Auction 185 - steady?

The last auction preview (auction 184) was titled “attempting to find a base”.  Notwithstanding that somewhat optimistic title, futures and price action ahead of the auction was suggesting further significant falls in both WMP (circa 4-6%) and SMP (circa 10%+).

The result of 184 (+1.7%) was therefore a positive relative to both futures markets and participant expectations. While the GDT Index was +1.7%, the fat complex was relatively strong with WMP (+2.9%), AMF (+3%) and butter (+4.9%) all in positive territory. SMP (-10.1%) was more in line with expectations.

The chart below sums up the recent price activity.

Ahead of #184, WMP had fallen in a matter of weeks from circa $3,300/t to prices of $2,550/t  to $2,700/t across the curve on the day of the auction. The result which saw all contracts clear above $2,800/t was therefore a positive surprise. The next day saw a sharp leap in futures pricing in line with the auction result and the market has maintained those levels over the last 10 days.

By contrast, the SMP outcome was weak and the market has continued to be weak. That divergence between WMP and SMP is also apparent in the chart below. The SMP price continues to converge on global prices. EU intervention levels are just below Eur 1,700/t and NZ prices are now at Eur 1,785/t (USD 1,910/t). This $90/t spread compares with the $650/t spread which existed in the first weeks of February and which we were struggling to explain.

The milk futures pricing has traded similarly. Having sold off to $5.90/kgMS, the 2016/17 contract rebounded to $6.00/kgMS and 2017/18 from contract lows of $5.55/kgMS to $5.80/kgMS. While there has been some activity and transactional volume, there has been no price movement over the last week.

With little movement in SMP, prices now approaching the lower bound of European intervention levels and increased auction volumes over the next month, it would seem likely that the price action will be focused on the WMP / AMP / butter complex at this next auction.

No changes to the offering were announced by Fonterra (a positive) but this auction sees lower levels of WMP on offer and significantly higher volumes of SMP. So the divergence in trends seen in the chart above may well continue.

With milk production also continuing its late season improvement (Feb production suggests -2.2% YTD), the market seems evenly poised. It is good to have some stability and it would seem we may have found that base that I was looking for. However, while not precise, the chart below is a reminder that some indicators may still suggest weakness ahead (ie. no room for complacency).

Other Developments:

The Fonterra interim results underwhelmed the market. Revenue was up 5% and net profit up 2% and the balance sheet was in better shape but EPS guidance was reduced from 50-60cps to 45-55cps. There was some explanation that changes in the milk price manual had resulted in a 6 cent boost to the milk price (at the expense of earnings) but guidance for that was left unchanged at $6.00/kgMS. The net result was a small but unexpected downgrade in earnings for shareholders and farmers. The Fonterra share price which had been showing strength and had hit my intermediate targets ($6.34) clearly suffered as a result (last at $6.06). I would hope that it will find support above its break-out level at $5.93.

 

Fonterra has some challenges.  One reason farmers wanted a transparent milk price was because they wanted clarity on whether Fonterra was earning its cost of capital on off farm assets. Using a WACC of 8.1% suggests that Fonterra is yet to achieve that target although it is gettng close. Some analysts would regard a WACC of 8.1% as conservative for this business.

And the bottom line is that while earnings suffered in 2014 from a high COGS (cost of goods sold), the bounce back in earnings in recent years has been disappointing with international (including Australia) proving a drag on earnings although some improvement has been evident.

To be clear, this is not an easy environment or market and the challenges at MG, Bega and other companies have demonstrated this fact. However, it is also the case that investors and farmers had expectations of better earnings than have been delivered to date on the capital investment pre the listing and adjusted for the significant capex of recent years.

Other corporate news:

Unpicking the broader industry news over the last couple of weeks has been interesting.

Ahead of Premier Li Keqiang’s visit to Australia and New Zealand there was an announcement from the Chinese Ministry of Commerce that suggested that “low value personal imports” would escape some of the more onerous labelling and disclosure requirements previously announced for e-commerce. This sent Bellamy’s and Blackmore’s shares up 12% - 15% on one day but that strength has not been sustained – notably by Bellamys.

