/milk, but Fonterra had a head start in food service in hotels and big restaurant chains. That is a good business.”
Still, Rimer says Fonterra is in the unenviable position of wanting to increase the amount of value-added products it sells, but being stymied by its cooperative structure when it wants to build the expensive plants that would be needed.
Building mega-factories and creating brands are very capital intensive and Fonterra can’t finance it through debt like a normal business, he says. “Another company might see an opportunity and raise capital for the project. But unless farmer shareholders choose to put millions of dollars into new plant and equipment, it’s hard for Fonterra to compete.
“It’s one of their major problems - having a limited way to supercharge their value business,” he says.
Mozarella, cream cheese and sliced cheese plants
Fonterra's Paravacini said last year that Fonterra has invested $850 million in new production capacity for foodservice since 2013 - $700 million of which has been in New Zealand. These include expansions at Waitoa for UHT creams, Eltham for slice-on-slice cheese, Clandeboye in Canterbury for extra stretch mozzarella, and Te Rapa (Waikato) and Darfield (Canterbury) for cream cheese.
Synlait is also investing in plant and equipment to turn milk into something more exciting. Over the past six months, investments have included an $11.2 million blending and canning facility, an $18.4 million wetmix kitchen, and an R&D centre in Palmerston North, chair Graeme Milne says.
And there’s more to come. “At Synlait Dunsandel we expect to spend $125 million on an advanced liquid dairy packaging facility and at Pokeno we will spend $260 million to establish our new nutritional powder manufacturing facility.”
Where's the R&D?
Synlait chief executive John Penno said research and development spending would rise from $4.75 million in the 2017 year to $7 million this year. The aim is to get it to 1.5 percent of revenue over the next few years, he says.
Perhaps tellingly, Fonterra doesn’t talk about R&D spend in its results presentations and the company didn’t come up with figures when asked. But an internet search found mention of an $80 million R&D budget in 2016 when the company made $17.2 billion in revenue. If that number is right, Fonterra is spending less than 0.5% of its revenue on research and development.
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