Buy Foster’s Says BA-Merrill Lynch

This story features FRUGL GROUP LIMITED. For more info SHARE ANALYSIS: FGL

By Chris Shaw

Foster’s Group ((FGL)) has long been criticised for its move into the wine business, firstly for making the move at all and then for adopting the wrong strategy in trying to implement a multi-business model in conjunction with its beer operations when the skill set for the two were seen as somewhat different. And analysts at Bank of America Merrill Lynch have been among the more vocal critics of the company since.

Now these same analysts at BA-ML believe there are signs of improvement within the company’s operations, enough to justify the broker upgrading the stock to a Buy rating with in increased target of $6.50, up from $5.40 previously.

An expected improvement in earnings is behind the broker’s more positive view, this improvement coming from a couple of sources. Firstly, BA-ML expects improved execution of the group’s business model in its wine operations, which covers everything from buying to manufacturing to selling, seeing this providing something of an earnings boost.

There are also signs wine industry fundamentals in general are improving as plantings are starting to decline and rationalisation continues to come closer to a reality. The current year should be a tough one but the broker suggests this is well known and so should now be factored into the share price, while also setting the stage for improvement as earnings for the division will be coming off a low base.

As well, BA-ML sees scope for the beer business to improve its performance as the ending of the multi-beverage model means management in this division is now free to concentrate on a single product line rather than two models as was previously the case.

The broker also points to some simple investment factors as reason for optimism, noting the company’s balance sheet is very strong, it generates good cash flows and there is no need to put additional capital into the wine business given it is profitable, albeit only marginally at present.

Looking forward, Bank of America Merrill Lynch suggests the beer business could soon generate EBIT (earnings before interest and tax) of $1 billion. Applying a multiple of 12 times to this number gives an enterprise value for the beer operations alone of $12 billion, which about matches the company’s current enterprise value.

In other words, the stock is undervalued in the broker’s view as it implies no value for the wine business even though it should generate around $350 million cash this year and likely more in future years. Throw in the fact the company is often touted as a takeover target for the likes of Asahi in Japan and there appears little downside from current levels.

Factoring this in sees the broker’s valuation on the stock at $6.77, with its revised $6.50 target set just under this level. This compares to an average target according to the FNArena database of $5.65, with Bank of America Merrill Lynch the new leader and JP Morgan the low marker with a $5.10 price target.

In ratings terms the database shows a total of two Buys, Six Holds and two Sells, Macquarie being one of the latter given its view the wine business is simply not a good one for the company to be in at present. Others such as RBS Australia see some value but are also concerned over the potential for earnings from the wine division to remain under pressure through FY10, so limiting the chance of share price outperformance.

Shares in Foster’s today are stronger in line with the broader market and as at 10.20am the stock was up 3.4% or 17c at $5.13, which compares to a trading range over the past year of $4.26 to $6.17.

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