Fonterra Co-operative Group Limited (FCG) Earnings Call Transcript & Summary

Hello, everyone, and welcome to our 2020 interim results webcast. I'm Miles Hurrell, Chief Executive of Fonterra; and I'm joined here by Marc Rivers, Chief Financial Officer; and Simon Till, Director of Capital Markets. Today, I'll take you through the headline numbers from our results, and then I'll pass across to Marc, who will take us through the detail behind the headlines. And then at the end of the presentation, we'll open up for your question and answers. Before I begin, though, I want to recognize the unprecedented situation that we find ourselves in with regards to COVID-19. It is now a global event, and I thought so with people and families whose health have been impacted by this outbreak. If we look at the financial results for the first 6 months of 2020, I'm pleased to say we've significantly lifted our financial performance. We've done this at the same time as we've continued to reset our business. We've introduced a new strategy, organized and resized our teams, so there's greater focus on customers and consumers. The headline numbers are total group EBIT is up $494 million to $806 million. This includes net positive one-off items of $222 million. So adjusting to this, our normalized EBIT is up $272 million to $584 million. We've continued to focus on our financial discipline, continued to reduce our operating expenses and we've made good progress on completing divestments as part of our portfolio review. Marc will provide more details on these in a moment. Across the board, we're seeing improved cash flows and our net debt is down from a year ago by $1.6 billion to $5.8 billion. And this has all been done with the forecast Farmgate Milk Price of $7 to $7.60 per kilogram of milk solids. I'm pleased with our performance in the first 6 months. However, we've decided to maintain our full year underlying earnings guidance as this reflects the higher level of global uncertainty that have impact our second half. That is also the rationale why we're not paying an interim dividend, and our aim is to be in a financial position at year-end to pay a full year dividend. As we've been resetting the Co-op, we've built a lot of momentum behind our 2020 priorities, which I shared when we launched a new strategy last year. These priorities are to hit our financial targets, reduce our environmental footprint, build a great team and support regional New Zealand. We're on track to meet these financial targets. While lifting our financial performance, we're also focusing on our social and environmental equipments. We've announced that we'll be stop using coal in our Te Awamutu site next season. And by doing so, we'll be reducing our coal usage by 10%. We're working with another 1,000 farms this year through our Co-operative Difference program to put in place Farm Environment Plans, and we're getting ready to provide individualized greenhouse gas emission reports supply in all farms by the end of the year. This will be a New Zealand first. Through our milk price, we contributed just $11 billion to the New Zealand economy this year. Our teams are very much part of the local communities, and I'm proud of what our people get out and do to help local communities. We saw that when we had floods in the south or dry across the rest of the country. We've also made good progress on building a great team. We've reorganized and resized our team to a greater focus on customers and consumers. We also focus on improving our culture, and I'm pleased to see how we're progressing. Over to you now, Marc, to take us through some more detail.

