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

Thanks for joining us. Welcome to our 2023 annual results briefing. I'm Miles Hurrell, CEO of Fonterra, and I'm here with Neil Beaumont, our Chief Financial Officer. We're going to kick things off with an overview of our performance before asking Neil to take us through the numbers. And then we're over to you to ask your questions. Before we get into it, I want to start by acknowledging and thanking our farmers and our people right across the corporate. We know it's tough on farm right now, but it's great to be reporting such a strong set of results today. Looking at the core metrics, profit after tax is up $994 million to $1.6 billion due to favorable margins in Ingredients Channel and the gain on sale of Soprole. The significant lift in earnings has meant the Co-op's return on capital has increased this year to 12.4%, up from 6.8% last year. And earnings per share increased from $0.36 to $0.95 per share. However, this has been against the backdrop of a Farmgate Milk Price that has dropped across the season down from $9 for prior year to $8.22 per kilogram milk solids in '23. As I mentioned earlier, we know that our farmers are doing a tough, but a strong balance sheet has assisted us to pay a full year dividend of $0.50, which is slightly above our dividend policy range of 40% to 60%. The $0.50 per share dividend comprised of $0.10 we paid off the half year results and the final dividend of $0.40 per share, which is to be paid in mid-October. As part of our strategy to focus on New Zealand milk, we completed the sale of Soprole at 31 March this year. In August, we used $804 million of the sale proceeds to give to unitholders and shareholders a $0.50 per share tax-free capital return. This means fully backed shareholders received $9.22 for the milk they supply the corporate. You will also see we have introduced two new metrics. These are gross profit from core operations per kilogram of milk solids and cash operating expenses per kilogram of milk solids. Neil will touch on these in more detail shortly. Looking at the Global Dairy industry. On the milk supply side, we have seen growth in the EU and U.S. largely due to growing herd sizes. However, production was down in Australia and New Zealand, both impacted by challenging weather conditions. On the demand side, imports were down in China, Asia and the Middle East and Africa, partially offset by a little bit of growth in Latin America. Reduced demand from these key importing regions impacted pricing of our reference products, particularly that of whole milk powder. As mentioned earlier, this has had a flow on effect to the Farmgate Milk Price. This graph illustrates how the price relativities compared to previous years. These higher margins mainly in Ingredient Channel are the key contributor to the earnings we're reporting today. The reduction in the Farmgate Milk Price this season was primarily driven by lower product prices, again, particularly whole milk powder. Around 60% of the Farmgate Milk Price revenue was derived from whole milk powder sales and the average whole milk powder price for the '23 season was 16% lower than the prior. In response to this, we allocated more milk to skim milk powder and its byproducts, particularly butter. And whilst skim milk and byproducts prices were also down in the prior year, it was to a lesser extent, in this case, 14% and 10%, respectively. Like most businesses, we've experienced inflationary pressures right across the board, which is part of the additional 13% you'll see in our costs. This includes things like manufacturing, transport, packaging and energy. This year, we had a lower FX conversion rate than the previous year, which partially offset the decrease in product prices. I'll now hand over to Neil to take us through the financial performance in a bit more detail.

