KEY POINTS:
Fonterra chief executive Andrew Ferrier says he expects record dairy commodity prices to take a heavy toll on the farmer co-operative's international specialty ingredients business next year.
The belief that prices as high as US$4000 ($5512) a tonne for skim milk powder will continue next season led the global dairy giant last week to forecast a massive payout, but those same conditions are expected to wipe out the profits of the separate ingredients business unit.
Ingredients is tasked with adding value to the underlying commodity milk price and selling customised dairy commodities and technically complex dairy ingredients.
Much of its business is done in developed markets such as Europe and the United States where domestic controls mean prices cannot be raised to reflect the staggering cost of the raw milk commodity it has to source on the open market.
Although Fonterra is forecasting a payout of $5.53 per kilogram of milk solids next season, its outlook for the value-added component of that amount - based on the profits from its consumer brands and ingredient businesses - has plummeted from 51c this season to just 20c.
"It's in the ingredients business that we're going to be taking a hit next year," said Ferrier.
"The bad news side from a profit perspective is that we do have a lot of business in developed markets like Europe and the US that traditionally have been done at a premium to the world market."
But he said the rapid rise of the commodity price and the duties Fonterra had to pay in those markets meant the ingredients business was no longer booking any profit.
"In the situation we're at now the cost of selling those products to the various markets is such that it's not a profitable venture."
Ferrier said Fonterra's accounting worked in such a way that the commodity price of those speciality ingredients went into its overall milk price and the amount sold above the commodity price became the profit or the value-add return. "Because we're selling them at the domestic prices in the US and in Europe the amount that we have to apply now to the commodity value has shot up."
But he said it didn't affect overall returns to farmers. "It's really a matter of taking it from one pocket and putting it into another."
Although Fonterra would see "a real squeeze" in ingredients margins in 2008, Ferrier expected profits would return, but that it would take a while.
Ferrier said it was the company's aim to make the ingredients business less vulnerable to commodity prices.
Although the outlook for the brands business was stable, high commodity prices would also have a significant impact on parts of it - especially in areas of Asia. "We just can't take pricing up as quickly as the ingredient prices are going up.
"But ... we've got enough growth in the business that even though some areas are going to be less profitable other areas are going to be significantly more profitable."
VANISHING VALUE
* Although Fonterra has predicted a massive payout next season, record milk commodity prices are set to wipe out the profits of its value-added ingredients business
* Much of the ingredients business is done in markets such as Europe and the US where prices can't be raised to reflect the rise in commodity costs
* This is reflected in the value-add part of the payout, which is set to fall from 51 cents to 20 cents.
