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

Kia ora. Thanks for joining us for our performance for the first 6 months of the financial year. I'm Miles Hurrell, Chief Executive of Fonterra, and I'm here with Simon Till, Acting CFO. We've had a strong first half with a lift in both earnings and dividend. Our total group earnings of $0.40 per share, up from $0.33, and our interim dividend is $0.15, up from $0.10 this time last year. This builds on a strong first quarter, and I'm proud of what the team have delivered. Our trading environment continues to have a backdrop of market volatility and geopolitical uncertainty. This is where our Co-op scale and strong balance sheet combined with the diversification of our channels and markets is important to our ongoing performance. The improved earnings are a key driver in our return on capital this year of 13.4%. It is important to note, however, that we calculate a return on capital on a rolling 12-month basis. So the 13% includes a strong second half of last year. Our balance sheet has supported both the increase in interim dividend and allows us to make milk price payments to farmers [ soon ]. Before I discuss the trading environment, I want to make a few comments on our earnings and, in particular, the change in composition across our channels. Our earnings relative to last year showed that the tighter margin in our Ingredients business have been more than offset by improved earnings in Foodservice and Consumer. I also note that last year's Consumer earnings included impairments that were not repeated this year. Shortly, Simon will talk more about the key drivers of the channel performance. The current global supply and demand dynamics are finally balanced, but overall, fundamentals remain positive. We're seeing limited global milk growth and while demand has fluctuated over the past 12 months, there are signs of it stabilizing. The key driver is China where we're seeing gradual rebalancing of the domestic milk production as well as inventory levels normalizing. With softer demand out of China over the last 12 months, we did see increased volumes flow into Latin America and the Middle East and Africa. More recently, Asia outside of China is up compared with the same time last year. Milk production out of Europe and North America is constrained by high on-farm costs. As a result, their production is flat to down for the 12-month period, and this trend is expected to continue in the near term. Production in Australia has improved slightly, mainly driven by better weather conditions compared to the same time last year. While here in New Zealand, milk production is up marginally over the 12-month period, but down for the last quarter as weather continues to impact pasture quality and production in parts of the North Island. These market dynamics provide context to the movement in the Farmgate milk price and earnings. Looking at this season, the softer demand out of China impacted the price of milk early in the season before increasing strongly over November, December and January. The lift was driven by strong increase in reference commodity product prices from August through to February. Asia, as mentioned earlier, was a significant contributor to the increased demand and price for reference products in the second quarter specifically. Going forward, the Chinese recovery will be an important factor in GDT prices, and we're actively monitoring their post-Chinese New Year consumption as a key indicator. We're also watching the extent of domestic Whole Milk Powder production occurring in China as it enters their new milk season. The profile of the monthly milk price is quite different this season compared to last, and this has contributed to stronger performance seen in both Consumer and Foodservice channels. Simon is now going to comment further on what's driving the performance.

Thanks, Miles. Before I get into the specifics of each channel, I'll take a moment to cover some of the key drivers of the overall performance. The increased net earnings for our continuing operations of $0.43 per share was driven by both higher operating earnings and lower financing costs. The $122 million increase in operating earnings reflects higher sales volumes overall, but importantly, higher sales volumes in both Foodservice and Consumer. Despite these higher sales volumes, overall revenue was down mainly due to the lower product prices in the Ingredients channel. These lower product prices were also reflected in lower cost of goods sold. And as a result, our overall gross profit was similar to last year. At a channel level, the improved gross profit in Foodservice and Consumer channels was largely offset by the lower margins and ingredients. Operating expenses are shown as being favorable relative to last year, but last year included impairments in Consumer. After removing the impact of impairments, operating expenses have increased $52 million, mainly due to driving the higher volume and margin through the Foodservice and Consumer channels, as well as upfront costs of driving efficiency improvements. Financing costs improved $40 million, reflecting lower average total borrowings, mainly due to higher earnings, improved working capital and divestments. On the right-hand side of the chart, discontinued operations made a loss of $40 million, reflecting the sale of DPA Brazil in October last year. DPA Brazil was profitable over this period, but this was more than offset by the release of the $68 million from the foreign currency translation reserve as part of the sale. This matrix view of our reporting segment shows the diversification by both channel and market, but also shows a more detailed the change in composition of earnings by channel and also by quarter. Last year, our first half results were heavily weighted towards Ingredients with the favorable price relativities especially in Q2 and also include the impact of the impairments in the Consumer channel. This year, the earnings profile is more balanced with approximately half of operating earnings coming from Ingredients, 35% from Foodservice and 15% from Consumer. The increased sales volume for Greater China reflects the higher sales volumes of UHT cream into the Foodservice channel. Global Markets Foodservice channel earnings increased as well, but its improved performance was driven more by the strong lift in earnings in the Consumer channel. While Global Markets' overall volume was similar to last year, it sold less Ingredients and more Consumer products. And finally, core operations lower earnings reflect the lower margins in the Ingredients channel, which we'll look at now. The reduced earnings from Ingredients mainly comes from lower margins, and there are a number of factors that contributed to this. Firstly, the relativity between the reference and nonreference product portfolios was less favorable than the prior year. This was at the revenue level where both volume and price were less favorable. And also at the gross margin level, where the cost of milk did not decline as much the nonreference products as it did for reference products. The decrease this year in the price of lactose was also a contributing factor to the low Ingredients margins. Lower margins were also experienced in the regions, mainly due to a higher milk price in Australia relative to the prices for exported Ingredients. Gross margin for Ingredients is expected to continue to tighten in the second half of the year, reflecting the recent increase in the price of reference products on GDT relative to nonreference prices. Our Foodservice business has performed well with an increase in operating earnings of $203 million. Sales volume grew by 8%. And as I mentioned earlier, this was mainly driven by UHT cream in Greater China. The improvement in margin was a combination of both lower milk costs and higher end market pricing, particularly in Asia. Gross margins tightened in the second quarter due to a combination of increased end market competition and higher cost of goods sold as the cost of milk increased. As anticipated, gross margin will continue to tighten in the second half, reflecting the recent increase in GDT pricing, which Miles spoke of earlier. Moving to the Consumer channel now. A big change from last year with an improvement of $302 million. Half of that is due to last year's numbers, including the impairments, which were not repeated this year and the other half from improved underlying performance driven by both higher volume and margin. Volume was up 8%, and the drivers of the improved margins were similar to Foodservice with both favorable pricing across the regions and a lower cost of milk. Pleasingly, all regions improved their performance. Similar to the Foodservice channel, margins did tighten in the second quarter and are expected to continue to tighten in the second half, reflecting the price increase on GDT. And lastly, for me, our balance sheet has continued to strengthen. Our debt is typically higher at the interim results than at the end of the year due to the seasonal profile of our business. Compared to a year ago, our net debt was $1.6 billion lower, down from $5.8 billion to $4.2 billion. The reduction reflects the strong underlying performance of the business, lower working capital and the impact of divestments. I'll now hand back to Miles to update you on our outlook for the rest of the year.

Thanks, Simon. Finally, looking ahead to the remainder of the year. We have narrowed the forecast Farmgate milk price range to $7.50 to $8.10 with the midpoint unchanged of $7.80 a kilogram. This reflects Fonterra being well progressed through the season. In the second half, we are expecting pressure on margins in Consumer and Foodservice due to the higher cost of milk. We're also anticipating price relativities between reference and nonreference products to return to more normal levels, which will impact our Ingredient margin. This is reflected in our full year earnings guidance, and we are maintaining our forecast range of $0.50 to $0.65 per share. The Co-op is in good shape, and we look forward to the remainder of the year. Thanks for your time.