Fonterra to lose more market share?

The ‘New Zealand Dairy Companies Review’ published in April says it seems likely that Fonterra’s competitors, with well-established relationships with farmer-suppliers and offshore customers and profitable operations, will have access to capital to permit them to continue growing at rates of about 10% per annum.

“If, as we assume to be the case, Fonterra grows by 2.5% per annum, Fonterra’s market share will fall from 84% to 79% over the next five years.”

It says the market share of NZ milk processing companies in 2016 was Fonterra 84%, Open Country Dairy 6%, Westland 3%, Synlait 3%, Miraka 1%, Oceania 1% and Tatua 1%.

“The NZ milk processing industry remains predominantly low risk with the large majority of volumes in commodities,” the report says.

“Competitors to Fonterra have improved the transparency of the sector’s risks and returns. The higher-risk strategies (Tatua and Synlait) are being adequately rewarded while at the other end of the spectrum OCD is generating returns materially above its (low-risk) cost of capital.”

Earlier the report says Fonterra’s NZ milk-processing competitors are now well established.

“The competitors’ milk volumes have grown from 600 million litres when Fonterra was established in 2002 to 2.9 billion litres in 2016.

“They now have a combined profitability (EBIT) of over $200m. Interestingly, Fonterra has grown its Australian milk processing volumes to 1.7b litres over the same period and in 2016 delivered a normalised EBIT on its Australian operations of $63m.”

Open Country Dairy is the benchmark commodity processor and Tatua the benchmark value-added processor.

“Both are focussed on their core businesses and delivering higher than expected risk-weighted returns to their shareholders and farmers. Both are paying some of the excess return to farmer-suppliers. When we normalise their cost of milk to Fonterra’s FGMP, their returns on assets in 2016 were 22% (Tatua) and 17% (OCD).

“Synlait is successfully shifting more of its milk into higher margin returns and has the access to capital and confidence from recent returns on assets of above 10% to invest in higher-value manufacturing assets that will continue its growth in volume and margin.

“Westland is the underperforming Fonterra competitor, and it is difficult to see that it could get shareholder support to invest more capital in higher-value processing assets.

“Westland has acknowledged its underperformance and we would expect little milk volume growth until it reduces its costs and regains the confidence of its shareholders.

“The balance sheets of Tatua and OCD show how significantly different their investment in long-term fixed-processing assets is.”

Tatua invests 250% more than OCD for every unit of milk processed, the report says.

“This additional investment is an indicator of the increased risk attached to a value-add strategy and underscores that a higher value-add strategy is not as simple as it sounds. It takes investment in long-term trusted customer relationships and investment in manufacturing assets that cost a lot more than is required for a commodity processor.

“If Tatua’s investment in manufacturing per unit of milk is applied to the other NZ dairy processors (including Fonterra’s NZ milk volumes), an additional $8b in capital would be required across the sector.”

The TBD Advisory report says given comments from the companies “we think it is reasonable to assume the current strategic positioning of the companies will remain the same over the coming few years”.