GDT 190 / dairy forecasts

Market Recap:

We are now several weeks into the new season and final price announcements for the 2016/17 are being made. It is too early for any commentary on the production side of the ledger! Price discussion this week was “headlined” by Synlait’s revised $6.15/kgMS 2016/17 final FGMP (down from a previously forecast $6.25/kgMS) with an average 14 cent premium across a number of “value add” categories including A2 milk.

The 2016/17 MKP contract has not traded for a number of weeks and has not been quoted in recent days. The last settlement was at $6.15/kgMS and while this is not a final Fonterra price, it would be surprising to see a final price for the season that varied more than 5c/kgMS from that last trade which was in line with Fonterra’s most recent indication.

The Fonterra initial pre-season projection was $4.25/kgMS but the MKP contract traded steadily up through the first half of the season to $6.40/kgMS before settling during the last quarter at just above $6.00/kgMS and then into a $6.15/kgMS close.

You will recall that the 2017/18 season quotes opened some 12 months ago with offers at $5.60/kgMS and was lightly traded for most of the last 12 months. Some weakness in the current season milk price at the end of the March quarter saw the 2017/18 contract trade at an unexpected discount to the then current season but it subsequently recovered and has traded more recently largely between $6.20/kgMS and $6.50/kgMS (closing on its highs today) as volume has come into this contract.

2018/19 is not being actively quoted but there are offers at $6.50/kgMS. There was broad based interest to hedge at this level with farmers seeing Fonterra’s initial guidance as being relatively aggressive.

Having said that, many respected commentators are in line with the Fonterra projections. For completeness (and independence) I include below Con Williams (ANZ) forecasts which are done with some rigour!

GDT #190:
The last auction came in broadly as expected. WMP was weaker (-2.9%) but this was offset by a solid SMP result (+7.9%) and results in the butter (+3.3%) and cheese (+14.5%) segments which exceeded expected positive results.

Activity since the last auction has been generally positive although there is significant divergence across geographies and products.

In Europe the price of SMP has traded above €2,000/t and both butter and cheese have been reporting some shortages in the physical market (indeed an amusing piece was published this week about French bakers complaining about high butter prices and the flow on impact on croissant prices). In the meantime, while butter prices were also strong in the US, the cheese segment lagged and remains weak. Generally the US appears to have surplus milk and lower prices than we are seeing on GDT but product is not finding its way into the global markets in a manner which is undermining prices on GDT.

The major observation that I would have based on activity on the NZX is that there has been solid volume and some large corporate trades, particularly in WMP. The net effect of that has been that the WMP market which was in backwardation at the time of the last auction (ie. Oct – Nov prices were lower than June prices) has now moved back into contango (Oct and November last settled at $3180/t - $3200/t versus June at $3110/t).

This is a very positive development and shows solid demand coming into Q3 where we have seen price movements in recent years. Sensibly the MKP market has reacted to these moves and this explains the rally this week from $6.20/kgMs to a close of $6.50/kgMS.

The futures markets suggests a move in WMP and SMP of approximately +2% in this week’s auction with support from other products. However, it is the ability of Fonterra to get deals done on product coming out of peak season at $3200/t (in WMP) which is most important and will support the robust pre-season $6.50/kgMS!

Dairy Company Review:
In recent weeks there have been announcements from a number of New Zealand’s and Australia’s largest dairy companies that have been revealing from a “state of the industry” and “corporate health” perspective. These are worth reflecting on as we enter the new season.

In essence, the volatility in the Australian market has continued with Bega the steadiest performer, notwithstanding its diversification into other foods (vegemite). Bellamy’s has stabilised and this week announced the purchase of the CDI canning plant in Victoria for $28.5m. This will provide its first physical asset and although the plant is old, it is CNCA licensed to export into China. Bellamy’s purchases its powder off both Bega and Fonterra so a positive resolution of Bellamy’s issues is a positive for both those companies. It has been suggested in the Australian press that a second brand to be canned at the plant has been provided to Mengniu Dairy Company. As a sign of consolidation to the bigger players, I would note that the CDI Braeside plant (until the sale) has been producing up to seven labels for smaller resellers into China. Those labels will struggle to continue and now face the same challenges that Bellamy’s has had to confront.

Murray Goulburn remains in a world of pain and its recently announced capital review and the low opening price for 2017/18 (compared with competitors) has left its’ suppliers with a good deal of uncertainty and further supplier defections are widely expected. The events of the last 3 weeks has seen its share price fall 38% from its already troubled levels.

By contrast, the NZ companies have benefited from the greater stability of the last season in NZ. At its current share price Fonterra is paying a 6.66% dividend. Synlait has benefited from a strong corporate performance (including the recent acquisition of canning capacity in Auckland) and the strength of corporate relationships with Bright, Mitsubishi, ATM and New Hope.

