Dairy Equity Reduces Fonterra Share Price

Published: Mon 18 Dec 2006 10:45 AM
MEDIA RELEASE – For Immediate Release
Dairy Equity Limited (Del) Changes Price Down To $6.56 For Fonterra Shares And Reports Net Asset Backing Of 49c Per Del Share.
Following the Fonterra announcement of a forecast nil increase in the share price of $6.56 and given the deteriorating cash flow outlook for dairy farmers, DEL has immediately reduced their buy price for Fonterra shares to the guidance given by Fonterra, within the lower end of the forecast valuation range, being $6.56.
The announcement by Fonterra of the forecast 45c return on Fonterra shares and the forecast maintenance of the share price for 2007/8 year at $6.56 translates into a current net asset backing for Dairy Equity Limited of 49c per share.
The forecast of the Fonterra share return of 45c (referred to as the Value Added Component (VAC) of the farmers payout) is a positive surprise, it represents a 6.5% yield on the Fonterra shares that DEL owns. However DEL has reservations that Fonterra can deliver this forecast – an outcome of 40c seems more likely given higher commodity prices, a stronger NZ Dollar, and lower returns from quota markets since the original forecast.
Enquiry from farmers has picked up and DEL is now in the process of settling four more transactions. As a result the portfolio will comprise:
• 91% in cash deposits ($41m), and
• 9% in Fonterra shares ($4m).
While DEL is making more progress in buying the shares the position remains strongly biased to cash (currently yielding slightly higher than 7.5%) – a favourable position given rising interest rates and the emerging cashflow pressures for dairy farmers.
The first year DEL profit, with the large bias towards cash, will therefore be substantially a function of the cash returns less the company costs (which in the first year include the IPO start up costs) and management fees.
DEL supports Fonterra’s decision to adopt an interim Fair Value for Fonterra shares for the 2007/08 season of $6.56, unchanged from the May 2006 final determination. However the independent valuer, Duff & Phelps, assessed the interim Fair Value range higher for the 07/08 season at $6.40 to $7.43, with a midpoint of $6.91. The independent valuer has continued to factor in optimistic growth assumptions to support an ever increasing share price since the formation of Fonterra, while the VAC returns have been largely constant across the same period. The forecast share mid point of $6.91 suggests that in future seasons the valuer is forecasting a sustainable rise in the VAC to approximately 57c yet given the risk that Fonterra will not make the 45c forecast for this year it seems reasonable to indicate the value of the shares towards the bottom of the range – this is a significant change as it is the first year that Fonterra has not increased the share price forecast since its formation.
For DEL this is a material change in the environment – it is the first time that Fonterra farmer shareholders have had nil increase in the value of their shares at the same time that the shares are yielding less than 7%, while their cost of debt is in the 9 - 10% area. Of greater concern to Fonterra suppliers however is that profits are very thin with no improvement in the outlook (other than from a significant fall in the NZD).
MAF is forecasting that over 50% of dairy farmers will run a cash deficit this financial year and there appears to be more dairy farms for sale at the moment than ever before. It seems that dairy farmers will not be able to rely on capital gains on their land and shares in the medium term to increase their wealth.
For DEL there is good reason to decrease price. It is important to retain yield and purchase the shares at a price that reflects a reasonable balance between yield and growth. We remain optimistic on Fonterra’s latent value but think it wise to adjust the price to the lower end of the value range until we are more comfortable with Fonterra’s ability to deliver returns that are consistent with the independent valuers more optimistic outlook.

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