Thanks, Miles. I'm pleased to present to you our key financial outcomes for the year as well as our new resource allocation framework and efficiency metrics. We have introduced a new resource allocation framework to increase our focus on the efficient allocation of our farmers' milk and cash. Our first priority is safe and efficient operations. We then allocate our farmers milk toward either our ingredients, Foodservice or consumer product channels and the brands and offerings within those, according to where we believe we will see the highest risk-adjusted returns. Following this, we allocate the cash generated from these channels to 1 of the 6 buckets. Each bucket needs to compete with the others, and we allocate based on which will generate the best outcome for our shareholders. The resource allocation framework is embedded across Fonterra and seeks to deliver enhanced value in the form of a strong balance sheet, total shareholder returns and fine profitability. The crop is focused on shifting our New Zealand milk into higher-value products. This is a key driver of our strategy to deliver both the strong Farmgate Milk Price and earnings growth. Looking at the graph on the left, you can see we continue to reduce allocation of milk solids to whole milk powder and increased allocation to skim milk powder, cream and cheese, where returns are more favorable. Now looking at the chart on the right, allocation to our Ingredients channel increased in FY '23. This reflects the sell-down of the additional 2022 financial year inventory. We also put more milk solids into our Foodservice channel as demand increased as a result of the COVID-19-related restrictions lifting, particularly in our Greater China region. Our reportable segments show we are diversified across both channels and markets. Before we look at the numbers, it is worth noting that we have updated our segments to be reported down to a profit after tax level and now fully allocate our corporate costs and interest and tax within the segments. Looking first at core operations, which represents the business activities that collect and process New Zealand milk through to selling the products to our customer-facing business units. Core operations is up $532 million to $572 million, reflecting the favorable price relativities. Global Markets profit after tax was up $77 million, reflecting improved pricing and higher sales volumes in the Ingredients channel. This was partially offset by recognizing impairment of our New Zealand consumer business and Asian brands of $121 million and $55 million impairment, respectively. Looking at Greater China. Profit after tax was relatively stable at $284 million, where we saw higher pricing in the Foodservice channel. This again was partially offset by recognizing a $46 million impairment of our Asian brands in the Consumer channel. Our Ingredients channel had solid results given the price relativities already discussed. Our Foodservice channels profit after tax increased due to improved gross margins, combined with higher sales volumes. The Consumer channel continues to be challenging and is down on last year, mainly due to impairments of our domestic New Zealand consumer brands and our Asian brands. This next slide is showing you the returns we generated across our three product channels relative to the capital they employ. As Miles and I have already said, the earnings performance for our Ingredients and Foodservice channels improved year-on-year and so do their return on capital. This said, our Consumer channel return on capital remains unacceptable with a return on capital of negative 4.6%, down from 40 basis points in FY '22. The Consumer channel performance this year was impacted due to recognizing impairments of our New Zealand Consumer business, our Asian brands of $121 million and $101 million, respectively. It's a key focus of ours to improve the value we extract from the capital employed into Consumer channel. I am very pleased to report that we have a strong balance sheet, and this remains a key priority for us. This has been achieved progressively over recent years through a combination of improved performance and increased financial discipline. Our net debt is down $2.1 billion to $3.2 billion, reflecting our lift in earnings, the reduction in working capital and divestment proceeds. This number also includes provision at balance sheet date for the amount we paid out for in the capital return. The improvement in the gearing ratio reflects the lower level of debt combined with higher equity from our increased earnings. By reducing our overall debt position, we have created optionality for our business to support farmers through increased dividends, the ability to pay the capital return and changes to our advance rate schedule. Importantly, we continue to be committed to maintaining our credit rating. Both S&P and Fitch have Fonterra as A rated, which allows our businesses to access capital with more favorable terms should the need arise in the future. We are very focused on further strengthening our business by safely and sustainably driving down costs by approximately $1 billion by 2030. As Miles mentioned earlier, we have introduced two new core metrics, which will keep us focused on driving efficiencies for the Co-op year-on-year. These metrics will help us be efficient by ensuring that our costs are managed relative to the value we can generate and the milk volumes that we collect. The two new core metrics are: cash operating expenses per kilogram of milk solid, where we will target a 4% improvement per year to assist long-term discipline in our global operating expenses; and gross profit from core operations per kilogram and milk solid, which will help ensure we stay focused on delivering value from our New Zealand operations, which is targeting a 2% improvement every year. Moving forward, we will advise progress against these metrics at our interim and full year updates. Miles will now comment on the outlook for FY '24.

Thanks, Neil. '23-'24 season Farmgate Milk Price is $6 to $7.50 per kilogram milk solid for the midpoint of $6.75. Demand for imported powders into China remains soft, but it's still early in the season. There are indications demand for New Zealand milk powder will start to return from early 2024. In the meantime, we'll continue to respond to market [indiscernible] and adjust our forecast on Farmgate Milk Price to ensure that the impact of current prices and currency movements is transparent. Looking now to F '24 earnings. Our guidance range for continuing operations is $0.45 to $0.60 per share. Earnings and discontinued operations will be affected by the timing of completion of the DPA Brazil sale. We anticipate that the favorable price relativity that we experienced in F '23 will reduce over F '24 and impact our Ingredients channel earnings. Our Foodservice and Consumer business gross margins are expected to improve over the year as the lower cost of milk flow through. The [indiscernible] is in good shape, and we look forward to the year ahead. Thank you for your time.

Thank you. We will now come back to the Q&A session. [Operator Instructions] Our first question are from Arie Dekker from Jarden.

Just first question, just on the CapEx, which is stepping up in FY '24. I mean it looks like sort of circa $550 million to $600 million is sustaining NZ operations and those green investment requirements you've signaled. But just in terms of sort of the $300 million to $400 million of capital being targeted to sustaining capital for other operations and for growth CapEx, can you just give a little bit of color on what is planned in FY '24 in each of those buckets?

