INVESTOR EDUCATION – Demystifying Fonterra
Recently there has been a considerable amount misunderstanding among Fonterra shareholders on exactlyhow dairy prices effect the company’s share price. Part of this confusion is a lack of understanding of how Fonterra makes its money and what Fonterra’s costs are. attempts to demystify the uncertainty on
how dairy prices effect Fonterra shareholders and accordingly explain the process of setting the farm gate
milk price.
Low Milk Prices good For Fonterra Shareholders?
Fonterra Shareholders Fund operates as a global dairy retailer. In its simplistic form, they purchase raw milk from farmers, process the milk and finally produce sellable dairy products to end customers.
By this method, FSF earns the margin from the cost of buying the raw milk from farmers to what they sell their dairy goods for to end consumers.
Fonterra Costs
In order to understand what price FSF pays farmers we must first understand how the
farm gate milk price is set.
The farm-gate Milk Price is intended to reflect Fonterra’s actual revenue and costs for milk powders (WMP and SMP) and their by-products (Butter, AMF and BMP).
The first step in the process is calculating the total amount that farmers would have received if the farmers had sold their milk directly on to the free market. To do this, the GlobalDairyTrade (GDT) Index is used. At each 2 week GDT auction prices are set to reflect the price that buyers of milk and milk products are willing to pay. By using the GDT index we are able calculate a theoretical value farmers would have revived if they had not sold their milk to Fonterra.
Secondly, Fonterra calculates what costs would have been incurred by:
- Shipping the raw milk to Fonterra’s factories
- The costs of producing these same commodities in an efficient way
- Overhead & operating costs
- Transporting these goods to market
These costs are then deducted from step one. Finally, Fonterra decides on an appropriate return on investment that they require for their investment in producing consumer goods and again deducts this from step one. Once these have all these steps have been decide, the remaining amount is the amount farmers receive for their milk.
This farm gate milk price is extremely important to the profitability of FSF. Even a small increase in the farm-gate Milk Price, although a small proportion of the total farm-gate Milk Price, it is a much greater proportion of FSF earnings. For example, a 5 cent higher farm-gate Milk Price is less than 1% of a farm-gate Milk Price of $7.50, but is around 15% of Fonterra’s recent operating earnings of 30-35 cents per share. Evidently, FSF shareholders want to pay as little as possible for the milk they buy from farmers in
order to maximise their total profits. In this way FSF way milk prices on the GDT index to be as low as possible as it reduces FSF’s total costs.
Fonterra Revenues
Once Fonterra has received the milk from farmers, they then undertake the process of transforming the raw milk into consumer dairy products such as butter, cheese, baby formula and milk powder. The price they get for selling these goods in retail shops and supermarkets is FSF revenue. FSF can increase their revenue by their selling higher volumes of their dairy products or by increasing the price that they sell these goods for. By increasing the selling price of the good, they are also increasing their profit
margins.
Hence, FSF shareholders should be concerned about what retail diary prices are doing and not the raw price of dairy (as this is actually a cost). A number of factors influence retail dairy prices, but competition is the major determinate. When competition is high among retailers, retail prices are generally pushed lower and therefore profits also tend to be lower.
FSF is attempting to target markets that have high retail margins on dairy. At the moment they these tend to be Latin America, Middle East and Asia.
Technical terms
Often the terms RCP and Non-RCP are used by Fonterra. These acronyms stand for Reference Commodity Products and non-Reference Commodity Products. RCP are milk powder products such as Whole Milk Powder (WMP) and Skim Milk Powder (SMP).
These RCP make up the majority of the GlobalDairyTrade Index. Non-RCP include cheese and butter etc. These can be thought of as products which are actually produced by Fonterra but which are not captured in the milk price cost formula. When there is a large divergence between RCP and non-RCP and the RCP is much than the non-RCP it is likely to result in a large loss of shareholders, as was the case in December
2011. Essentially, FSF is paying more for the raw milk than they are able to sell their
finished goods for.