Thank you, Miles. So starting with revenue, it's increased by 7% or $678 million to $10.4 billion. This is mainly due to improved pricing and product mix. Our gross margin increased by 12% to $1.7 billion, and this improvement was driven mainly by the significant increase in gross margins in our Foodservice business and also a small uplift in our Ingredients business. Our Foodservice business gross margins increased $90 million to $260 million, and this flowed through to their EBIT as well. The team achieved this through growing sales in the bakery and beverage channels across both Greater China and Asia. And in case you're not familiar with the language, beverage channel, of course, consists mainly of coffee and tea houses, for example, the likes of Starbucks. In our Ingredients business, we increased gross margins by $22 million due to improved gross margins in Australian Ingredients as well as a small increase in the gross margin of the New Zealand Ingredients business. Our normalized gross margin for our Consumer business was down $31 million to $499 million. Consumer also significantly reduced its operating expenses, and this is what enabled them to significantly improve their EBIT. So in addition to the savings made by our Consumer business, we're pleased that the overall cost savings are down $140 million compared to this time last year. In terms of the China Farming business, our wholly owned farms achieved a profit in these 6 months but this was offset by increased losses from our China Farming joint venture. Bringing this together gives us a total normalized group EBIT of $584 million, which is up 87% on last year. With our reduced debt and lower interest rates, our interest expense reduced, but this is partly offset by a high tax expense, resulting in a net profit after tax for the first half of $293 million, also up from last year. So after adjusting for minority interest, this equates to $0.18 per share. We'll continuously, of course, review our portfolio to ensure that our assets are aligned to our strategy. We've completed the sale of DFE Pharma and Foodspring over the last few months. And from that, we've received cash proceeds of $624 million from those divestments and a gain on sale of those for $469 million. In addition, we received a $26 million dividend from DFE. We've completed strategic reviews for our wholly owned China Farms and DPA Brazil businesses. And the outcome of that is we've decided to start a sales process for those assets. And those sales processes are underway for both assets. And through that, of course, we've gained additional information and further insights which have required us to revise down the valuation of both assets by a total of $134 million. That's a $63 million impairment on the wholly owned China Farms and a $71 million impairment on DPA Brazil. Our share of this $71 million is $31 million on an after-tax basis. So under accounting rules, these sales processes impact, of course, how we prepare our financial results. And as we're treating them held-for-sale, we will also classify them as discontinued operations. The new information and insights that we gained through the sales process for China Farms has also been used in the impairment test for our China Farming joint venture. And as a result, we've taken a $65 million impairment. The adjustments to get to the normalized EBIT total to a net positive of $222 million, and the full breakdown of this is shown in the appendix. The improved cash flow and $1.6 billion debt reduction is a big part of the performance story in the first half. Our economic net interest-bearing debt is now $5.8 billion, still higher than we want, but down significantly on last year. We've done this through significant improvement in our cash flow, thanks to improved earnings, lower working capital requirements and lower capital expenditures. The sale proceeds from divestments have also made a significant contribution to our debt reduction. For transparency, I do want to highlight that our net debt number is after removing $336 million of debt from DPA Brazil as a result of it being classified as held-for-sale and a discontinued operation. However, it also includes an additional $547 million due to changes in the accounting policies for operating leases. Over to you, Miles.

Thank you. Our strategy has a triple bottom line approach. So as well as focusing on the financial performance, we'll also be driving our contribution socially and environmentally. We've already talked briefly about the contribution our people are making to local communities. Sustainability is a cornerstone of our strategy. We're in it for the long term, and we are making progress. We recognize the significance of the risk the climate change presents to communities, food systems and economic growth. We take our responsibility to play a role in mitigating these risks seriously, and that's why we put sustainability at the heart of our strategy. In terms of what we're doing, I think about it in 2 ways. Firstly, how are we helping reduce the impact starting on farm. And secondly, what are we doing within the business itself. I mentioned a few highlights at the start of the presentation across both these areas. But what I think is worth highlighting today is the Co-operative Difference program. I'm not sure if you're familiar with the program itself, but I want to talk to you about it briefly today. We launched it at the start of our last milking season, and it's a way of bringing together what our farmers need to know today and what they need to prepare for in the future to be sustainable and resilient. Our on-farm services are big part of that. In fact, our entire Farm Source business, which is the part of our business that supports our farms, operates through the Co-operative Difference. And there are some great things happening as a result. And this will only grow in importance in our Co-op, and I'm looking forward to talking to you about it over the next 2 to 3 years. Finally, our outlook for the rest of the year. We are maintaining both our forecast Farmgate Milk Price range and underlying forecast earnings guidance. But there is no doubt we have a number of risks in the second half. And the 3 main ones are, of course, the global impact demand on COVID-19, continued civil unrest in markets like Chile and Hong Kong and the ongoing dry conditions we see here in New Zealand and how that may impact collections and potentially increase our input cost if supply and demand picture becomes too unbalanced. Obviously, right now, there's a lot of uncertainty around the impact of COVID-19 could have on our earnings in the second half of the year. And it's for this reason, the Board have elected not to pay an interim dividend. Our aim is to be in a financial position at the end of the financial year to pay a full year dividend. At the end of the financial year, the Board will assess the Co-op's financial position and review the decision to pay a dividend. We now welcome your questions.

[Operator Instructions] Our next telephone question is from Arie Dekker from Jarden.

Yes, just a little bit more color to start off with just in terms of the China Farms sale process. Obviously, you've made a reasonably minor impairment there following on from last year's one based on sort of where that sale process is at. Could you just sort of talk about the approach and how far away you think you are? And also, I guess, just the extent to which it's just a full exit that you're targeting or whether you are looking at some arrangements that would sort of see you still take milk from those farms, just albeit of the economic interest of ownership?

