When first announcing the downgrade, Fitch blamed Fonterra’s business profile having been weakened and the volatility of global dairy prices revealing its vulnerability to adverse business and conditions.
According to the latest report, Fitch said there were two specific steps Fonterra took which the rating agency believed to be financially costly to the co-operative, including choosing not to reduce its advance-rate milk payments to farmer shareholders when milk prices declined. The higher advance-rate milk payment resulted in a decline in subordinated farmer-shareholder milk payables by about $900 million at the end of the 2015 financial year.
The other step was Fonterra's August announcement that it would provide interest-free loans to farmer shareholders to ease cashflow strain associated with weak dairy prices. The loan of 50 cents per share-backed kilogram of milksolids (MS) for production through to December has been taken up by 76% of its farmer shareholders at an initial cost of $390 million.
Tomorrow morning Fonterra will detail whether it will extend the period of the loan beyond December, and announce whether it has revised its forecast $4.60/kg MS farmgate milk price payout for the 2015-16 season.
Fitch said that possibility has already been factored into the two-notch downgrade which reflected Fonterra’s business profile being more in line with an 'A' rated company which maintains a conservative policy with modest deviations.
In previous difficult seasons, such as 2004-5, Fonterra had shown a disciplined approach in both working capital management and capital expenditure control, moves that kept its credit metrics largely stable, the rating agency said. It believed the change to support farmer shareholders during the 2015-16 season shows Fonterra has a heightened vulnerability to adverse business conditions, which largely contributed to the downgrade’s timing.
Fitch said the fundamentals of dairy demand remain strong though volatility in global dairy prices is likely to remain for the medium term due to over-supply.
Farmer shareholder wealth is key to Fonterra securing milk supply for the upcoming milk season and Fitch expects farmers will be able to continue servicing outstanding debt.
It expects Fonterra’s leverage to improve by the end of the 2016 financial year when debt will be reduced substantially to a debt equity ratio of between 40-45% after advance-rate milk payments return to historic levels and capital expenditure is lowered.
Fonterra’s leverage will likely keep improving over the next two years but still not hit the level at which it would consider a positive ratings lift, Fitch said.
“We expect improvements in Fonterra’s operating ebitda margin as the co-operative implements its business transformation process,” it said. “We expect its recently completed capex programme that improves manufacturing options and reduces peak costs to improve efficiency and contribute positively to margins.”
Fonterra has previously said the revised ratings wouldn’t impact its strategy or the farmer shareholder payout.