Yes. Thanks, Arie, and thanks for the question and for joining the call. I mean I would just give some context, which is you are right, and it's part of the reason that we wanted to sort of provide that profile. There is a bit of a bow wave of CapEx that we're facing with respect to regulatory requirements around water -- wastewater and decarbonization. What I think I would say in terms of additional color on that sort of kind of core sustaining CapEx is the vast, vast, vast majority of that is for our New Zealand operations as opposed to global operations. And it's really kind of part of our long-term asset and health kind of program. I'd say -- and there's not a lot in that number, probably I'd limit to -- my comments to that around specific growth capital projects.

Yes. But I mean I guess if I look at the chart, it's suggesting sort of $150 million to $200 million in each of sustaining capital for other operations and growth CapEx in '24, which aren't small numbers. What sort of envisage in '24 in terms of investment in those three buckets?

Great. Are you talking about the $150 million?

Yes. And it's of sustaining capital for other operations and growth CapEx...

Yes. So you correctly called that out. I don't have it in front of me right now, but that number is -- to those with our operations outside of us, so that's mainly dominated by Australia CapEx. And again, as I'm saying, we folded growth CapEx in there as well, but it's a relatively small number. So the lion's share of that in terms of other would be based in Australia.

Sure. And just in terms of the CapEx for FY '24 and look in this question, I guess, applied across the buckets, is that pretty much committed? Or is there still discretion as you go through the year in terms of whether you'll actually sort of invest that full bucket?

I think I would say this, if you sort of look at the resource allocation framework that we've gone public with this year, we will always sort of spend the money to sustain our operations so that we can produce safely and efficiently, and we will always spend our money for that even in times where results kind of aren't so strong because that's really, really important for the long-term core or the Co-op. That said, through various procurement practices, et cetera, we're always trying to improve upon, kind of improve upon that number. The regulatory capital really is pretty much fixed and required based on -- sort of based on regulation. So you will see some movement in those numbers as we sort of juggle the profile, hopefully get better pricing, et cetera. But we wanted to provide this profile for a reason because we wanted to be able to help the market sort of better model cash flows.

And then in terms of I guess, growth CapEx, in particular, there wouldn't be any change to, I guess, when you outlined in the LTA, I guess there was a bucket of circa $1 billion that would depend on the strength of the opportunities. And then so certainly, as we look at it over that more medium to long-term horizon, that would still be the case. Or have you got -- when you share the update to the LTA in early '24, are you sort of suggesting that you've got a lot more color and visibility at least over the next few years on where that CapEx is going, and we should actually be starting to factor then?

Well, I wouldn't want to preempt in terms of what specifically we might say when we update what -- if you update the LTA. I think what I can say on growth capital is every project has got to provide the appropriate risk-adjusted for churn for it to sort of qualify. And so we don't look at it in terms of sort of filling a bucket of spend, it either provides an economic rate of return for farmers or if it doesn't. If opportunities did arise, well, obviously, when they arise, we will sort of modify this chart. But yes, I'm not trying to signal any deviation from our previous disclosures that we put out there.

Sure. And then just a couple of quicker ones. Just on your earnings guidance, and you have highlighted that it's based on continuing operations. Just in terms of the exit of DPA, which I think, correct me if I'm wrong, that you're sort of targeting for this calendar year still. Do you anticipate there to be any meaningful earnings benefit or cost associated with that so that impact, I guess, the earnings for dividend purposes or can we sort of size the dividend of that $0.45 to $0.60 guidance and the payout range that you have on that?

I think you'd be quite sensible to size the dividend off the $0.45 to $0.60 guidance.

Great. And then last one, just in relation to impairments. Just on the amount you laid out in the accounts for NZ Consumer and Foodservice, are you able to just clarify how much of that is in the Consumer versus NZ Foodservice? And then just also just any color on what the $26 million of other impairments related to?

So we're not providing any additional breakdown or detail on the breakdown between Consumer and Foodservice on New Zealand. And on the other one, I'd say, regrettably, no, I don't think we're providing any more particular details on that. It's really broadly a collection of a series of sort of smaller items on which that we thought were particularly meaningful to call out. So sorry about that.

Next, we have Joshua Dale from Craig's Investment Partners.