Yes, it's Marc. I'll take that one. So yes, we're well advanced in the sales process on the wholly owned China Farms, and we've run a really good process through that. Obviously, like we would for any of the assets, we want to make sure that we get maximum value for each of those and be very disciplined as we go through that. So we've opened it up to a large number of interest, had various discussions, and we're at the pointy end, I would say, of the process for it. So I think feeling comfortable that we're on track for that one. But again, we're going to stay disciplined through it. And it's -- we're going to stay pretty firm on value on that and not compromise. We -- the approach we've taken is we want to sell the entire China Farms. So it's in full. When we look at strategically, we also have the JV farms. And so in terms of the amount of milk that we need for the local fresh strategy, we actually are comfortable that we can either get that through that, or we also are confident that, if necessary, we can access high-quality milk locally. So we don't see a connection necessarily strategically to being able to have optionality to continue to participate in the fresh -- local fresh milk if we so choose, and having full ownership of the wholly owned China Farms. So feeling good so far about the progress.

Sounds good. So would it be fair to say that you're basically reverting back to what, I guess, was the original intent, which was -- and doing it through that joint venture farms, which was to have some exposure inside China in terms of -- in participation in farming, but without having to have such a massive operation that we've got to strategically.

I think that's fair where it's at. But we're also comfortable that the landscape has certainly changed over these years. And so there is high-quality local milk available if we want to access that. So we feel like there's enough optionality. And to be fair, that probably did not exist 5 or 6 years ago. But now that we have -- our farms exist and other firms have also come into play, which are available to get -- to buy milk off of.

Just on the guidance this year. I mean, obviously, the situation's lowered, although you've obviously been sort of operating in China with COVID sort of present there over the last couple of months. Was it -- given the strength of the first half result, is it fair to say that you're being reasonably conservative and not at least sort of reducing the extent of your guidance range towards the upper end? Because it looks like you're pretty well placed given that start. And if you could just -- within that comment, perhaps also on what you're sort of seeing in stream returns, given that powders are under a bit of pressure in the last few auctions.

Arie, Miles here, I'll give a quick view from my --. I mean, you're right. I mean, a really solid underlying business performance for first half. And if you extrapolate that out, it would push the boundaries on that guidance. But there are absolutely unknown risk as we sit here with COVID, and even in the last couple of weeks, how that's run up, and the contagion effect from China into Mainland Europe and the U.S., it's clear we need to watch it very carefully. So I wouldn't call it a conservative approach, but I think probably a prudent approach is the way that we've gone about maintaining our guidance range.

Sure. Okay.

Comment on stream returns also.

Yes. So yes, just continue on that. So obviously, we're going to monitor week by week, and there's new information really almost -- it seems like hourly at the moment. The biggest -- and to be fair in the half year results, there's really hardly any impact from COVID that's built into that. So any impact from that will be in the second half. And certainly, there's -- we expect in China, with the foodservice business, will be impacted. And we've said -- we've hinted before it's sort of on a scale of $40 million to $50 million kind of impact, and that's kind of in our base assumptions of -- for the modeling, but again, that can play out. Some encouraging signs over the last couple of days. I think one important metric is around the number of restaurants and stores closed. So I think at the nadir, we were looking at around 77% closure rate. Over the past week or so, that's improved to, I think, around 25% closed, so 75% open, so that's quite encouraging and signals around encouraging folks to kind of get back to a little bit more normal. And also interesting to see how those stores have -- and restaurants have adapted to more home delivery and these sorts of things. So there are encouraging signs there, at least on the China piece, which is the biggest exposure for foodservice. Now the next wave will be Southeast Asia, which is really just now going through things. In Malaysia, overnight, with almost Martial law kind of lockdown. So a little bit less exposure for us from a foodservice perspective there, but it's enough uncertainty just to give us pause and be prudent. Stream returns, I guess, just links back to the dynamics on milk price, which was the other part of the uncertainty is you got kind of 2 opposing forces happening. On the one hand, this sort of demand shock around an uncertainty with the COVID impact and what -- how that would play out in the GDT auctions. And on the other side, you've got pretty dry conditions in New Zealand to kind of go in the other direction. So that was another reason just to kind of see how that's going to play out. I think last night's GDT event was encouraging, frankly. Also important for the New Zealand economy, I think, the outcome last night, where there are probably some speculation we would have seen a much bigger impact given that since the previous GDT event, we've seen oil basically come down more than 30% and all of those things. So it shows actually, relatively speaking, a pretty comforting level of resilience that we're seeing so far, at least for this year. But you're right. I mean that kind of movement does -- if that continues, then that helps from a stream returns perspective.