A2 Milk (ATM) has been the stellar performer with multiple revenue and profit upgrades as it has become a sought after product via multiple channels including by both Daigou and on the Alibaba platform (which I witnessed personally last week). While the A2 Milk strategy is more soundly and broadly based than the initial Bellamy and Blackmore strategies, I would note that Blackmores traded to a high of $220.87 (would be 22.09 on my adjusted chart below) and Bellamys to $15.06 at their heights. At its current share price ATM has a market capitalisation of $2.78b and is trading on a PE of 47 times so it needs to deliver on the lofty growth expectations!

I noted above the challenges facing Murray Goulburn. The chart below compares (on the left) closing FGMP payments for last season (or those currently indicated) and the chart (on the right) compares opening prices for 2017/18. While opening prices in Australia appear more conservative than those in NZ (and Fonterra, Bega and MG have all said that they expect final payments to be higher) it is the relativity of the prices that will see more defections. The lower prices in Australia were also compounded by an estimated 7.5% fall in production for the year to 8.95 billion litres.

Land prices – another value and wealth driver!
While we are on the subject of asset price performance, it is worth a quick comment on land prices.

12 months ago (with a pre-season FGMP estimate of $4.25/kgMS), farmers were facing the potential of a 3rd consecutive season of challenging cash flow and rising debts levels. The RBNZ had previously estimated that were that scenario to eventuate it could be anticipated that farm prices would fall at least 15% in 2016/17 (with more falls to follow depending upon commodity prices).

REINZ data up to the end of March suggests that prices for dairy farms have stabilised and risen over the prior 12 months (9.4% on $/ha and 1.4% on $/kgMS). As we know this data is sometimes taken on small sample size and the “averaging” process hides a multitude of sins but for Canterbury it reports dairy land prices up 7.1% (based on sales) notwithstanding it remains 4% below the December 2014 numbers.

The data does hold some fact patterns that ring true. Taranaki and Waikato prices have largely held their ground over the last 2 years (in fact Waikato is up) while Southland is off by more than 20% (reflecting the reduction in demand for conversions and the differentiation between Tier 1 and Tier 2 properties).

Nevertheless, the bulk of farmer wealth is in the land price, stock and cooperative / dairy company shareholdings. The stabilisation / improvement in those asset values is important and, given the relatively high debt levels in the sector (see last report), provides comfort to the banks.

Interest rate and the currency – an update to complete the picture:
The charts below provide a post GFC perspective. They show clearly that while interest rates (the left chart is 5 year swap rates) have risen since their lows last year (when commodity prices were low), interest rates remain low on an historical basis (notwithstanding that bank credit margins are rising). With respect to the currency, its recent strength primarily reflects USD weakness. The offset to this is that a weak USD imposes less downward pressure on commodity prices than a strong dollar does and given the choice of a weak dollar or robust commodity prices, I would always prefer the latter!

Summary and conclusion:
There is not a uniform status for the NZ dairy sector but as I have commented a number of times recently, the current situation is much improved over that 12 months ago. However, the fact that there is less of an “industry” issue does not mean that there is not still a considerable challenge for those most indebted farmers (>$30/kgMS), particularly if they are on second tier farms or country.

The outlook for farm incomes this year is for a further improvement on last year, which if it transpires will lead to solid profitability and the opportunity to repay debt.

The futures market is providing opportunities for farmers to lock in some of these returns at better levels than last year and the interest rate market is providing competitive hedging levels (notwithstanding margins).

From a balance sheet perspective, farm prices have stabilised and slightly improved, particularly for tier 1 farms and share prices for most NZ dairy companies (Westland aside) are also steady to improving with, in the case of Fonterra, a steady to improving dividend payment.

The challenge is to recognise that we are in a volatile market where prices can move substantially both intra-season as well as inter-season. We remain dependent on informed and astute broader industry leadership to ensure we don’t suffer from some of the challenges that we have seen in the Australian market over the last 12 months.

Finally, a reminder that in this new globally deregulated (for the most part) world of dairy, the swing producers appear to be the US and Europe and developments in those markets can have large and sustained impacts on the market so we need to protect our low cost and efficient position on the production frontier. Locally, water and environmental issues look likely to continue to impact on costs and the industry’s social license. Given it is an election year, increased focus is inevitable notwithstanding the much valuable work being done in this area.

A brief post script on my trip to China! China and China demand can be hard to read but any doubts that China can manage a move from an economy driven by fixed asset investment to a more consumption oriented economy faded (for me) last week. The increased access to “mobile” and the up take and use by consumers is astonishing. A trip to Alibaba revealed online sales (84% over mobile) of >$500b last year. The US, Europe, Japan and Australasia are the regions from which they source the greatest volume of goods and Australasia is clearly preferred for food and health products. A2 featured prominently on the mobile based shopping lists of the ANZ staff that I quizzed (and I can report that they pay RMB 799 [NZD $95] for a 900g can of A2 platinum). There is huge upside still in this market but reputation is everything. NZ and Australia certainly do not have any exclusivity on product but we do have and retain an advantage on clean and green and it will be critical that we retain this brand!