A falling powder price is positive for Fonterra as it results in higher margins on products such as cheese and casein and the branded consumer business in Australia, New Zealand and Asia.
Morningstar analysts believe the fall in powder prices will propel the company's operating earnings in the 2015 financial year.
The consumer and food services businesses will also see benefits of lower input costs, albeit with a lag.
''Our fiscal 2015 forecasts for operating earnings and net profit after tax are 27% and 56% respectively above our previous estimates.''
Morningstar retained its longer-term projections and its fair value estimate of $6 for Fonterra Shareholder Fund (FSF) units remained, the analysts said in a briefing paper. The units last traded at $5.90.
While the company was the world's largest exporter of dairy products, its business was driven by commodity products such as whole milk powder and skim milk powder which made up 60% to 65% of its operating earnings.
Consequently, the vast majority of the firm's business had no pricing power and generated mid single-digit operating margins.
''This pales in comparison to mid to high teens generated by some of the other multinational food companies. Fonterra aspires to sell more branded products to move up the value chain and boost returns.
"However, we think it will face significant competition from companies such as Nestle and Danone, given their well-entrenched positions in several key markets and geographies.''
A good example was in Australia and New Zealand where margins and earnings on branded products had taken a knock because of competitive pressures, the analysts said.
Fonterra's main risks stemmed from the movement in global dairy prices, exchange rates and the supply of milk in New Zealand.
A rapid rise in dairy prices could undermine margins on consumer-branded and out-of-home food service products.
Fonterra was also exposed to foreign exchange risk since its revenue was derived globally.
Fluctuations in the New Zealand dollar versus other currencies could undermine earnings, the analysts said.
Fonterra collected about 89% of New Zealand's total milk supply, which was processed into commodities such as whole milk and skim milk powder and sold globally.
''This over-reliance on New Zealand's milk supply exposes the firm to supply risks.''
Morningstar expected Fonterra's revenue and earnings to increase at a compound average growth rate of 3% and 45% respectively during the next five years, reflecting worldwide growth in demand for dairy products and recovery from a poor fiscal 2014 result.
Morningstar had not assumed any price increases through the period given the difficulty in predicting dairy prices.
Bulls say
• The branded business has some strong brands such as Anchor, Fernleaf, Anlene and Anmum in its portfolio.
• Fonterra is doing ''extremely well'' in South America where it owns Chile's largest dairy company, Soprole, which processes some of the region's leading dairy brands.
• Fonterra's margins could be less volatile than they were in the past as it resorted to shorter tenure contracts benchmarked to the GlobalDairyTrade auctions.
Bears say
• Margins and returns are low, indicating the core milk processing business is not very profitable.
• Strong competition from other companies and pressure exerted by retailers to cut product prices is crimping margins in the all-important Australasian market.
• The exchange rate continued to remain volatile, which could increase earnings volatility.
