Milk price introduction

Fonterra Farmgate Milk Price

An Introduction

Russian Dairy News Group

Auckland Monday 23 February 2015

Mark Hannagan - Milk Price Manager

Confidential to Fonterra

Page 2

Topics Covered

• Why do we have a Milk Price?

• Organisational Structure. And Governance

• Basics of the Milk Price Calculation.

Confidential to Fonterra

Page 3

• Currently there is no true market for all raw milk produced in New Zealand.

• No ‘market price’ for milk collected within NZ

• Therefore the Milk Price needs to be a modelled price

RATIONALE FOR A MODELLED MILK PRICE

The Fonterra Farmgate Milk Price

is the theoretical estimate of the

maximum amount a

properly-managed and efficiently-run,

producer of commodity milk products

could afford to pay for milk

and still make a return on new capital to justify investment Fonterra 86.8%

Westland 3.8%

Open Country

Dairy 4.6%

Synlait 2.6%

Tatua 0.7%

Other 1.4%

Share of New Zealand Milk Collection 2014

Information from Dairy NZ Annual Reports

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MILK PRICE OVERVIEW

• MP should strike a sustainable balance between returns to milk suppliers and shareholders in Fonterra by: – Ensuring suppliers receive a MP that reflects their collective selling power.

– Reflecting an unbiased assessment of the total amount which can be paid for milk while

allowing shareholders to obtain a return that warrants long-run investment in new and replacement plant necessary to process milk.

– Ensuring Fonterra faces strong incentives to maximise prices for commodities in global markets, optimise product mix and obtain market-leading efficiencies in processing and capital utilisation.

Confidential to Fonterra

Page 5

Organisational Structure & Governance

Confidential to Fonterra

Page 6

MILK PRICE MANUAL

Milk Price Manual

Milk Price Model

Principles

Dairy Industry

Restructuring Act

Page 7

Milk Price Management

Steering Committee

Internal Audit

Internal

6

7

The Fonterra Board has established a robust governance structure to oversee

the setting of the Farmgate Milk Price

Fonterra Board

Milk Price Group

External Reviewers

External Auditor – PwC

Commerce Commission

External

2

3

4

5

• 2 x Shareholders Council Appointees

• 2 x Appointed Fonterra Directors

• 1 x Farmer Director

Milk Price Panel

1

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Milk Price Calculation

Confidential to Fonterra

Page 9

KEY ASSUMPTIONS

• No reliable NZ wide benchmark price for milk supplied in NZ. If an alternative benchmark becomes available, it will be the basis for the Milk Price.

• Fonterra's near term competition would be from new entrants who build milk powder

plants. • Processing capacity of Standard Plants of Fonterra is greater than processing plant capacity

of Fonterra’s efficient near-term competitors.

Underpinning the Milk Price Model is a notional pure Commodity manufacturing business. The revenue, cost and asset data of Fonterra used are adjusted to reflect that assumption.

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MILK PRICE OVERVIEW

DEPRECIATION (NET OF REVALUATIONS)

REASONABLE RATE OF RETURN

ASSET BASE

EXISTING ASSETS

CAPITAL EXPENDITURE

CAPITAL RECOVERY

OPERATING COSTS

REVENUE

less

less

equals

TOTAL AMOUNT PAYABLE FOR RAW MILK

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IMPACT OF MILK PRICE COMPONENTS

(0.68)

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Milk Price Model (MP)

Confidential to Fonterra

Mixture of Actual &

Modelled Cost

Information

Costs covers Milk

Collection to Delivery of

Finish Product to the NZ

Export Port

Independently reviewed

parameters based on

standard powder and

cream plants that match

current Fonterra

capacities and locations.

Model Assumptions

Plant Size

oWMP / SMP 1.9M L/day

12 MT per Hour

8.5 MT per Hour

o Butter / AMF 0.5M L/day

14 MT per Hour

o BMP 0.8M L/day

4 MT per Hour

Milk Solids based on

Fonterra total supply (incl

Town Milk)

Plants have Current

Appropriate Technology &

Efficient 1-Spec

manufacture

Approx 250k tonnes

lactose for standardising

Qualifying

Revenue

$8.00 / kgMS

Cash Cost

MP MODEL

Depreciation

Economic

Charge

MILK PRICE

$6.00 / kgMS

Less

Less

Less

=

Based on 5 products –

WMP, SMP, Butter,

AMF, BMP that inform

Milk Price revenue

Sales Commission

Milk Collection

Lactose

Operating

Supply Chain

Overhead

Modelled on

Replacement Costs

Working capital Costs

Includes WACC on assets

Tax expense

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REVENUE

• MP revenues reflect allocation of all milk supplied in a June – May season to the manufacture of powder Reference Commodity Products (RCPs) - Note the Milk Price Model processes the total amount of milk collected by Fonterra

• RCPs reflect 4 product streams: WMP/Butter/BMP, WMP/AMF/BMP, SMP/Butter/BMP &

SMP/AMF/BMP

• Allocation of milk to product streams broadly aligned to Fonterra’s.

• Sales phasings broadly aligned to Fonterra’s sales of RCPs.

• WMP, SMP and AMF sole reliance on prices achieved on GDT.

• Notional revenue converted from USD to NZD at Fonterra’s average monthly conversion rates (i.e. FX risk largely passed through into Milk Price).

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CASH COSTS – KEY ASSUMPTIONS

Cash Costs

Milk Collection

Factory

Lactose

Supply Chain

Admin / Overhead

• Fonterra’s Collection Cost

• Manufacturer’s specifications of resource

usages (energy, labour, losses) for modern

powder plants, but Fonterra’s unit costs.

• Bought-in lactose for powder standardisation

• Reflect assumption that Milk Price business

supported by an offshore network.

• Based on Fonterra’s, but reflect narrower

scope of Milk Price business.

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CAPITAL CHARGE

Fixed asset base reflects: • Manufacturer’s costs for ‘standard’ 1.9m litres per day milk powder plants

• Other assets based on Fonterra replacement costs

• WACC charge & depreciation allowed for in respect of fixed assets.

• Working capital requirements over the course of the season primarily vary with Milk Price sales

phasings and the profile of payments to farmers (Advance Rate Schedule).

• Capital charge is applied to monthly net working capital balance. (One implication is that farmers are compensated for deferral of payments for milk, & that Milk Price therefore effectively includes an interest component, which varies from year to year.)

• WACC is post-tax, so separate provision included for tax.

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Questions ?

Confidential to Fonterra