Some investors still think Fonterra gives them exposure to raw milk - "the opposite may in fact be true": Harbour Asset Management

By Andrew Bascand and Oyvinn Rimer*

The Fonterra Shareholders Fund (FSF) lists this Friday.

Clearly investor interest in Fonterra has been unprecedented.

Retail, farmer and global demand was very strong.

That is why it is relevant to remember the key short term drivers of this investment and valuation is not the milk price, but instead centres on Asian growth and Fonterra’s ability to maintain a fast growth rate in the Foodservices segment.

Investors must also keep an eye on governance.

The IPO was placed at the top end of the proposed pricing range at $5.50. At that price the FSF is expected to yield about 5.5%.

In the lead-up to this listing, Harbour has had the opportunity to learn about Fonterra and to provide constructive comments on the proposed security. It has been a long time coming and now that the listing of the Fonterra Shareholders’ Fund is finally here, we thought it could be constructive to discuss what the Fonterra Shareholders’ Fund is, how Fonterra operates and how it generates earnings.

Trading Amongst Farmers is the term for the overall “structure”. This includes a Fonterra Shareholders Market (colloquially known as the Farmers market) and the FSF (where “Units” provide external investors access to the same underlying cash-flows as the shareholders).

A Registered Volume Provider facilitates trading in the Famers market but can also exchange Shares for Units, effectively arbitraging pricing differences¹.

Fonterra – the world’s largest processor and exporter of milk

No other New Zealand company has a global reach on quite the same scale as Fonterra. Its large size and integrated business model gives it a unique positioning in the global dairy market.

At a very high level, it can be useful to think of Fonterra in two silos:

1) The New Zealand Milk business, which includes the collection of raw milk, processing of the milk, logistics related to the sale of the milk and end sales. Most Kiwis have seen the milk tankers on the roads, transporting raw milk from the farm gate to the processing plants, where most of the milk is processed into milk powder and then sold to end users across the world. This business earns a steady cash-flow albeit at low margins, but provides Fonterra with a secure supply of milk (matched by no other global competitor) for its own higher margin consumer-focused business; and

2) Consumer (or Brands) business, which includes Fonterra’s global consumer brands and foodservices businesses, as well as a range of joint ventures and equity investments in dairy-focused companies. Fonterra has the ability to leverage its strong milk supply to grow this business, targeting higher margin products in growing regions to sustain the company’s growth strategies.

Fonterra is NOT an investment in raw milk

As obvious as it may be, there are still investors who think that an investment in Fonterra gives them exposure to milk prices, when the opposite may in fact be true.

Milk is an input cost.

Significant controversy has in the past been associated with how Fonterra sets the Farm Gate Milk Price.

Much of the uncertainty associated with this key input-cost has been eliminated by publishing the Farmgate Milk Price Manual and the transparent Global Dairy Trade auctions. Moreover, investors have “fought” hard to improve governance, of both the Milk Price Panel and the Fonterra Shareholders Fund.

At the end of the day, we are starting this new “model” for New Zealand’s capital markets with a lot of trust and transparency and experienced global investors are now a large part of the new capital base.

This is important as there are several global examples of similar structures where valuation “discounts” are placed on the inability of investors to vote as ordinary shareholders.

These discounts fluctuate markedly and it seems as perceptions of governance vary.

This is a risk and an uncertainty for FSF as the structure “beds” down.

The exciting prospect is the growth in Asia and Foodservices globally

Whilst we can all “talk-up” the fast growing infant formula market, this is now a highly competitive segment and is not without risks.

Fonterra has a much broader array of Asian growth opportunities and is focussed on adding value through better supply chain management.

Perhaps the segment that is more exciting is the Foodservices industry, where margins are high and the direct access to customers, together with innovation in product, may continue to see fast growth in both revenue and earnings.

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1. The Units traded in the Fonterra Shareholders’ Fund (FSF) are entitled to all Economic Rights of Shares in Fonterra. The key differences from a Share are that a Unitholder does not hold legal title to the Share (i.e. does not become registered as the holder of the Share) and a Unitholder does not have any voting rights on Fonterra resolutions.

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Andrew Bascand  is the managing director of Harbour Asset Management and Oyvinn Rimer is their analyst for Fonterra. You can contact them here »