At the offer price of $5.50 a unit, the Fonterra Shareholders Fund float a year ago was a real money maker for those who got a piece of the action.
The price soared on listing and peaked at $8.09 in May, a gain of about 45 per cent in just six months. Even at last week’s price of about $6.60 investors have received a comfortable gain along with dividends totalling 32c.
I wasn’t able to get any stock in the float, not that I’m bitter.
Would I buy it now? The short answer is it’s not currently on my shopping list.
The Shareholders Fund was always going to be a peculiar beast, a weird concoction of financial rights tacked on to a complicated co-operative structure. Its behaviour since listing has borne out some of those quirks. Analyst Andy Bowley at Forsyth Barr described it as «lethargic and shockproof» in a research note this month.
«Shockproof in the sense that farmers and investors may transact in opposing directions, and therefore offset the impact of profit-impacting news. Lethargic in the sense that farmers’ perception of value may change far less dramatically and at a slower pace than that of investors,» he wrote.
His recommendation on the stock was «reduce», upgraded from his earlier «sell» rating, with a 12-month price target of $6.20.
Bowley’s description reflects the fund’s awkward straddle of interests. In the hands of investors its units offer returns equal to Fonterra dividends. In the hands of dairy farmers they are convertible into Fonterra shares, which also offer the right to supply milk to the co-op in return for the milk price.
Generally speaking, the higher the milk price the lower the dividend, which means returns for investors improve when returns for farmers decline, and vice-versa.
There was a stark reminder of this in Fonterra’s update on Monday about the dairy market and trends in the New Zealand milk business.
Translated from its customary jargon, the update said high prices for milk powders and butter were squeezing margins for cheese and casein, to the extent that some products were being sold at a loss.
The overall effect required a provision of $157 million against the value of inventory, said Fonterra – in effect, a downgrade of profit expectations.
The background involves the way Fonterra works out how much to pay farmers for milk, which is based on the price of «reference products» on a global auction market, less estimated production costs.
Those reference products don’t include cheese, which, believe it or not, hasn’t increased in price by nearly as much.
This would all be a bit of a technicality if it wasn’t for that fact that about 25 per cent of Fonterra’s production is «non-reference» products, such as cheese, which tend to have a lower price under these market conditions.
The upshot is that high prices paid to farmers for milk supplies mean low margins for non-reference products and lower profits.
Lower profits mean less money available to pay dividends.
The effect was apparent in September when Fonterra announced its forecast milk price for 2014 of $8.30 a kg of milk solids – well up on the previous year’s $5.84 – along with a forecast dividend maintained at 32c a share.
Noting that profits would be constrained by the high milk price, Fonterra said it would «draw upon its balance sheet and cash flow performance to support the estimated dividend».
This looks like a clear signal that 2014 profit may not be enough to pay out 32c a share under normal circumstances. To be fair, the co-op is explicit that it will take a long view on dividends.
As chief financial offer Lukas Paravicini has said: «In some years the co-op will retain more and in other years less …. However, the intention is that over time this will balance out to meet the policy of retaining 25-35 per cent of adjusted net profit after tax.»
Except some farmers see it differently.
«The board is raiding the balance sheet to prop up the dividend,» one farmer told me last week. As well as poor governance, he said, it artificially inflated the share price to the detriment of some farmers who had to buy shares to supply the co-op – they need one share to supply 1kg of milk solids.
Although Fonterra’s share standard measures a farmer’s milk supply over a three-year rolling average, a high share price was a disadvantage for farmers growing their milk production or buying into the co-op.
With Fonterra legally obliged to ensure farmers can freely enter and exit the co-op, the issue could become a matter for the Commerce Commission, said the farmer.
The implication is that Fonterra is looking after the financial investors in its Shareholders Fund at the expense of its farmer suppliers.
Some investors, meanwhile, see the high milk price as partly influenced by a formula favouring farmers at their expense.
It’s not a happy combination.
Analyst Arie Decker of Craigs Investment Partners seems generally optimistic that Fonterra is making progress to reconcile its conflicted stakeholders, but his research note dated October 30 gave only a cautious endorsement of the Shareholders Fund.
Fonterra «remains a turn around story with earnings momentum remaining elusive despite sustained growth investment,» he said. «Volatility and elevated [whole milk powder] prices are conspiring against [it] and a lack of visibility in underlying earnings makes forecasting difficult.»
He rated the fund a «hold» with a 12-month price target of $6.66.
Of course, that was before Monday’s «inventory provision» and it seems likely that analysts will weigh their views more negatively as a result.
A year on from its float the fund looks to have hit the doldrums. Here’s hoping for some trade wind.
Tim Hunter is deputy editor of Fairfax Business Bureau.
Source:Stuff