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

Thank you for standing by, and welcome to the Fonterra Limited Q3 Investor Briefing Conference Call. [Operator Instructions] I would now like to hand the conference over to Mr. Miles Hurrell, Chief Executive Officer. Please go ahead.

Thank you, and good morning, and thank you, everyone, for joining us here today. Here in the Fonterra office. I'm joined by Marc Rivers, our CFO; and Simon Till, Director of Capital Markets. This morning, we released to NZDX and ASX, our media release slide presentation on our Q3 business update. So what I'd ask to do now is we'll take you through a handful of slides, provide a brief summary and then hand over to you all for questions. And so if you do have the slide pack in front of you, which is obviously a summary slide, this shows the business performance improvement has continued during what has been a challenging third quarter. Our group EBIT is $1.1 billion, up $679 million from the prior year. This includes a net positive one-off items of $242 million, which is slightly up from what we reported at half year and further details being provided in the appendix. Adjusting for this, our total group normalized EBIT is up $301 million to $815 million. This came from an improvement across all 3 of our business areas. Ingredients up $53 million, Consumer up $59 million and Foodservice up $73 million on a year-to-date basis despite the challenging third quarter. I'm pleased with the team's focus on financial discipline. Operating expenditure has reduced by a further $148 million to $1.7 billion, and we are managing our capital expenditure carefully to remain under our maximum limit of $500 million for the full year. Free cash flow has improved by $1.4 billion to $698 million. This has been driven largely by improved earnings, lower capital expenditure and proceeds from the divestment of DFE and Foodspring, which we announced at the half year. We have maintained our forecast normalized earnings range of $0.15 to $0.25. And we've also updated our forecast Farmgate Milk Price range for the year to $7.10 to $7.30 with the midpoint of $7.20 and for the -- from the original $7 to $7.60. And for the opening forecast for the New Year ahead, a range of $5.40 to $6.90 with the midpoint of $6.15, I'll provide a bit more color on these updates shortly. Before I discuss on the performance, I want to touch on how our operating -- how we're operating during this global pandemic. Firstly, our process in scheduling logistics and delivery activities in all markets continue to operate. Of course, we export 95% of the milk we collect. So have a proven world-class supply chain as an important part of our business. Part of this is a joint venture with Kotahi, which is -- which has long seen agreements in place with key partners such as Maersk line in the Port of Tauranga, which gives the Co-op secure access to reliable export supply chain, and we've seen this benefit through this pandemic. Another feature of our Co-op has -- that's been demonstrated is our ability to adapt to change in the global market through optimization and flexibility of our product mix. All as moving cheese out of the Foodservice sector when we saw that impacted, which is significantly reduced during lockdown to consumer sector where people are staying at home and consuming more. To this point, we've diversified also our customer base, both in terms of product, geographically and also the sales platforms. As an organization, we remain agile and custom lead. As an example, during lockdown we received an urgent order for one of our customers where one of our Ingredients goes into a product used to feed people who are incubated in hospitals. There is demand for this product, obviously, and this gave us a real importance and shows importance of been an essential service. Going forward, we know there's going to be continued uncertainty in volatility, but we continue to have confidence in our strategy, and we'll continue to work closely with our customers and draw on the Co-op's proven strengths. If we look to the next slide of healthy business, I've covered the headline figures, except for revenue, which was up $1.1 billion to $16 billion for the full year due to better pricing the underlying milk price improvements. Looking at the business platforms along the bottom of the slide, these have appeared in the same base as the half year results. With our -- for our continuing operations and exclude 2 businesses held for sale such as DPA Brazil and China Farms. Ingredients gross margin was up $119 million to $1.2 billion, mainly driven by New Zealand's Ingredients gross margin up $105 million, with margins improving across the portfolio compared to the last year. This is due to a favorable price relativities in the third quarter, higher margins within our global sourcing business and improved manufacturing performance. Ingredients EBIT was up $53 million due to New Zealand Ingredients EBIT up $24 million due to the improved gross margins. The current year does not include DFE earnings, of course. But if these were included, they will be around $30 million for the first 9 months. Australian Ingredients business also continues to improve on last year, bring cost savings and favorable product mix. It was a lower quarter for Australia, but the third quarter is always -- as always, due to seasonal milk profile. Year-to-date, Australian Ingredients business is $28 million ahead of last year. Within Foodservice, the COVID pandemic impacted our third set of sales volumes due to store closures and restaurant, bakeries, et cetera, across most of the markets, and this reduced our year-to-date growth rate relative to last year. However, due to a very strong first half in Greater China and Asia, our Foodservice EBIT is up $73 million year-to-date at $208 million. Markets are in various stages of reopening during the fourth quarter. Greater China Foodservice started its recovery relatively quickly through the end of March, although the sector is not back at 100% levels in Greater China. Fourth quarter Asia and Oceania Foodservice sales volumes will be further impacted by the COVID situation. COVID, on the other hand, gross margin will decline to $44 million to $759 million, predominantly due to the removal of the Tip Top gross margins following that divestment last year, which contributed around $45 million for the first 9 months. And with the ongoing disruptions in Hong Kong that we saw outside of COVID. However, Consumer EBIT was up $59 million to $187 million due to the reduced operating expenses across all regions and gross margin growth in Asia due to improved performance specifically in Sri Lanka. Overall, Consumer and Foodservice EBIT has increased $132 million to $395 million for the first 9 months. China Farms end-to-end has improved from a $23 million loss at this time last year to a $6 million loss. Our Fonterra owned farm-hubs EBIT was up $27 million from a loss of $19 million due to a profit of $8 million, but offset by a joint venture our farm-hub losses, which increased from $7 million loss last year to a $15 million loss. If I look at the outlook 2020 slide, I mentioned earlier, we've maintained our normalized earnings guidance for the year of $0.15 to $0.25 per share. And we're giving guidance to the market that based on the 9 months, we're currently tracking to be at the top half of this range, but there are significant uncertainties in the last quarter. For example, how quickly the Foodservice sector can recover in Asia Pacific. The timing of shipments and how the broad global economic downturn will impact our business. Therefore, we consider it appropriate to remain -- retain rather our current range for our forecast normalized earnings per share. The lower midpoint of the narrowed season milk price forecast of $7.10 to $7.30 reflects lower Ingredients prices following the softening of supply relative to demand as noted on recent GDT events. Finally, I want to touch on the forecast Farmgate Milk Price for the 2020/2021 season. COVID adds further uncertainty into our process of forecasting that will happen over the next 18 months. A global recession will continue to have a negative impact on consumers' purchasing power, and we won't be immune from that. We're also expecting to see more milk from Europe in the U.S. going to product types that determine our milk prices, farmers and milk processors will be chasing government support programs and longer life products. And it's because of the supply/demand picture that we've announced, an opening price of $5.40 to $6.90. This initial range of $1.50 reflects the uncertainty we face in the coming months. You can see from the milk price perspective, the 2020 and the 2021 years are looking to be very different. I'll cover -- hand across to Simon to take us through some questions from here. Thank you.

