Fonterra: Turnaround In Q3 '20 Results

Summary

• Solid 3Q20 results despite COVID-19 challenges.
• Focus on de-gearing with low target leverage.
• Notwithstanding its strong results, dividend may be postponed in FY20.

Company Profile

Fonterra Shareholders Fund (FSF) is one of the world's largest processor of dairy products accounting for roughly a fifth of global dairy trade. FSF generates revenue from businesses including milk processing of commodities, largely in New Zealand and Australia, and food services and consumer dairy businesses in Australia, New Zealand, Asia, Africa, the Middle East and Latin America. FSF is well placed to participate in strong global growth in demand for dairy products.

Strong 3Q Results; Likely to deliver FY20 earnings above 15-25cps guidance range

FSF's 3Q20 normalized EBIT was solid, +15% YoY to $231m, as new management returned the co-op ‘back to basics’, which has involved streamlining operations and taking cost out, and divestment. Despite COVID-19 challenges, normalized Group EBIT was +59% to $814m for the nine months to March, with Ingredients +9%, Food Services +54% and Consumer +46%.

FSF now expects FY20 earnings to be in the top half of the 15-25cps guidance range. Indeed, earnings delivery year to date is already sufficient for FSF to deliver FY20 earnings towards the top end of the guidance range, with 3 months to spare. While management's outlook commentary suggested earnings growth rates may ease in Q4, most notably in Food Services where demand has softened with many cafes, bakeries etc. shut or suffering from reduced patronage due to the impact of COVID-19, and the spike in Consumer product sales from pantry stocking that boosted 3Q sales and EBIT has not been maintained, I still believe FSF as likely to exceed the top end of the FY20 guidance of 15-25cps.

Debt reduction prioritized over dividend payment

While FSF’s turnaround looks to be on track, a key part of that turnaround is prioritizing paying down debt over paying FSF dividends. Recall that while FSF did not pay an interim dividend in March, it expected to be in a position to pay a final dividend come September. That comment has now been removed and now final dividend looks less likely to be paid for 2H20. Indeed, FSF may not resume paying dividends until as late as FY22, given the tough near term economic backdrop, FSF's expectations that the milk price will decline from $7.20 to $6.15 (midpoint) and the need to support farmer payouts, and the company's focus on reducing its still elevated bank debt levels ($5.1 billion).

Q3 Results Summary

Key takeaways from the 3Q20 update include:

- Earnings: Normalized EBIT of $815m for the nine months to March 2020 was solid, up +$301m/59% on previous corresponding period (PCP) and driven by improved performance across all divisions. While the year-to-date result has been buoyed by a much stronger 1H20, 3Q20 itself also improved 15% on pcp to $231m.

- Net debt: Net debt is currently at $5.7 billion, down a further $0.1 billion over the quarter.

- Free Cash Flow: FCF generation was much improved at $698m YoY, driven by both an improvement in operating cash-flow as FSF goes ‘back to basics’ under new management, and a reduction in capex. Positively, FSF remains on track to hit its target of sub $500m capex for FY20.

Divisional performance:

-Ingredients: EBIT improved +9% YoY to $668m due to a high proportion of the milk supply had been previously contracted, protecting margin despite softness in demand due to COVID-19.

-Food Services: EBIT improved +54% YoY to $208m, despite an initial impact from COVID-19 particularly in China. However, management flagged further impact in 4Q as many restaurants, cafes etc. have been shut for a period and even those that have re-opened have seen reduced patronage, particularly in Oceania, South East Asia, and Latin America. On a positive note comments on China, which was the first country to go into lock-down and the first to come out, give some reason for optimism with demand continuing to recover there through April, although is still not quite back to pre-COVID levels.

-Consumer: EBIT +46% YoY to $180m due to cost savings and mix improvements. FSF also noted pantry stocking that occurred in Feb/March causing a spike in sales in Q3, but this has not been sustained so far in Q4.

Outlook:

-Guidance: EPS guidance was maintained at 15-25cps for FY20, however I expect now EPS to be at the top end of the range. This came as no surprise given the strong 1H result already banked.

- Milk price: FSF also flagged a slightly lower milk price in FY20 (i.e. $7.10-$7.30, midpoint $7.20, versus $7.00-$7.60 previously), and a significant decrease in FY21 (i.e. $5.40-6.90, midpoint $6.15 -19% YoY), as food services demand for dairy reduces and as European and American producers look to replace lower demand levels in their domestic markets with exports.

In September last year, FSF reset its dividend payout policy to 40-60% of reported NPAT (ex abnormals) but subject to two debt-related restraints:

- Not borrowing to pay dividends i.e. needs to be paid out of FCF generated.

- Maintaining a reasonable debt/EBITDA ratio. Management has previously targeted a 3.75x ratio by end of FY20, which management is still confident of achieving.

Key Take Away

FSF showed that its turnaround strategy is working and that it is now on track to fix its balance sheet. I think the above policy is prudent and sensible, and will eventually help steer FSF’s balance sheet back to sustainable levels of debt. However it is also likely to result in lower dividends for FSF shareholders for the foreseeable future, Therefore, this stock is a hold for now.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.