Scratching beneath the surface of Fonterra’s accounts

[This article is published today at and is forthcoming in Farmers Weekly]

Fonterra’s loss of $196 million for the year ended 31 July 2018 has left nowhere for the Fonterra Board to hide. Wisely, it has chosen to take the loss on the chin. In line with this, it has completed the jettisoning of CEO Theo Spierings. Two of its most experienced directors (Wilson and Shadbolt) are also departing.

Fonterra plans to now take stock of the situation before charting a path to the future. However, the latest Fonterra communications at farmer meetings are emphasising debt reduction.

A black and white sort of a guy
New Chairman John Monaghan has been described to me as a black and white sort of a guy. That might be exactly what Fonterra needs; someone who calls a spade a spade and cuts through the public relations massaging that bedevils Fonterra.

One of the biggest problems with public relations massaging is that directors themselves become prisoners of the company line. Directors need external networks to tell them what is really going on in the company and its markets. For those who have such networks, there are no surprises in the situation as it has evolved over the last few years.

The starting point
The starting point for moving forward is to understand something of the current situation.  Fonterra’s accounts are always opaque but some progress is being made. This year’s improvement has been to separate out some but not all of the consumer-product measures from food service. I have been calling for this for many years.

Food Service
In recent years. Fonterra has been making excellent progress with some food service products. These are branded ingredients which are often sold directly to food manufacturers. Mozzarella cheese is one such example.

The problem with food service is that although branded, the products are essentially sold on technical formulation and price. Accordingly, it is much harder to defend a leading position in food service than it is in consumer goods.

This year has seen markedly reduced margins in food service related to increased competition from other suppliers, but also influenced by high commodity prices for milk.  Sales gross margins declined from 21.7 percent to 15.7 percent.

There is some prospect these margins can be increased, but probably only at the expense of commodities. Let there be no doubt, it is commodities that still drive overall profitability of the New Zealand dairy industry through farmgate prices, so we don’t want those going south.

Consumer Goods
Fonterra is struggling with its consumer goods and in all likelihood this will continue.  This is the area where Fonterra’s public relations massaging has done the most damage. We all hear about the successes, but the mis-steps get hidden away.

Fonterra now claims to be the biggest marketer of imported UHT milk in China. That is indeed an impressive feat. Alas, it does not compensate for all the other consumer products that are struggling. One important product that is missing in action is infant formula in China.  In most Chinese infant formula surveys, Fonterra does not even register.

Fonterra relies on Australian and Chilean sales for much of its consumer products income. Both are proving challenging markets and could become more so. In Australia there is lots of competition for farmgate milk, and in Chile it would seem that Fonterra is losing market share.

Fonterra reports its overall gross margin from consumer goods as 27.9 percent, down from 29.2 percent the previous year. As students of accounting will know, there are two big steps from there to a final profit. The first is to add the marketing and administration costs to get an EBIT figure. Then there is interest to be paid on the loans that financed the business development.  These figures are not provided.

Combining the value-add components
Although separate net profits of food service and consumer products are not provided, Fonterra does provide an EBIT (earnings before interest and tax) figure of $525 for the combination. This is on a normalised basis with so-called abnormals such as the Beingmate fiasco scrubbed out.

The overall message from this normalised EBIT for food service and consumer products is that it is insufficient to allow for a fair share of unallocated company costs ($493 million across all segments, plus net finance of $416 million)  and still provide a significant net return. Accordingly, even on this normalised basis, it is evident that it is commodities and some other ingredients that are propping up the overall business.

China farms
Fonterra’s China farms have made a stated loss this year of $9 million EBIT. However, this is not the real loss. First it is necessary to add in another $30 million that the ingredients business lost by buying the milk well above market prices and then selling it at a loss. This brings it up to $39 million loss before interest is charged.  Production has also declined this year, apparently linked to effluent management issues.

What happened to cost control?
Shareholders will recall that Theo Spiering’s $8 million payout in 2017 was because of the big cost savings he had made over the previous two years, which led to him getting big bonuses. Well, as can so often be the case with cost-cutting, short term gains lead to longer term losses.

It would seem this is exactly what has happened, with normalised costs going up seven percent this year.

What else is buried in the accounts?
he headline figure of $183 million that Fonterra had to pay Danone was not the final figure. Fonterra had to pay Danone an additional $49 million to cover interest and Danone’s legal costs. These details are in the small print on p102 of the Annual Report.

Fonterra also advises in the small print that the Danone saga may not yet be complete. Fonterra states (p102) that “It is unclear whether Danone will continue to pursue the New Zealand High Court proceedings that were stayed pending the decision in the Singapore arbitration. Due to the uncertainty regarding whether Danone will seek to re-initiate these proceedings, and the nature and scope of these potential proceedings in light of the arbitration findings and award, no amount has been recognised in relation to these proceedings”.

Another unknown going forward is the amount that can be recovered from the Beingmate fiasco.   The shares are currently valued in the books at $204 million. No-one really knows whether or not these shares have any value.

What are the good points?
Amongst all of the problems, surely there have to be some successes apart from UHT milk to China and mozzarella?  Well, I am still looking!

The most obvious strength at Fonterra is that it is a very efficient processor and marketer of commodities. And that is just as well given all the other issues.

 Who bears the cost?
This year’s losses are borne by the balance sheet. It is not only the losses that have to be carried, but also the $160 million of dividends paid out back in April.

