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GDT # 199: some softness expected...

A bit of a longer commentary this week but there has been a 3 week gap since the last auction and there has been a reasonable amount happening!

Volatility in the market remains contained but the last month has effectively seen WMP prices drop back from the $3,000/t - $3,300/t trading range into a $2,900/t - $3,000t range.

As the chart below illustrates (WMP prices in yellow and SMP prices in pink), notwithstanding this move lower in WMP, the market does still feel a little like it is defying gravity and pressure remains for prices to soften somewhat further.

The “basis” between the WMP / SMP and the MKP (FGMP) has remained narrow when calibrated against the MyFarm model. The market was trading at $6.61/kgMS in line with the model at the time of the last auction. Based on today’s prices the market is trading at $6.45/kgMS against a model calculation of $6.40/kgMS so it remains broadly in line. The MKP contract has, however, rallied about 5c from last week’s lows despite some further weakness in underlying products. This “bid” follows Fonterra maintaining its $6.75/kgMS guidance at last week’s AGM.

One input that has changed in recent weeks is the NZD. From trading in a US73 – 74c range, the kiwi has fallen post the General Election to now be trading at US68.9c. I have seen references to a 1c move lower in the kiwi being worth +5c on FGMP but I would remind you that this season’s returns were already 71% hedged at US72c as of 31 July. That hedge ratio will already be higher and depending on the hedging strategy, at this point, Fonterra would be doing well to have a conversion rate much below US71.5c for the current season (the lower kiwi will be much more impactful for 2018/19).

I have struggled with the kiwi this year as I felt that election risk and narrowing interest rate differentials would weigh on it. For the first 9 months of the year this view looked premature.

I have illustrated the Fibonacci bands I used back in January to call the kiwi range at US68.4 – US73c. The top of that range was tested early but decisively broken in June / July as the USD weakened significantly (against my expectation). In recent weeks (and again against market expectations) the kiwi has weakened for its own reasons and the USD has rebounded strongly with robust US economic data. The kiwi is now retesting the bottom of the range and looks like it could move lower just as the USD feels like it can continue to rally. However, just as the kiwi broke out of the topside mid year, while I think we could see a move below the range here, I am not expecting the kiwi to gather a lot of momentum to the downside from this point. I do think, however, that the rising US interest rate environment (a rate rise in December and 2 or 3 rate rises next year) would see US libor rates at 2.25% by Q3 (50 bp higher than the current OCR) and this should cap the upside in the kiwi from here - absent a loss of USD confidence driven by the POTUS!

So commodity prices in the dairy complex look softer but helpfully (for next season) the NZD has weakened. Domestic milk supply remains soft but the industry data is a little less soft than Fonterra supply – as has been documented. The chart below (from Global dairy Directions) shows continued momentum in global supplies as we have discussed in recent weeks. It’s not “taking off” but with the SMP overhang (shown in the second chart) and doubts about the European intervention price, rising European supply continues to put some pressure on the market.

The good news for NZ has been the ongoing robust demand for product coming from China. As illustrated below, China demand increases have been much stronger in WMP, SMP and for infant formula than for butter and cheese. This has played to NZ’s strengths [the charts below are from Rice Dairies].

Specifically – and reflected in the A2 and Synlait stories – the infant formula story has been particularly powerful. However, as you can see below, this hasn’t just been a NZ story. European exporters (such as Danone) have also been major beneficiaries. An article in the WSJ last week discussed a “phenomenal 8% rise” in Chinese births last year to 17.9m. It put the current demand down to this rise (which it believes is temporary due to 2016 being the Year of the Monkey [deemed to be an “auspicious year in which to be born”]) and restocking as the regulatory landscape becomes clearer. Whether this is the case or part of a long term trend, only time will tell. The share prices of A2, Bellamy’s, Blackmores etc appear to be betting on it being a sustainable trend albeit they are reaching elevated levels where analysts are struggling to see value.

The raw data on infant formula looks compelling and hard to dispute!

 

The MG Story:

The MG story continues to play out at pace.

Friday 27 October was the MG AGM and ahead of that meeting Murray Goulburn announced an agreed (and Board recommended) asset sale to Saputo Dairy Australia. The price is $1.310b for the sale of “all of MG’s operating assets and operating liabilities”. In addition, there is a farmer support package in the form of 40c retention for suppliers this season and a boost in the FMP for this season from $5.20/kgMS to $5.60/kgMS.

From my reading, MG have delivered the farmers an excellent outcome in the context of a distressed company auction. For unit holders who subscribed at $2.25 just 2 years ago, a 75c return (with potentially another 35 – 40c depending upon costs of legal action etc yet to be determined) it will be less satisfying!

