Fitch Revises Fonterra Outlook to Negative on Profit Downgrade

(The following statement was released by the rating agency) Fitch Ratings-Sydney-March 04: Fitch Ratings has revised the rating Outlook on Fonterra Co-operative Group Limited to Negative from Stable, and affirmed the Long-Term Issuer Default Rating at 'A'. The revision of the Outlook to Negative follows Fonterra's reduction of its forecast earnings for the financial year ending July 2019 (FY19). In our view, this indicates that the co-operative has structural issues that it needs to address to retain the defensive traits that have underscored its historically strong business profile. A full list of rating actions appears at the end of this rating action commentary. Fonterra said on 28 February 2019 that it has reduced its forecast earnings for FY19 to NZD0.15-NZD0.25 per share from NZD0.25-NZD0.35 per share. The co-operative attributed the decline to challenges in its ingredients business in Australia and Foodservices businesses in Asia, as well as difficult trading conditions in Latin America and an increase in the forecast of its Farmgate Milk Price to between NZD6.30 and NZD6.60 per kilogram of milk solids (kgMS), its main production input. Nevertheless, in our view, Fonterra's announcements that it will not pay an interim dividend, that a decision on any full-year dividend can only be made at the end of the financial year and will depend on the co-operative's full-year earnings and balance-sheet position, and that it will review its dividend policy as part of a wider strategic review currently undertaken by its board, is positive for bondholders - and continues to reinforce Fitch's expectation that Fonterra will prioritise the strength of its balance sheet over payments to farmer shareholders. KEY RATING DRIVERS Structural Issues Limit Profit Defensibility: The effect that volatility in the dairy market and other industry issues in specific geographic regions continue to have on Fonterra's profits indicates that there are structural issues within the co-operative, which limit its ability to absorb these effects. We previously expected Fonterra's inherent defensive traits, including its ability to pass on global dairy-price and foreign-exchange movements in its global ingredients business to farmers and the resilience of profit margins in its consumer business when dairy prices are low, to reduce its profit volatility and help Fonterra restore its leverage metrics to within our rating guidelines. The co-operative's strategic review being undertaken and the successful implementation of actions to resolve these issues over the next 18 to 24 months will be crucial for Fonterra in retaining the defensive traits that have historically underpinned its strong business profile. Asset Sales to Address Leverage: Leverage - defined as total adjusted debt/EBITDA including subordination - has, since FY15, remained above or around 2.5x, the level at which we would consider taking negative rating action (FYE18: 2.4x). The co-operative is committed to reducing leverage, and is undertaking a portfolio review to ensure its investments and major assets support the group strategy, as well as generate targeted returns. We believe that asset sales are critical for Fonterra to return its metrics to a level in line with its current rating, given the impact that structural issues continue to have on Fonterra's ability to organically deleverage. The company expects more than NZD800 million in asset sales as part of the portfolio review, the proceeds of which will be used primarily to reduce debt. Should Fonterra achieve financial close on these sales as expected, we project that leverage will improve to around 2.2x by FY22, including the asset sales. However, any lack of progress will put pressure on Fonterra's rating. Effective Subordination of Milk Payments: Fitch believes the effective subordination of New Zealand milk payments at Fonterra to its principal and interest obligations (and other costs) is a key rating driver. This is underpinned by the effective subordination's inclusion in the co-operative's constitution and its return to historical levels over the past two years. Nevertheless, adverse business conditions can affect this driver, as highlighted in FY15 when milk payment retention for New Zealand-sourced milk fell to 2% after the co-operative decided not to cut its advance-rate milk payments in line with the decline in global dairy prices to assist farmer-shareholder cash flows. Among Most Competitive: The co-operative's large scale and dominance of the domestic dairy industry serve as key barriers to entry. Fonterra is the world leader in dairy exports, representing around 15% in the global market, including around a 42% share in whole-milk powder; and