Interest-bearing debt is rising, and is now $6.9 billion. Fonterra’s total liabilities, including money owed to trade and farmer suppliers are over $11.7 billion. This leaves only $6.3 billion of equity.

That means the squeeze is now on, with further borrowing options now restricted. That is why Fonterra faces a constrained future.

[An earlier version of this article implied that EBIT segment earnings were not net of depreciation. This has been corrected. However, the segment earnings do need to cover  a fair share of $493 million of unallocated costs plus $416 million of net finance, as now stated.]

About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
This entry was posted in Dairy, Fonterra, Uncategorized. Bookmark the permalink.

10 Responses to Scratching beneath the surface of Fonterra’s accounts

  1. Rick g says:

    Calling a spade a spade might also mean he is simple. What fonterra obviously lacks is marketing expertise ie beingmate and political decorum ie previous ceo pissing off the chinese by saying they can’t be trusted.

  2. Scott Smyth says:

    Hi Keith
    Thanks for your analysis. By the way those EBIT figures are after deducting depreciation, but before interest & tax.
    Cheers, Scott

    • Keith Woodford says:

      Thanks Scott
      Yes, you will be correct if they are indeed true EBIT.
      Are you in a position to confirm that is the case?
      Keith W

      • Scott Smyth says:

        Hi Keith
        I’m a shareholder/dairyfarmer/ex accountant. EBITDA would be earnings before depreciation (& amortisation, interest & tax). EBIT is after depreciation and Fonterra has always been consistent with this, as they legally have to be in their audited accounts.
        Of more concern to me in analysing the various business units is the fact that there is a large amount of unallocated (or ‘head office’) costs which theoretically do not relate to any single business unit. In FY18 these amounted to $444m or about 18% of operating expenses.
        Scott Smyth

  3. Keith Woodford says:

    Thanks Scott
    My error was in substituting the term ‘EBIT’ for ‘earnings’, with the later as defined by Fonterra being pre any depreciation and amortisation. Adding the various earnings figures for the various divisions gives a figure well above the company EBIT. So I am comfortable with the conclusions I drew but I did use the term EBIT incorrectly. My bad. I have asked the editor at Farmers Weekly to correct this in the forthcoming publication there – assuming the printers are not already running.

    Yes, the issue of overhead costs is always an interesting one. I think Fonterra does allocate overheads to the various business units but I will need to scratch again to try and confirm what remains unallocated – I had not myself picked up the $444 million unallocated.

    I note that last year’s foodservice and consumer goods earnings were significantly restated because of an allocation of additional overheads.

    • Keith Woodford says:

      Yes, the $444 million of unallocated overheads was there staring me in the face on p95. This all confirms to me that there is lots for the Board and senior management to address.
      When I referred to public relations massaging, perhaps I was being too kind.

      • Keith Woodford says:

        I trust that I have now (finally!) stated the segment position correctly. I did indeed get myself in a tangle with the detail and it has taken me some time to disentangle myself. The segment incomes are indeed EBIT (net of depreciation) but there are $493 million of unallocated company costs still to be considered, plus finance costs.
        So the messages remain the same.

  4. Tom Hunter says:

    This is extraordinarily depressing, less because of the current poor results, than because it is increasingly apparent that there is a cultural problem in Fonterra that changes in personnel and plans are unable to overcome. Rather than getting better, things are steadily getting worse, especially relative to other companies in the same business.

    It used to be just Tatua, and Fonterra farmers were willing to shrug off their success as the result of being small, focused and flexible – something not translatable to Fonterra. But now we have A2 and Synlait as other different examples that are also proving to be better investments than Fonterra.

    It reminds me very much of the business culture problems of GM and Chrysler in the 80’s, and IBM in the 1990’s, which were very much the focus for me as business student and later a consultant in those years. You could put your finger on many different problems, around product development, marketing, general business management and so on and so forth – but all of that seemed merely symptoms of some wider, general malaise. Frighteningly those companies never did fix that general problem.

    It’s all this that caused me to give up on Fonterra several years ago. It took time and planning, but I eventually managed to sign on with a different outfit, although timing of the deal – over which I had no control – mean that I still have the legacy of some unsold shares, which have dropped 20% this year. So even at the end, Fonterra is proving to be more millstone than safety harness to me. Here’s hoping for at least some crude improvement in performance and share value so that I can cut the final cord and escape without further damage.

    Whether that same hope applies to the dairy industry as a whole is the big question – and although you have said many times that Fonterra must do well for the good of the whole industry, I’m less confident than ever that that is possible.

  5. Tom Hunter says:

    Worse and worse and worse and…..–and-got-it-wrong

    At one point his words are translated to say “Today we have a retail network of over 80,000 retail outlets”.

    However China infant formula market analyst Jane Li said the phrase is a mis-translation, and what Xie actually said was “Beingmate knows well the sales data from 80,000 outlets.”

    Let alone their other problems:

    Writing on the website Sina, dairy analysts said Beingmate’s problems were many fold. It had too much capacity, consumers lacked confidence in it as a brand, competition had increased in the sector, and it suffered brand damage following an alleged milk powder tampering incident two years ago.

    Added to that it has had an unstable management team. In the last four years there have been seven chief executives. Last year alone a director, vice-president and chief financial officer left the company.

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