Thanks, Miles. So yes, please, if you've got a question, please ask them now.

[Operator Instructions] Your first question comes from Marcus Curley from UBS.

Just a couple from me. Could you talk a little bit about how you're seeing the fourth quarter in Foodservice at the moment? Clearly, you're talking about the potential risks with COVID spreading outside of China. But given where your guidance is, it would suggest that you could be expecting quite a poor fourth quarter in Foodservice?

Yes. So Marcus, it's Miles here. If we think about China, which went through a pretty rough February, as you'll recall. In early part of March, that bounced back relatively quickly. I don't predict we'll see that same level of uptake when -- if and when markets open throughout Southeast Asia, and in particular, Asia Pacific. So we did see a nice bounce back in China, but we are suggesting a slower recovery when markets open up from a Foodservice perspective in Q4, which is why we've taken the approach that it will be are relatively flat for that -- for Q4.

And outside of China, what are you seeing there at the moment in terms of volume impacts?

So we are seeing impact as we speak. So I mean, New Zealand's a nice proxy for what we're seeing across the right throughout Southeast Asia, when all those markets effectively have been in lockdown. Out-of-home consumption has effectively dried up in a lot of those markets. So as I say, it's how fast they can come back and New Zealand, again, being a proxy, you move to the living that we're at, you start to see restaurants open on a limited basis. So as I said, I think it's going to be a slower recovery than what we saw in China. And it's the case of how fast that they will come back is the point.

Okay. And I just wondered if you could talk a little bit about the dynamics that you're seeing in the non-milk powder Ingredients business. It looks from the third quarter that, unsurprisingly, you saw the benefit of very strong stream returns. But it also looks like the potential price premiums in that space may be contracting. And I just -- is that a function of the fact that people are chasing those Ingredients products at the moment given where stream returns are at?

I mean I'll give more of a sort of a higher level view before I let Marc and Simon maybe make a comment. But I guess the point you make, if the spread across reference versus non-reference products becomes too great, and remains too long, you very quickly do see our international competitors start to move product mix around where appropriate to start to close that gap. So it is a fair reflection, we're starting to see that. Couple that with, of course, our major competitors, whether it be North America or Europe, their Foodservice markets have been hammered at the same rate as what we're seeing down in Asia Pacific. In fact, you could argue more so, what was pretty strong milk growth through that period. So they're not supplying the Foodservice markets in their own countries, they're looking to sort of take advantage of the international market. So one could assume that those relativities will be tightened up over time.

Yes. Not much more to add.

Summarize it.

And then just looking on that topic or the Ingredients topic into next year. Obviously, I take note about your comments about increasing competition. Would you expect that to turn up in lower margins for you Ingredients next year?