Just three questions from me. First one on your dividend payout. I appreciate there's lots of factors that go into that, but you paid above the top end of your dividend policy range this year and were at the top end last year. Do you think you'll keep the 40% to 60% range going forward.

Yes. I think I can say that we remain comfortable with that range. As you said, we do apply judgment in terms of making a recommendation to our Board. Obviously, the dividend -- actual dividend paid a decision of the Board. But I think given the number of noncash items that went through earnings, I think, given the strength of the balance sheet, we thought it was quite prudent in terms of the level of dividend that was paid.

My last two questions are really around earnings for the year ahead. I appreciate the guidance you provided. But just firstly, on your stream returns have obviously been very strong. Is there some sort of pressure in the market to eventually arbitrage that give away in terms of the differential between reference and nonreference products and does that pressure come from yourselves or your competitors? What's the best way to think about this?

I think what I would offer up is we've looked -- obviously, the really strong earnings that we've just reported have been as a result of some unprecedented stream returns. And so that delta between reference -- nonreference and reference pricing is -- has been quite large. And so that's what driven earnings. When we sort of look at the market, we're not really identifying anything structural in the market that's changed, which would otherwise cause us to think that we wouldn't see mean reversion happened in terms of the relative gap between nonreference and reference products. I think we'd offer up that. The other thing that I would certainly say, though, is obviously the teams in market are working incredibly hard every day with customers in terms of challenging pricing, where it's commercially viable, putting those price increases through. So regardless of what is being sold that we're maximizing the return.

Okay. And second question on your earnings for the year ahead, you increased pricing in your Consumer and Foodservice divisions to better reflect the high cost of milk historically, but how sticky do those price increases tend to be as the cost of milk falls back down to lower levels like it has recently?

Yes. I mean it's clearly a competitive element to that. So we'll hold that price in the market as long as we can. But ultimately, competitive pressures will come to bear at some point once it's big but as we sit here today, we're trying to keep those high pricing up or [indiscernible] the COGS.

Next, we have Nick Mar from Macquarie.

Okay. Just one more on the CapEx. If you look at the at -- from '24 [indiscernible] it's about 9% higher than what it was in the LTA for the same period. Would you characterize the majority of this just price adjusting strong [indiscernible] in the last couple of years? Or is this sort of a step change? And ultimately, where is the step change between the sort of different buckets? And then finally on that, there's sort of [indiscernible] the additional CapEx [indiscernible] sort of long-term earnings.

I apologize. I didn't quite get the second part of your question. But the first part of your question, yes, that's basically reflecting inflationary increases.

Yes, typically [indiscernible] should have been particularly much incremental earnings on that CapEx.

That's fair, recognizing that in terms of what ultimately drives earnings, there's a number of very material moving pieces for us, including realized prices and FX, just to call out, too.

And then thinking about sort of using the balance sheet -- times are tougher for farmers as we've seen and sort of we'll see how long this goes on for [indiscernible] relative breakeven. What other mechanisms would you consider outside of the [indiscernible] rate changes that you've already made to support farmers -- was sort of that sustained period of [indiscernible] prices?

Yes. So I guess I'll answer it another way, Mark, Nick rather, if there's something in there around how we're looking at farmer support loans, that's not part of our [indiscernible] I'll make that clear upfront. But looking through probably our retail network, what we can do to extend a little returns for on-farm and put the purchase for our [ farm sales ] network, but also a potential discount and keep costs down. So that's sort of where we're looking to use the balance sheet as appropriate, but nothing sort of significant beyond that. I think the question earlier around the dividend policy is no change to our policy at this point is 40% to 60%. So no change to that, but nothing significant that we're looking at, at the moment.

Our next question comes from Marcus Curley from UBS.

I just wondered if you could provide a little bit of more specific color around the quantum of stream returns in the results, and what's assumed in the guidance for FY '24?

So I think, Marcus, [ Richard Wyman ] here, the couple of observations around stream returns. We think this year, sort of an estimate of the economy stream returns and the $0.95 is about $0.40 and in the guidance for next year, the $0.45 to $0.60, probably a number of around $0.15, just sort of see from the price -- of charts is coming forward.

Sorry, that was $0.40 contribution to earnings in FY '23?

Yes.

And then you said $0.15 , would that be -- is that at the midpoint? Is that fair enough to describe?

There's a wide range of possibilities there. I think I am always conscious when talking about sort of the impact of stream returns and price relativity that's -- it's a difficult thing to quantify exactly. And I think that clearly, there's a wide range of possibilities that can happen through '24.

