S&P drops Fonterra long-term rating to 'A-' from 'A' and its short-term rating to 'A-2' from 'A-1'; industry 'volatility' blamed

Credit ratings agency Standard & Poor’s has dropped the ratings on both Fonterra’s long and short term debt, blaming ‘industry volatility’.

The long-term rating moves to ‘A-‘ from ‘A’ and its short-term rating to ‘A-2’ from ‘A-1’. The rating on Fonterra’s subordinated note issue drops to ‘BBB+’ from ‘A-‘. S&P has now removed the ratings from CreditWatch with negative implications where they were placed on August 12, 2015. The outlook is “stable”.

“The downgrades reflect our view that Fonterra’s financial risk profile has weakened in the past two years, as the company’s peak capital expenditure and sizable debt funded acquisition coincided with a high level of volatility in the global dairy market,” Standard & Poor’s credit analyst Brenda Wardlaw said.

Fonterra’s chief financial officer Lukas Paravicini said: “Our underlying financial strength and credit quality remain strong. This is recognised by Standard and Poor’s maintaining our rating in the ‘A’ category and reflects our fundamental strength and financial discipline.

“It is important to note that the revised rating will not have any impact on Fonterra’s strategy or on farmer shareholder payout.”

He said Standard and Poor’s noted that its new methodology for agricultural co-operatives introduced in March does not always adequately capture the significant financial flexibility, and hence strength, of the Co-operative.

“Given this, we are disappointed that Standard and Poor’s has not reconfirmed its rating from April, especially when global dairy prices have significantly improved and we have continued our strong financial discipline,” Paravicini said.

This is the full statement from S&P:

MELBOURNE (Standard & Poor’s) Oct. 14, 2015–Standard & Poor’s Ratings Services said today that it has lowered its long-term rating to ‘A-‘ from ‘A’ and its short-term rating to ‘A-2’ from ‘A-1’ on New Zealand-based Fonterra Co-operative Group Ltd. and its associated debt issues, including the Greater China regional scale rating to ‘cnAA’ from ‘cnAA+’ on the Chinese renminbi notes and debt issued by Fonterra’s subsidiary New Zealand Milk (Australasia) Pty Ltd. In addition, the rating on Fonterra’s subordinated note issue was lowered to ‘BBB+’ from ‘A-‘. At the same time, we have removed the ratings from CreditWatch with negative implications where they were placed on Aug. 12, 2015. The outlook is stable.

“The downgrades reflect our view that Fonterra’s financial risk profile has weakened in the past two years, as the company’s peak capital expenditure and sizable debt funded acquisition coincided with a high level of volatility in the global dairy market,” said Standard & Poor’s credit analyst Brenda Wardlaw.

Fonterra has a high degree of financial flexibility in setting milk price forecasts, which underpins the ‘A’ category rating on the group. In line with this financial flexibility, Fonterra lowered its forecast payout progressively during the year ended July 31, 2015 season in response to the significant decline in global dairy product prices. Nonetheless, the group’s financial flexibility late in the season was diminished due to the speed and magnitude of the drop in global dairy product prices, relative to the level of advance rate payments to its supplier shareholders. This also resulted in a material increase in its working capital at balance date, which added to the already elevated debt levels from capital investment and acquisitions during the year. In addition, Fonterra’s offer of a loan to suppliers in our view implies there may be limited headroom to lower the payout at the bottom of the global dairy product price cycle. However, we note that loan payments will be phased as savings from the co-operative’s transformation program are delivered.

Notwithstanding the lower rating, we acknowledge that the recent increase in global dairy prices, together with reducing capital expenditure, better working capital flows, and likely transformation benefits should meaningfully improve the group’s financial risk profile in the next one-to-two years. However, we expect the group’s financial risk profile to remain more consistent with the ‘A-‘ rating in the next few years, particularly given the potential for further volatility in the global dairy market. We continue to view Fonterra’s business risk profile as “strong”, supported by its global market leadership position and global cost competiveness.

Ms. Wardlaw added: “The stable rating outlook reflects our view Fonterra will be able to maintain its financial performance in line with our expectations for the ‘A-‘ rating including an adjusted debt to EBITDA in the 3x-4x range, despite its exposure to the volatility associated with the global dairy market.”

The fact that the effective subordination of the company’s payments to its supplier-shareholders remains entrenched within Fonterra’s business model also supports our stable outlook. Implicit within the ratings is our expectation that future investments are unlikely to materially change the proportion of milk supplied from New Zealand.

Downward pressure on the rating could occur if Fonterra were to undertake further material debt-funded transactions, particularly in higher-risk geographies that alter the supply mix and that may also undermine the subordination benefit. We could also consider lowering the rating if Fonterra’s financial performance deteriorated, evidenced by adjusted debt to EBITDA sustained at more than 4x.

Supporting an upward rating trend would be an improvement in key financial metrics, evidenced by debt to EBITDA sustained at less than 3x, and underpinned by conservative financial risk management in light of the exposure to global dairy market volatility.

And this is Fonterra’s response:

Fonterra Co-operative Group Limited has been notified today that rating agency Standard and Poor’s has downgraded the Co-operative’s credit rating from A to A-.

Chief Financial Officer Lukas Paravicini said: “Our underlying financial strength and credit quality remain strong. This is recognised by Standard and Poor’s maintaining our rating in the ‘A’ category and reflects our fundamental strength and financial discipline.

“It is important to note that the revised rating will not have any impact on Fonterra’s strategy or on farmer shareholder payout.”

Mr Paravicini said the Co-operative’s current debt is at expected levels for this stage of the investment cycle.

“We carefully planned our investment strategy by first reducing our gearing over a number of years to enable us to make higher levels of investment in key strategic opportunities.

“These investments are making the Co-operative stronger and positioning us well for the future. We have built additional manufacturing capacity in our home base of New Zealand which is improving returns by giving more product options during the peak production period and our planned investments in China are building our presence in our number one strategic market,” Mr Paravicini said.

Fonterra is also continuing its strong financial discipline including capital investment management, setting a prudent advance rate payment to farmers for the current season, and applying its dividend policy to ensure an ongoing retention of a portion of earnings.

“In addition we are progressing well with our business transformation and this will further strengthen our financial position. Global dairy prices are also recovering which is a positive development, particularly for our farmer shareholders,” Mr Paravicini said.

Standard and Poor’s noted that its new methodology for agricultural co-operatives introduced in March does not always adequately capture the significant financial flexibility, and hence strength, of the Co-operative.

“Given this, we are disappointed that Standard and Poor’s has not reconfirmed its rating from April, especially when global dairy prices have significantly improved and we have continued our strong financial discipline,” Mr Paravicini said.

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