However, one announcement that attracted limited discussion back at the end of February was Bega’s announcement that it was selling one of its four spray dryers at Tatura and its Infant Formula finishing plant at Derrimut to Mead Johnson. There are several aspects of this transaction that are interesting:

  • Bega is selling these interests for circa $200m to finance its $460m purchase of the Vegemite brand from Mondolez. This fits into a broader “food brand strategy” by Bega but it a little “off message” despite the iconic nature of the Vegemite brand (Mondolez struggled to boost global appetite!)
  • Mead Johnson is securing its infant formula manufacturing as the Derrimut plant is “licensed”. This is similar to A2’s action in taking a stake in Synlait except that it has made the investment at the asset level rather than the company level.
  • Despite initial assurances from Bellamy’s that their production via Derrimut would be secure, it has become apparent (and confirmed by Bellamy’s) that the sale of the Derrimut plant means Bellamy’s “ PRC (People’s Republic of China) products can no longer be registered at Bega’s Derrimut canning line”.
  • This leaves Bellamy’s looking for alternative registered canning capacity and they informed the market that they are unlikely to secure and register an alternative before the new rules are effective on 1 Jan 2018. Presumably this plays somewhat into Fonterra’s hands as their other key production relationship is via the Fonterra / Beingmate Darnum plant. Bellamy’s could alternatively seek to access/purchase a registered plant. However, the stretched nature of its balance sheet may also preclude this from happening.

The bottom line here is that the Australian industry remains in flux and the adjustment to the new 1 January 2018 regulations is still occurring. The value of the licenses attached to the manufacturing and canning sites is now being better recognised and those distributors with key brands and core manufacturing relationships (Fonterra and Beingmate, Synlait and A2, Bega and Mead Johnson) look to be better placed and appreciated by the market than the more pure distributors (think Bellamy’s and Blackmores) although the distributors are working hard to rectify this situation.  

A2 has been a big winner in recent weeks (up from $2.12 at the beginning of the year to $3.03 today), navigating its way through the regulatory announcements and becoming a favourite of the “daigous” – replacing Bellamy’s. A2 has benefited from its corporate stake in Synlait and a reported (Aztec data) 57% surge in infant formula sales through Australian supermarkets in the latest 4 week reporting period. A2 is seen to be doing a good job with daigous and a good job with its supply chain management (ie. keeping enough tension in the system to ensure there is not an over-supply while being able to fulfil the orders). However, I would just caution that an over-dependence on the daigou distribution chains is a 2 edged sword as we have witnessed with both Bellamy’s and Blackmores.

Some big thinking from Con Williams at ANZ:

Con is well researched and data driven.  The analysis shows that global milk production is still contracting (-3%) but that contraction is now driven by the southern hemisphere. With milk supply “contraction" looking to have peaked - providing that we don’t go back to a 2% supply growth phase, prices should be stable to rising. While this relationship is imprecise it does appear that small changes in the supply demand balance does have a major impact on price.

You would think we could forecast supply more accurately. However, exactly a year ago (when sentiment was at its nadir) I was “speculating” (not forecasting) that if global milk supply only grew by 1% in 2016, prices could rally by 30%. History now shows (below) that output contracted by 2-3% and prices rose by 50%. It is reminder that we should be modest about our forecasting skills!

Con and I agree that these markets remain supply driven and NZ remains an important part of that with Europe and the US being equally important and potentially even more important depending upon their domestic policy (Europe) and demand (US) issues.

Conclusion:

There is a great deal happening as we enter the tail end of the NZ 2016/17 season and much to ponder, as there was a year ago – although we start from a better place..

The industry news and corporate news is interesting. The industry in Australasia is shaking out and it is becoming clear to investors and farmers that you need more than just a brand or a license to succeed.

From a farmer perspective, we would hope to see a stable outcome to this week’s auction. Futures prices are pointing to a relatively flat outcome for GDT on Tuesday night although the different supply and demand dynamics of WMP and SMP make this a tough outcome to pick, not helped by the fact that some of us are still scratching our heads a little over the outcome of #184.