Total gross margin in the giant ingredients division across New Zealand, Australia, and Latin America was $1.862 billion, up nearly 20% from the $1.562b the previous financial year.
The higher gross margin flowed on to $1.2b normalised earnings before interest and tax (Ebit), up 24% then formed a large portion of the record $834 million profit.
The return on capital for ingredients jumped to 13.4%, compared with 9.3% the year before.
“Every year we convert more and more milk into higher-returning products through ingredients solutions and the consumer and food service business,” chief executive Theo Spierings said in the annual report.
“Our increased ingredients earnings this year show we have matched production to the highest value customer demand while taking advantage of our reduced costs, especially at the peak of the season.”
Making higher volumes of the more profitable non-reference products like cheese and casein pushed their share of gross margin up to 60% of the divisional total in NZ processing, a 42% increase in dollar terms.
Reference products like milk powders, butter and anhydrous milk fat were used to calculate the milk price at the farmgate.
In the previous financial year non-reference products contributed 46% of total gross margin.
In the 2014 financial year, when China was buying all the NZ milk powder it could get, non-reference products contributed only 1% of the NZ ingredients gross margin.
From 1% to 60% in two years demonstrated an extraordinary flexibility, which Fonterra called product optionality, now built into the mix of processing facilities on 33 manufacturing sites in NZ and 10 in Australia.
Fonterra did not disclose the actual tonnages of different products made each year but it did report on the shares of gross margin and earnings that came from reference and non-reference products and from the regions of the world in which it operated.
Last year the gross margin per tonne for non-reference products was $1348, which when divided into the total gross margin dollars suggested production of about 720,000 tonnes.
The alternative was $330/tonne for reference products, suggesting 1.92m tonnes.
“Every year we convert more and more milk into higher-returning products through ingredients solutions and the consumer and food service business.”
Theo Spierings
Fonterra
The volume ratio of reference to non-reference products made in NZ was therefore 70:30, versus 75:25 the year before.
Non-reference products generated $1000/tonne better gross margin in FY2016, compared with $600 the year before.
Improved optionality was greatly assisted by a lower peak milk flow, at 86.9m litres highest daily volume collected, down 3% from the year before.
Fonterra now had surplus processing capacity at peak times that enabled it to make decisions on product choice based on price and demand rather than having to run all plants flat out to process all the milk every day.
The three main regional markets for all ingredients, reference and non-reference, were: Europe, the Middle East and Africa, 778,000 tonnes, down 4%; southeast Asia, 721,000 tonnes, up 2%; and China, 630,000 tonnes, up 17%.
Fonterra also sold 353,000 tonnes of NZ and Australian ingredients into Latin America, 297,000 tonnes in Oceania (much of which would have been further processed into consumer and food service products) and 161,000 tonnes into north Asia.
The Australian business transformation had resulted in the right foundation for sustainable returns, Spierings said.
The sale of non-strategic assets in yoghurt and dairy desserts meant Fonterra Australia would now concentrate on cheese, whey and nutritionals along with the focus on core consumer and food service brands.
Fonterra was now in pole position for what Spierings called the Australian “end game”, in which the market leader, Murray Goulburn, was now in difficulties.
Equities analysts said Fonterra’s much-improved results now asked the question whether the capital investment in more product options would maintain earnings from ingredients through the upswing of the dairy commodities cycle.
Its ambition targets had been largely met in just one year because of very low input costs feeding into high margins, Forsyth Barr agriculture analyst James Bascand said.
The sustainability of those metrics was now the question in a higher cost environment, something that Fonterra had acknowledged by providing a 9-14% range for future returns on capital.
The earnings per share guidance for the current financial year had been left at 50c to 60c and Bascand reduced his expectation to 53c but increased his share target price to $6.15.
First NZ Capital research head Arie Dekker also increased his target price by 10c to $6.22 and upgraded his earnings expectations for FY2017 to 58c.
The big test ahead of Fonterra was demonstrating resilience to the commodity and milk price cycle, something that had not been done consistently, Dekker said.
In FY2016 Ebit had broken through the $1b ceiling it had hit five times in the past eight years.
Dekker said three factors to watch were:
Could ingredients maintain earnings with the flexibility it now had in more normal commodity market conditions?
Could the positive momentum in consumer and food service be sustained when the cost of NZ-sourced inputs increased?
Could Fonterra start to generate a return on the capital invested in the China farms and Beingmate?
