Fitch Downgrades Fonterra to 'A'; Outlook Stable

(The following statement was released by the rating agency)SYDNEY, October 21 (Fitch) Fitch Ratings has today downgraded Fonterra Co-operative Group Limited's (Fonterra) Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'A' from 'AA-'. The Outlook is Stable. Fitch has also downgraded Fonterra's Short-Term IDR to 'F1' from 'F1+'. A full list of rating actions is at the end of the commentary.The downgrade reflects Fitch's view that Fonterra's business profile has weakened and is now in line with an 'A' rated company. The rating continues to recognise the strong global market position of the co-operative's ingredients business, the financial flexibility afforded by its ability to adjust the forecast milk price and the advance rate milk payments to farmer shareholders, and the effective subordination of farmer payments. However, the impact of the recent volatility in the global dairy market, and more recently the low dairy prices, has illustrated a vulnerability to adverse business and conditions, which Fitch has now factored in. The effective subordination of milk payments underpins the co-operative's financial flexibility and this in turn has been a robust credit enhancer. However the sharp fall in global dairy prices led to a weakening of this financial flexibility. Fonterra elected not to reduce the level of advance rate milk payments in line with the sharp decline in milk prices in the financial year ended 31 July 2015 (FY15). As a result, subordinated farmer shareholder milk payables declined by around NZD0.9bn at end-FY15, which the co-operative funded with bank facilities. This, and higher debt to fund capacity expansion and the purchase of a stake in China's Beingmate, led to deterioration in Fonterra's credit metrics at end-FY15 with leverage, as measured by the ratio of adjusted debt to EBITDA (including subordination), reaching 5.2x. In August 2015, Fonterra also offered loans to farmer shareholders, to be funded by one-off working capital savings. While these actions support Fonterra's farmer shareholders' financial stability, they are to the potential detriment of bondholders and highlight a weakening of Fonterra's financial flexibility.Fitch recognises the actions Fonterra have taken over recent months to restore its credit profile. The measures included reducing planned capital expenditure, setting milk payment advance rates to normal levels for the 2015/16 season and implementing a range of efficiency measures to improve profitability under its transformation programme. Our Stable Outlook reflects our view that Fonterra credit metrics will be in line with the 'A' rating in the next few years. The re-assessing of Fonterra's business profile and heightened volatility in global dairy prices also led to a revision of the rating sensitivities. KEY RATING DRIVERSReduced Financial Flexibility: Fonterra's financial flexibility has previously been demonstrated by actions taken to protect its financial strength, including setting the FY14 Fonterra Milk Price to its farmer shareholders below the Farmgate Milk Price determined in accordance with Fonterra's Milk Price Manual and declaring a dividend in FY15 at the low end of its guidance. However, in FY15 Fonterra elected to not reduce its advance rate payments in line with the sharp decline in milk prices, and it funded the payments to farmer shareholders with debt. Further, Fonterra said in August 2015 that it will provide loans to farmer shareholders to ease cash flow strain associated with weak dairy prices. These measures were taken to support farmer shareholder financial stability, but they reduced the level of subordinated farmer shareholder milk payables and degree of financial flexibility, which are the cornerstones of Fonterra's credit profile.Higher Financial Leverage: Fonterra's leverage, measured by the ratio of adjusted debt to EBITDA (including subordination), increased to 5.2x at end-FY15 (end-FY14: 2.1x) after a rise in outstanding debt to fund higher advance payments, the acquisition of a stake in Chinese dairy company Beingmate, and plans for higher capital expenditure. Fitch expects Fonterra's leverage to improve in FY16 as it returns to historic levels of advance payments and capital expenditure, but does not expect leverage to improve to below 1.5x on a sustained basis over the rating horizon.Subordination of Milk Payments: The effective subordination of milk payments to its farmer shareholders to principal and interest obligations (and other costs) is provided in Fonterra's constitution. In its forecasts, Fitch assumes that the proportion of unpaid milk supply costs to its farmer shareholders at the end of each financial year will continue to be a minimum of 10% of the total annual cost of New Zealand sourced milk. This assumption is based on Fitch's understanding of the underlying legal framework underpinning the effective subordination of milk payments to farmer shareholders and Fonterra's setting of advance rate payments.Strong Business Profile: Fonterra has strong defensive characteristics, underpinned by the margin protection that stems from its fully integrated model with the ability to pass through global dairy price movements in the ingredients business, while the Consumer and Foodservice division is able to insulate profits during periods of low dairy prices. The business profile is also supported by Fonterra's scale as the global market leader in dairy exports, commanding 48% of international exports in whole milk powder, and its status as the largest dairy producer in New Zealand. The depth and breadth of Fonterra's supply chain, and the scale of its operations, serve as key barriers to entry.Farm Debt Levels Sustainable: Fitch expects the level of borrowing by farmers to the value of milk solids production - a measure of farm leverage - to remain above its historical average over the rating horizon. However, Fitch expects farmers to be able to continue servicing outstanding debt, helped by industry bodies, which have been working with farmers to help achieve cost savings.KEY ASSUMPTIONSFitch's key assumptions within the rating case for Fonterra include:- Farmgate Milk Price to return to its historical average over the rating horizon;- Consumer and Foodservice growth to be in line with market forecast demand growth;- Non-New Zealand sourced milk to increase to 15% of the total cost of milk;- Farmer shareholder milk payables at balance date to be 10% of the annual cost of New Zealand sourced milk;- Capital expenditure to decline to around NZD900m over the rating horizon; and- Dividend payout ratio to be at the higher end of 65%-75% of net profit after tax guidance.RATING SENSITIVITIESNegative: Future developments that may, individually or collectively, lead to negative rating action include:- Leverage, as measured by adjusted debt to EBITDA (including subordination), rising above 2.5x; or - EBITDA margin deteriorating to below 5%, both on a sustained basis.Positive: Fitch does not anticipate any positive rating action over the medium term, however future developments that may, individually or collectively, lead to positive rating action include: - Leverage falling to below 1.5x; and - EBITDA margin improving to above 10%, both on a sustained basis.FULL LIST OF RATING ACTIONSFonterra Co-operative Group Limited- Long-Term Foreign-Currency IDR downgraded to 'A' from 'AA-'; Outlook Stable;- Short-Term Foreign-Currency IDR downgraded to 'F1' from 'F1+';- Senior unsecured rating downgraded to 'A' from 'AA-';- Subordinated debt rating downgraded to 'A-' from 'A+';- Commercial paper rating downgraded to 'F1' from 'F1+';- Short-term senior unsecured rating downgraded to 'F1' from 'F1+'.Contact: Primary AnalystKelly AmatoAssociate Director+61 2 8256 0348Fitch Australia Pty Ltd., Level 15, 77 King Street, Sydney NSW 2000Secondary AnalystSajal KishoreDirector+61 2 8256 0321Committee ChairpersonVicky MelbourneSenior Director+61 2 8256 0325Media Relations: Leni Vu, Sydney, Tel: +61 2 8256 0304, Email: leni.vu@fitchratings.com.Additional information is available on www.fitchratings.com.Applicable Criteria Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr _id=992614Solicitation Status https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=992614Endorsement Policy https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&det ail=31ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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