Okay. Maybe a different way of asking the question. You noted that there has been a moderation, but it looks like steam returns to remain very healthy. If we saw stream returns or prices -- relative prices remain at current levels for the rest of the year, do you have an estimate for what the stream return would be in FY '23 -- I'm sorry, FY '24?

I think it's -- to your point, it's fair to say that the assumption of $0.15 assumes the stream returns, obviously, that gap closes as the season goes on in terms of the -- and I mean, obviously, the number you saw what it was last season, it was $0.40. It's quite a wide range of things are possible if the gap stays open for the whole season.

And sorry, just finally, a full normalization of stream returns, what would you normally attribute a contribution to profit on that basis?

In terms of the $0.40, how much is a normal BAU level? Is that your question? I guess somewhere between sort of $0 and $0.05 at that level.

Okay. Perfect. And then secondly, I just wanted to maybe, Miles, you could talk about the current demand dynamics in Foodservice in China, particularly what you're seeing from a volume perspective, obviously, mixed messages in terms of obviously reopening versus economic pressure. And also same in terms of Asian consumer products.

I'll answer that just because Miles have to step away. I think there's obviously been a lot of press about some of the headwinds that are happening in China. I think what we would say is focusing more kind of on sort of maybe medium term is we're pretty comfortable that demand will remain robust. I think one of the things that's, I think, quite critical besides despite lower growth rates, they are growth rates and incomes are rising. But I think quite critically, the governments from a policy perspective has been quite clear that they think dairy is a core part of nutrition and there -- they're being very consistent and persistent around that message in terms of recommendations to sort of two consumers. So that's certainly quite helpful. So I think on the ground, we're continuing to see -- our China Foodservice business is one of our flagship operations for sure. And some of the price increases, specifically in Consumer, so far seem to be sticking. Southeast Asia is a little bit more of a mixed bag, I would say, but still ultimately Foodservice is strong. I think the market that is really worth calling out is Sri Lanka, which is -- has had a fantastic year and seems to be performing well. And even just I know there's been challenges in years gone by around currency, et cetera, and that so far seems to be going well.

Okay. And then just finally, a couple on the capital structure. So what's the plans on the buyback as the year progresses?

So I think off the back of the new capital structure going live, we were providing some liquidity support as things sort of went live, it turned out that we really spent very little money on liquidity support. The market seems to be operating fairly well. We have earmarked a relatively small amount of funds as part of our capital allocation framework that if we see value that we may choose to go back into the market to buy back shares. But our driver would be different. It wouldn't be to provide liquidity support. We think that's going to no longer be required. But we would do it if we saw -- if we thought there was value.

And so you've got a valuation benchmark?

Well, we have to -- obviously, we have to have a view on value if we're going to -- if we're going to end up buying back shares for the purpose of value, so sure.

Have you formed that view on value yet?

We formed that view, but obviously, we're not going to provide that information externally.

And the second question, could you give an update in terms of the farmers ownership levels of [ FSF ]?

Yes, hopefully [ FSF ] if you take it on current supplying farmers, it's just under 10%.

Did you recall that on -- I think that's well down. Do you have to hand what that was a year ago? Or...

So on supplying farmers, it's always been -- it has been eating up, but it has been around -- last year would have been around the same level. You might have been thinking just in terms of there was some work done and it was released at the [indiscernible] on just total so even the farmers that list the Co-op that had been much higher around the 50% to 60%, and that number still remains about that.

And then just -- sorry, one more on the CapEx. Just to be clear for me, when I look at the blue bars, does decarbonization and the other one, regulatory requirement for wastewater or including wastewater, do those -- both of those go into the milk price calculation? Or is it just sustaining capital for NZ operations?

So the short answer is partially they do to the extent that they would impact a reference producing company, they do. So obviously, the decarb mostly yes, but the timing is a little bit different and the wastewater, the nonreference products tend to be more wastewater intensive, so it's...

Okay. So from a modeling perspective, will just put -- is it fair enough to put all decarbonization in and leave wastewater or other regulatory out?

So as a combination of both buckets, it suggests that the milk price will provide a support for maybe 25% of that spend...

Of the two?

Of the two.

I would now like now to hand over to Neil for closing remarks. Thank you.

Well, I just -- on behalf of Miles and myself, I really wanted to thank everyone for participating on today's call and your questions and your interest in the Co-op. So we look forward to seeing you in the future. Bye for now.