October 19, 2017 / 5:02 AM / a year ago

Fitch Affirms Fonterra at 'A'; Outlook Stable

(The following statement was released by the rating agency) SYDNEY, October 19 (Fitch) Fitch Ratings has affirmed Fonterra Co-operative Group Limited's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'A'. The Outlook is Stable. Fitch has also affirmed Fonterra's Short-Term IDR at 'F1'. A full list of rating actions is at the end of this commentary. The affirmation reflects the ongoing strength of Fonterra's business profile, in particular, the co-operative's ability to pass through global milk price movements to farmers. This defensive trait helped limit a decline in EBITDA to around 17% in the financial year ending-July 2017 (FY17), despite a yoy increase in the co-operative's largest cost, New Zealand-sourced milk, of around 57% per kilogram of milk solids (kgMS). This, combined with a rise in the effective subordination of milk payments at year-end to around 14% of the total cost of New Zealand-sourced milk (FYE16: 12%), led to Fonterra's leverage - defined as total adjusted debt/EBITDA, including subordination - returning within the guidelines for its rating at 2.4x at FYE17 (FYE16: 2.6x). The Stable Outlook reflects our view that Fonterra's leverage will improve to around 1.9x by FY21, remaining in line with its 'A' rating. We expect Fonterra's ability to service its outstanding debt to remain supported by the defensive traits inherent in its business as well as rising demand for dairy in emerging markets and a continued focus on efficiencies. KEY RATING DRIVERS Effective Subordination of Milk Payments: Fitch believes the effective subordination of milk payments at Fonterra to its principal and interest obligations (and other costs) is a key rating driver. This is underpinned by the 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 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 Cost Competitive: The average cost of dairy production in New Zealand is among the world's lowest. The country's cost-competitiveness arises from favourable climatic conditions for grass-fed herds, the depth and breadth of Fonterra's supply chain and the scale of its operations, particularly following its investment in improving efficiencies and capacity. Strong Business Profile: Fonterra has strong defensive traits, underpinned by its ability to pass on global dairy-price and foreign-exchange movements in its global ingredients and operations business to farmers; while the consumer and foodservice division is able to shield profit margins during periods of low dairy prices. The co-operative's scale as the world's market leader in dairy exports - representing around 15% of exports, including around a 45% market share in whole-milk powder - and its status as New Zealand's top dairy producer - collecting around 82% of the country's total milk supply - serve as key barriers to entry. Stable Leverage: Fitch expects earnings growth to help improve leverage to around 1.9x by FYE21. This follows the significant improvement in leverage to 2.4x at FYE17, from 5.2x at FYE15, due to strong profitability, higher retention of milk payments at year-end of around 14% of the total annual cost of New Zealand-sourced milk (FYE15: 2%) and lower working capital. 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 its 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 FY16 lows. Potential M&A Opportunity: Australia's largest dairy company, Murray Goulburn Co-operative Co. Limited, has embarked on a wide-ranging strategic review that has led to a number of non-binding indicative proposals, ranging from the sale of certain assets to whole-of-company transactions. Fonterra has confirmed it has registered its interest in this process. Fitch will continue monitoring developments and any potential impact on Fonterra's business profile and credit metrics. However, we believe Fonterra will evaluate potential opportunities with a view to maintaining its balance-sheet discipline, taking into account its demonstrated commitment to maintaining its balance-sheet strength. DERIVATION SUMMARY Fonterra's rating compares well with global peers, Nestle SA (AA-/Stable) and Unilever PLC (A+/Negative). Nestle's and Unilever's ratings reflect their larger scale and diversification as the world's largest food and third-largest food and consumer product companies, respectively. Fonterra's operations, on the other hand, are concentrated in the global dairy market, although its business profile 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 milk payments under its constitution. Nestle and Unilever also have better profitability and credit metrics, even after the companies announced shareholder-friendly actions in 2017 and taking into account the effective subordination of milk payments at Fonterra. These factors underscore Fonterra's two-notch rating differential to Nestle and one-notch differential to Unilever. Fitch includes Fonterra's effective subordination of milk payments to its principal and interest obligations (and other costs), as specified in its constitution, in measuring the co-operative's leverage. We calculate Fonterra's leverage as total adjusted debt/EBITDA (including subordination) to assess the strength of its financial profile. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Fonterra include: - The Farmgate Milk Price returning to its historical average of NZD6.00/kgMS from FY19. The FY18 Farmgate Milk Price is based on Fonterra's forecast of NZD6.75/kgMS at 25 September 2017. - Reference product sale 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 40% premium to reference product prices. - Capital expenditure of NZD850 million in FY18, NZD800 million in FY19 and NZD750 million in FY20 to FY21. - Dividend payout ratio to remain at the higher end of the 65%-75% of net profit after tax guided by the co-operative. - Subordination, as measured by amounts owing to suppliers/cost of New Zealand-sourced milk, to remain at 10% at FYE18 to FYE21. RATING SENSITIVITIES Positive: Developments that may, individually or collectively, lead to positive rating action: - leverage - as measured by adjusted debt/EBITDA, including subordination - falling below 1.5x on a sustained basis (FYE17: 2.4x); and - EBITDA margin to remain above 10% on a sustained basis (FY17: 8.4%). Negative: Developments that may, individually or collectively, lead to negative rating action: - leverage rising above 2.5x for a sustained period; or - EBITDA margin deteriorating to below 5% for a sustained period. LIQUIDITY Adequate Liquidity: Fonterra had adequate liquidity at FYE17, with 82% of its NZD4.7 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, United Kingdom pound and Chinese yuan in FY17. Fonterra's debt maturities are well spread, with its bank facility weighted-average term-to-maturity (WATM) at FYE17 at 3.0 years and its bond WATM at 5.7 years. FULL LIST OF RATING ACTIONS Fonterra Co-operative Group Limited -- Long-Term Foreign-Currency IDR affirmed at 'A'; Outlook Stable -- Short-Term Foreign-Currency IDR affirmed at 'F1' -- Senior unsecured rating affirmed at 'A' -- Subordinated debt rating affirmed at 'A-' -- Commercial paper rating affirmed at 'F1' -- Short-term senior unsecured 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 Analyst +61 2 8256 0323 Committee Chairperson Vicky Melbourne Senior Director +61 2 8256 0325 For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Media Relations: Leslie Tan, Singapore, Tel: +65 67 96 7234, Email: leslie.tan@fitchratings.com. 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