And then just the last question. Just referenced in the letter from the Chairman to the capital structure review. I mean, I guess -- and I guess it pains to point out that you won’t got a time line on the process. But if you could just talk to sort of, I guess, where the process is at. And then also, I mean, as referenced too, in the first instance, determining a direction, if you could kind of just sort of talk about what is kind of driving the consideration on that at the Board and management level. And just any color really at all for investors just on where that's going.

Yes, I'll give a quick comment, Arie. I mean, the comments that the Chairman's made by not putting a time line on it should not be read as that there's no work – no work is continuing on behind the scenes internally. So a lot of work is underway now to assess the options, the unseen consequences of any changes and what those options may look like. So that work's underway, and we'll be in a position to start to talk to the Board over the next couple of months, and then they'll determine how the hell they take that forward into farmland. But I don't think it's a -- we're at a point yet where -- that we want to communicate with anyone around a hard time line. I think it's important we understand what's needed, what are the issues we're trying to solve for and the unseen consequences of any potential change.

And just in terms of the range of options. I mean, is there anything that you can sort of talk to about there, and particularly in terms of if that's narrowing at all? Or are you just not at that point yet?

No. We're in the phase of looking at all options at the moment other than to confirm that we'll remain a cooperative, I guess, is probably the point that's not on the table for discussion.

[Operator Instructions] Our next telephone question is from Marcus Curley from UBS.

Just a couple for me. Just starting with the New Zealand Ingredients business, within the report you referred to what sounds like pricing pressure or margin pressure in selected nonreferenced commodities. Can you talk a little bit about what's happening there in terms of supply, particularly in UHT?

Yes. So I guess you're referring to just the dynamics between referenced and nonreferenced? Is that right...

I suppose, specifically, obviously, your nonreferenced margin's down in the half. And in the report you referred -- you're calling out UHT, I suppose, is one of the key drivers of potentially that dollar margin decline?

Yes. So I guess, one, it's a mix effect. So just having increased volumes of UHT cream relatively in the mix. And of course, that's a relatively lower-margin product for us within Ingredients in order to pass that on to Foodservice. So there's a bit of dynamic going on.

And the UHT comments in the report? It sounds like you're seeing greater competition in that space.

I think the point that we're making here is that we've increased our volumes of UHT cream. So -- but because it's at the lower end of the margin level by default, it now becomes a larger portion of our nonreferenced just by default, and that's what's played out with it in the numbers there. But we're not seeing any increased margin erosion, if that was the question, I guess, from where we've been previously. We're still holding our own in that space.

Where we've seen more competition coming through is on the cheese side, and that's where you see more supply coming online, mozzarella, in particular. And so that has compressed margins to a certain extent, which is playing out in the numbers there as well.

Okay. And then, secondly, on the guidance, previously, you've been willing to give ranges for the Ingredients business and the consumer foodservice. You’re not willing to provide that for the -- for this year at this stage?

Yes. I think, Marcus, the -- I mean, it's not so much a case of not wanting to provide. I think, historically, that was looking at what had to be done in the second half year to give some context on that. And I think really for the situation we're in now, which is what both Marc and Miles have talked about, is that, obviously, a very strong first half, but there is still a reasonable amount of uncertainty in that second half. So trying to put ranges on that I'm not sure would be really meaningful. And you'd end up with such wide ranges that we decided that it's probably not going to be particularly helpful.

Okay. But I suppose just broadly, would you be assuming gross margins in consumer foodservice down sequentially in the second half?

If you take the impact of COVID-19 in China, which we've seen play out through February and the first part of March, which we have baked into our plans for the remainder of the year, you could make that assumption. But as I said, I wouldn't be concerned. The overall impact, we're still confident in remaining in the guidance.

Okay. And then, I suppose, just finally for me, you had, I think, $45 million worth of other costs. By the sounds of things, those were redundancies. If that's the case, have you seen the benefit of those labor reductions in the OpEx reported? Or is that still to come?

Yes. So we do have redundancies in that number, and we do expect some benefits to come through for that. So for example, part of the Australia ingredients improvement in performance is from the decision to close Dennington. And so you would see that -- the benefit of that starting to flow through and likewise, in the other lines. So absolutely, all of those need to have a business case behind it for -- to justify the approach.

[Operator Instructions] Currently, there's no further questions at this time. I'd now like to hand the call back to today's presenters. Please continue.

Okay. Well, thank you very much for your time. And if anyone does have any questions, please give us a call, we'll be very happy to go through them, and thank you for your time today.

Thank you.

Thank you.

Ladies and gentlemen, that does conclude the call today. You may all disconnect, and goodbye.