it is New Zealand's largest dairy producer, collecting around 82% of the country's milk supply in the 2017/2018 season. The average cost of dairy production in New Zealand is among the world's lowest. Cost competitiveness arises from the favourable climate for grass-fed herds, the depth and breadth of Fonterra's supply chain and the scale of its operations, particularly after investment to improve efficiencies and capacity. Sustainable Farm Debt Levels: Fitch expects farm leverage, as measured by the level of borrowing by farmers/value of milk-solids production, to remain above the historical average over the next few years. However, farmers are likely to continue being able to service debt, helped by industry bodies, which have worked with farmers to achieve cost savings, as well as a recovery of global dairy prices from their historic lows in FY16. DERIVATION SUMMARY Fonterra may be compared with European peer, Royal FrieslandCampina NV (BBB+/Stable), as both cooperatives focus on dairy products and have similar scale and profitability. However, Fonterra's rating benefits from its position as the world's largest dairy exporter, the calculation of the Farmgate Milk Price incorporating a regulated return and the effective subordination of New Zealand milk payments to the company's principal and interest obligations (and other costs), as specified in Fonterra's constitution. These factors, combined with Fonterra's stronger financial profile, lead to Fonterra's rating being two notches higher than Royal FrieslandCampina's. Fonterra is also comparable with global peers Nestle SA (SIX:NESN) (AA-/Negative) and Unilever (LON:ULVR) PLC (A+/Stable), whose ratings reflect their larger scale and diversification. Nestle is the world's largest food company and Unilever is the third-largest food and consumer product company. Both Nestle and Unilever also have better profitability and credit metrics than Fonterra. These factors result in Fonterra being rated two notches below Nestle and one notch below Unilever, despite the benefits afforded to Fonterra by its Farmgate Milk Price calculation and effective subordination of New Zealand milk payments. KEY ASSUMPTIONS Fitch's Key Assumptions Within Our Rating Case for the Issuer - The Farmgate Milk Price to return to its historical average of NZD6/kgMS from FY20. The FY19 Farmgate Milk Price is based on the mid point of Fonterra guidance of NZD6.30-6.60/kgMS at 28 February 2019. - Reference product sales prices in global ingredients and operations to move in line with changes in the Farmgate Milk Price. Non-reference product prices to be at a 15% premium to reference product prices in FY19 and 20% in FY20 to FY22. - Capital expenditure of NZD650 million per year over FY19 to FY22. - Dividend payout ratio to remain at the lower end of the 65%-75% of net profit after tax guided by the co-operative. No interim dividend to be paid for 1HFY19. - Effective subordination, as measured by amounts owing to suppliers/cost of New Zealand-sourced milk, to remain at 10% at FYE19 to FYE22. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Revise Our Outlook to Stable - Successfully selling assets resulting in a reduction in Fonterra's leverage to below 2.5x on a sustained basis. Developments That May, Individually or Collectively, Lead to Negative Rating Action - Delays in the guided asset sales, resulting in Fonterra's leverage remaining above 2.5x. LIQUIDITY Adequate Liquidity: Fonterra had adequate liquidity at FYE18, with NZD3.7 billion in committed bank facilities remaining undrawn. The co-operative's funding structure also benefits from continued access to the New Zealand and international debt capital markets, demonstrated by the co-operative having outstanding bonds denominated in New Zealand dollars, US dollars, Australian dollars, euros, British pounds and Chinese renminbi in FY18. Fonterra's debt maturities are well spread, with its bank facility weighted-average term-to-maturity (WATM) at FYE18 at 2.8 years and its bond WATM at 5.6 years. FULL LIST OF RATING ACTIONS Fonterra Co-operative Group Limited - Long-Term Foreign-Currency IDR affirmed at 'A'; Outlook revised Negative from Stable - Short-Term Foreign-Currency IDR affirmed at 'F1' - Senior unsecured ratings affirmed at 'A' and 'F1' - Subordinated debt rating affirmed at 'A-' - Commercial paper rating affirmed at 'F1' Contact: Primary Analyst Kelly Amato, CFA Director +61 2 8256 0348 Fitch Australia Pty Ltd Level 15, 77 King Street, Sydney, NSW, 2000 Secondary Analyst Leo Park Associate Director +61 2 8256 0323 Committee Chairperson Vicky Melbourne Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com; Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com. 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