Numerous challenges exist for Fonterra in evolving from a commodity mindset and strong dairy industry competition across emerging markets is a key issue, Forsyth Barr broker Andrew Rooney said yesterday.
Fonterra was competing against larger, and perhaps more capable, companies.
''We are concerned the premium New Zealand image will be devalued as the co-op increases its international milk pool and as foreign investors become more heavily involved in New Zealand.''
The weak performance of Fonterra over the past 18 months suggested several underlying issues existed, particularly in Oceania and the global ingredients and operations division, he said.
The board and management had a clear long-term strategy but the short-term issues that continued to arise hurt sentiment.
Numerous board and management changes had occurred since listing but shareholder and unitholder concerns around earnings volatility remained, Mr Rooney said.
Decision-making and market interpretation at a board and management level were integral to the financial performance Fonterra had achieved over the past 18 months.
Farmers and unitholders should rightly feel aggrieved at the poor first-half performance, of which neither party was adequately forewarned.
Management continued to highlight the longer-term strategies around value-add as the key focus.
But Mr Rooney was concerned the focus on improving the core operations in the global ingredients business had waned.
The dynamic was best highlighted by the significant capital expenditure into commodity production that caught investors off guard following a potential period of under investment.
The board consisted of 13 members, nine of whom were farmer directors and four who were independent directors.
Since the initial public offering, two directors had resigned and Sir Ralph Norris was set to be the third (and second independent) to indicate he would not seek re-election in November.
The board remains weighted towards farmer directors.
As such, a strong focus was expected on ensuring the co-operative structure was operating in the best interests of farmer shareholders, Mr Rooney said.
''Whether this is necessarily in the absolute best interests of unitholders is something we continue to question. Clearly, a conflict of interest between the two shareholder groups exists.''
Trading Among Farmers (Taf) was implemented in late 2012, allowing farmers to trade shares among themselves and external parties, stabilising Fonterra's capital levels.
The Fonterra Shareholders Fund (FSF) was introduced alongside Taf to help liquidity in the market, providing non-farmers the ability to participate in the economic returns through dividends of Fonterra.
Mr Rooney said Taf appeared to be working, based on Fonterra's key goals.
But Fonterra needed a stable price. With the implementation of Taf, and the increase in independent processing options, farmers had become more cognisant of the capital tied up in Fonterra shares and its financial performance.
If the share capital required to supply milk to Fonterra performed poorly relative to other investment opportunities, farmers with supply options were likely to look to other independent producers which required lower or no capital requirements to supply.
The disappointment of a low farmgate milk price and downgraded dividend outlook had, in some cases, already led to diversification of farmers' milk supply, he said.
Farmers with limited independent processor options were likely to be more expensive for Fonterra to collect milk from.
Conversely, if the Fonterra share price increased significantly, the risk to further milk supply growth would lie in the high entry cost.
Given the more transparent and liquid sharemarket delivered by Taf, farmers were also more likely to realise share capital gains and again move some milk supply elsewhere.
''Moving or diversifying some milk to another independent processor, where possible, is a sensible decision for farmers, as Fonterra is obliged to take their milk if the independent milk processor gets into difficulty.''
While Taf had achieved its initial set-up goals, the risks to supply growth of the co-operative having transferred the redemption risk to farmers was material, Mr Rooney said.
Forsyth Barr retained its neutral rating on Fonterra, downgraded the target price from $5.85 to $5.45 and left its earnings forecasts unchanged.
At a glance
Fonterra's Trading Among Farmers (TAF) has been operational for more than two and a-half years. The scheme has achieved most of its goals, in particular stabilising Fonterra's capital base and providing liquidity to farmer shareholders. However, a disconnect with unitholders will mean further capital raisings are unlikely and seasonal stock pricing biases remain.