Yes. And yes, the simple answer, I think, is yes, and that's why we've reflected a lower milk price -- opening milk price forecast for next year is because if there is surplus milk, again, depending on how fast those Foodservice markets, in particular can recover in Europe and North America. They will certainly have to put that into, call it reference products that we see that will hit up in the international markets. Of course, we are -- only where capacity allows. If they don't have drying capacity, of course, they can't. But if there's drying capacity available in those markets, you may see them take advantage of the international market, which is why we suggest there may be some pressure on milk price next year and therefore, the lower end of the range. But again, a similar comment I made around Foodservice, if China bounced back relatively quickly, I don't think we'll see the same in Asia Pacific, but we may see a faster bounce back if, again, in particular, North America, and more specifically, the U.S., if they can get through the health issues that they're all dealing with. If they can get through that relatively quickly and safely, you may see a bit more of a bounce in Foodservice. So they are the unknowns. But that's more of a milk price conversation, which is -- that's why we've given a wider range to cater for those uncertainties.

And then just finally, could you talk Miles, a little bit to the OpEx profile? It looks like in the third quarter, there was pretty modest OpEx savings. Obviously, in the first half, they were very strong. Are we sort of coming to the end of the benefits of the rationalization program in terms of OpEx savings?

Yes. I mean, generally, I think that's probably a fair reflection. We needed to make some tough calls, as you know, in the last couple of years, we've done that. And I think we're getting to a level where the business is probably right-sized to the level that we need to operate at, to continue to focus on the core business, but also look at growth. So I'm feeling comfortable with where it's at. You won't see significant reductions, I wouldn't think from here. But I mean, [indiscernible] that our team is certainly tasked with being more efficient every day. So you'd like to see more savings come through, but not to the same rate you've seen previously.

I think what you also see play out is just a change in the portfolio mix of our businesses as we've made some portfolio choices. So for example, Tip Top is out. So you see the full year effect of those. So to some extent, you see some of that expense reduction is coming from having exited some things in addition to the restructurings and savings and all that playing through. And so kind of the full -- as the full year effects of those things kind of normalize, you can expect that, that would -- but we'll continue to be very focused, of course, on efficiency. And hopefully, you can see that playing through. It's a -- the strategy is about value. And we want to chase after the most valuable options for us, and that's the advantage. I think, of the structure we have as well as that we've got really a broad range of choices, which markets, which channels do we want to go after and I think that gives us an optionality and ability to pivot to go after the most valuable opportunities.

Your next question comes from Paul Jensz from PAC Partners.

Just two quick questions about Australia to start off with. Just you talk about a wide range of the opening milk price in New Zealand there. Have you got any comments in Australia with the opening milk price as well?

No, we don't have a position on Australia at this early stage. We are obliged. I think, if I recall correctly, by the 1st of July to announce our price under the new legislation in Australia. So within the next month or 2, we'll be out with our official numbers in Australia, but not too early at this point.

Okay. And you talked about a turnaround of about $28 million on pcp in Australia. And just trying to see where that is coming from? Whether that's the brand then or Ingredients or a combination?

I think that was in the Australia Ingredients portion only. So that's just an improvement over last year. And what's driving that is the benefit, one, of taking some capacity out, right? Because overall, the Australia situation is with the pressures on milk. There -- there's a general, I think, overcapacity, it's fair to say in the industry. We've responded to that last year with the closure of Dennington site. And so we see the benefit of that coming through. The cost savings on taking that capacity out and partly also just general other cost savings that the team has worked through. And then last component of that is the team have done a really good job of looking at the portfolio mix and having an improved approach there, which is showing up now in better results. Still not where we want to get to, we still need to improve further in the Australia Ingredients picture, but it's good progress here. Separate from that is the Consumer business in Australia, which has had a really good first 3 months. Foodservice obviously impacted as well with the same phenomenon with the restaurants closing, et cetera, but the Consumer part of the puzzle has done well. So in aggregate, for the total Australia business, it's, again, in a much better position than it was last year, and is performing well. Although, again, we've got to manage through the kind of overcapacity circumstance for the whole industry. I think everyone is probably in that same boat as we head into the new season.

[Operator Instructions] Your next question comes from Marcus Curley from UBS.

Just one more, gents. I just wondered if you can provide a little bit of update in terms of the asset sales. In the current COVID environment. Has the prospects of executing on China farms or the Brazilian business deteriorated at all?

Yes. Thanks, Marcus. So we're continuing to process on both of those. They're always fair to say they're probably going at different speeds. China Farms at a better speed than Brazil. Our focus is on value, of course, and we're not going to compromise on that. But I'm pleased that both of them are progressing. Maybe related to that, the bigger picture for all of that is that we're on comfortable and we're on track with the debt-to-EBITDA targets that we need to get to for this year. So we don't need those for those 2 deals to be concluded in this financial year for us to achieve where we need to get to from a debt-to-EBITDA by end of this fiscal year, which is to do better than 3.75. So we continue to be on track with that.

[Operator Instructions] There are no further questions at this time. I'll now hand back to Mr. Hurrell for closing remarks.

Simon here. Look, thank you very much for your time. I know there's lots of news flow on at the moment. So we appreciate you dialing in today. And if you do have any follow up calls, please feel free to give me a call. Thanks very much.

Thanks, everybody.

Thank you.