The press since the announcement has featured the usual critical headlines such as “Farmers slam $1.3b Murray Goulburn sale” and “Farmers angry at MG deal”. Some farmers at the AGM were reported to have criticised the Board for “capitulating” and “giving the company away”. However, I would note that the Chairman (John Spark) was endorsed by 87% of shareholders so it would seem perhaps that there is a noisy minority.

Whatever the headlines, the reality is that MG needed a capital injection to carry on and the press is also reporting that the Chair and CEO had explored a government bailout. The government (as it should have) rejected that approach saying that this was a corporate, not an industry issue and MG needed to find its own solution.

In this context, the prices paid for the assets and the assumption of debt looks like an excellent outcome has been obtained by the Board, management and their advisors. As noted, the transaction is structured as an asset sale, not a company sale. By structuring the deal this way, the company avoids the requirement to have 90% of shareholder / farmer support to complete the transaction. Hence:

“the transaction is subject to approval by an ordinary resolution (my emphasis) of MG’s voting shareholders (6) and other customary conditions including ACCC and FIRB approvals”

  • Footnote (6) reads: for an ordinary resolution to be passed, it requires more than 50% of the votes cast to be in favour of the resolution.

The management and advisors will be very focused on a successful execution of this transaction. If an ordinary resolution is required, it makes transaction approval much more straight forward.

On the issues of ACCC and FIRB I would make the following comments:

  • It is reported that post completion (on a pro forma basis), Saputo will have 2.9b litres of milk supply and Fonterra close to 2.5b litres. This gives them between 50% and 60% combined market share and considerably higher in Victoria. It is not clear that the ACCC will order dispositions but if it does it would probably prefer that Fonterra wasn’t the acquirer.
  • On FIRB, the government wanted a corporate solution and has one. Saputo was granted approval to acquire the assets of WCB 2 years ago and has kept out of the limelight. Arguably, it has given farmers less grief than its major competitors and given that the other acquirers (except for Bega) were also foreign, I would think that FIRB will find few grounds to object – although, as noted, with Saputo and Fonterra now having almost 60% market share, the next foreign acquisition probably faces a higher bar!

Fonterra AGM:

Just a couple of charts that are worth including from the presentations of the Chairman, the CEO and Shareholder Council Chairman at the AGM last Thursday.

The first chart is from John Wilson’s presentation and summarises the last 8 seasons. The average FGMP has been $6.055 /kgMS and the average dividend 29.5c/kgMS (32c if you exclude 2014). This compares with current forecasts of a FGMP of $6.75/kgMS and perhaps a 37.5c dividend (based upon an available for payout estimate of 45c – 55c) for the current season. Perhaps a better way to think about it is that last season was a bit better than average and this season should be a little better again! Notably (perhaps), Fonterra has again appeared to reiterate it’s $6.75/kgMS FGMP projection (or at least chose not to revise it).

I have chosen this chart from Theo Spierings’ presentation. There was quite a lot in his presentation but I thought it worth highlighting his 2018 strategic priorities. He has a lot on his plate but I would note that protecting his market share of NZ milk and delivering on the “China and Beingmate partnership” are amongst the priorities. I always remind Fonterra that a highly competitive FGMP and an improving dividend are the best retention tools!

Following from Theo’s strategic agenda, it is therefore interesting to note Duncan Coull’s scorecard. He gives Fonterra a “tick” on most things other than EPS and return on capital. To link this with Theo’s agenda, EPS is the critical path to a higher dividend and therefore milk pool retention.

Finally I should acknowledge the election of 2 new Directors to the Board. I think we can safely say that Andy and Brent will give 110% to the task in hand because that is their modus operandi and we congratulate them and I know that Fonterra will be better for having them as Directors. Andy may not, however, be as keen on taking those Sunday evening calls from Melbourne going forward and I, in turn, will have to wait in the queue! Taking the lead from Brent, I think a Twitter account is possibly the way to go and then we can all contribute!

Summary:

The auction outlook remains weak. WMP has softened in the November and December contracts since the last auction (circa 5%) and most other products have weakened by a similar amount. Only the FGMP futures (-2.5%) have held up. In addition, the product futures curves remain in backwardation through into Q1 2018 (ie. prices in the next calendar year are lower than spot prices) providing purchasers with little incentive to bring purchases forward. Both WMP and SMP volumes are higher in this auction than the prior auction.

Hence all indicators are pointing to another weaker outcome which will, in turn, put pressure on the MKP futures price and Fonterra’s $6.75/kgMS projection. However, a different result would be welcome!!

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