Small Caps | Sep 22 2015
-Material recovery in prices expected
-Earnings upside from value-adding
-Large investment in state-of-the-art
By Eva Brocklehurst
Australia's value-added dairy products have grown at a rapid rate over the last few years. MG Unit Trust ((MGC)) is the so-named – unusually ordinary for current times – ASX-listed entity for Murray Goulburn, Australia's largest milk processor. Murray Goulburn accounts for 38% of the national intake of milk and 54% in Victoria.
There were more than 2,500 farmers supplying 3.6bn litres of milk in FY15 to the co-operative. It has nine processing facilities, in three Australian states and China. Several brokers have initiated coverage recently, with supportive views based on the expectation of a material recovery in dairy prices over the next couple of years.
The company has expanded substantially since 2012, when it revealed a strategy to increase its exposure to value-added dairy products, culminating in a listing in 2013. Murray Goulburn has invested $229m to upgrade existing UHT, butter, cheese and infant nutrition facilities and expanded into processing fresh milk in NSW and Victoria. Its flagship brand is Devondale.
Bell Potter initiates coverage with a Buy rating and $2.37 target. The broker believes the stock offers leverage to the benefits of its recent capital investment and this could lift farm-gate returns by a further 50-60c per kilo of milk solids, independent of moves in the price of the commodity.
Over the last five years the supply of milk from the major exporting countries has materially outpaced demand, which delivered a significant correction in prices. Now, at current levels this is typically associated with a contraction in supply, which Bell Potter observes is starting to happen. For example, New Zealand FY16 milk production is forecast to be down 2-3%.
The weakening Australian dollar is also beneficial. Morgans expects significant earnings upside to flow as a result, plus from the investment in higher margin, value-added product. The company expects to deliver additional cost savings to achieve a target of $280m by FY19, without assuming any improvement in dairy prices or a falling currency.
Additional benefits are expected to come from the $550-635m in capital invested in state-of-the-art cheese making, UHT and nutritional facilities. Assuming a 15% return on investment, Morgans calculates the capital projects should deliver additional earnings between $82.5m and $95.3m. The new facilities should be highly automated and provide a cost advantage over competitors.
Morgans cites figures from Rabobank, which signal demand for dairy from emerging countries is strong. By 2020, Asia's import demand for dairy product is expected to increase by more than Australia's current production, as its consumers demand more protein and a westernised diet. Australia, being the fourth largest exporter, is well positioned to supply China.
The Free Trade Agreement with China should increase Australia's competitive position in this market. Food safety issues in China also mean Australia's produce is viewed favourably.
The trust allows investors to participate in the earnings pool that is linked to the farm-gate milk price. Outcomes for suppliers through farm-gate prices and dividends are aligned to outcomes for investors through distributions. Essentially, the higher the milk price paid to suppliers the higher the distribution to unit holders. The main risk in this structure is that unit holders lack voting rights.
The potential for investors to benefit from a control premium does not apply. Still, given the new structure provides greater access to capital, Morgans believes Murray Goulburn will be involved in consolidating the dairy industry. Because of the lack of unit holder control, the stock deserves to trade at a discount to the average market multiple. Morgans initiates with an Add rating and $2.50 target.
Macquarie also initiated earlier this month with an Outperform rating and $2.70 target. This broker also maintains, with dairy becoming a preferred source of global protein and demand continuing to rise, that Murray Goulburn is well set to prosper.
In FY16 the company expects value-added goods will make up over 70% of total volumes compared with 52% in FY12. Murray Goulburn operates in the second lowest-cost dairy region globally, Victoria. Its well-known brands are also entrenched in their respective categories.
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