Small Caps | Apr 28 2016
-Still pursuing higher value products
-Taking on additional debt
-Uncertainty over CEO, CFO departure
By Eva Brocklehurst
Dairy co-operative MG Unit Trust ((MGC)) has been overly ambitious in its forecasts, downgrading FY16 guidance to the disappointment of brokers and unit holders. The chief executive and chief financial officer have also resigned following the downgrade.
Morgans maintains the downgrade is particularly poor given management's recent comments to ASX and the press about there being no material impact stemming from China's regulatory changes, and in the light of the progress being made on its dairy foods strategy as well as the signing of a five-year private label contract with Coles from January 2017.
Macquarie on the other hand is less concerned, attributing the downgrade simply to over-optimism in relation to milk power sales to China. The broker does not believe the downgrade signals a material deterioration in the company's strategy of pursuing higher value dairy products.
Moreover, the company has taken a conservative stance on milk powder sales in FY16 and growth is still expected to occur going forward. The inventory revaluation due to lower milk prices, is also expected to reverse as the product is sold in FY17, Macquarie asserts.
The company’s available southern milk region farmgate price is expected to be $4.75-5.00 per kg, down 13%, equating to net profit of $39-42m from the previously expected $63m. The revised guidance is attributed to lower-than-expected second half adult milk powder sales in China, a higher currency and non-cash inventory write-downs. Sales of adult milk powder have been downgraded to 28,000 tonnes, given the reduced demand.
Still, Morgans observes unit holders are not impressed with the need to take on additional debt to fund a milk supply support package. The milk supply package is designed to assist farmer cash flows and to protect future milk supply. It will allow the company to pay suppliers the cash equivalent of $4.47 kg in FY16 and net debt is expected to rise by $95-165m.
While debt will increase over coming years the banks have signalled their support and the broker accepts gearing remains within policy guidelines, while growth projects are underpinned by long-term contracts.
The company still expects to fund its planned investment in cheese, dairy beverages and nutritional powders, which Morgans acknowledges are higher-margin growth projects, largely underpinned by take or pay contracts. Cash flow from these project is expected to be used to pay down debt over time.
Macquarie is mildly concerned about the support payments as it creates some risk of loss of supply, but acknowledges other processors may not be chasing milk given current commodity prices. The broker retains an Overweight rating, while reducing the target to $1.70 from $2.60, as the positive long-term outlook is intact. Macquarie reduces forecasts for FY16 by 36% and FY17 by 14%.
The stock may be oversold but, until a new CEO and CFO are appointed and there is clarity on the forward strategy, Morgans downgrades to Hold from Add. The broker reduces FY17 earnings forecasts by 35.8% and forecasts FY17 profit growth of 18%, underpinned by improved dairy prices, a slightly lower Australian dollar, the new Coles cheese contract and a full contribution from infant formula.
Morgans suspects it will take time for confidence to rebuild, but in its favour the company has a strong brand and remains Australia's largest dairy producer, leveraged to improving industry fundamentals. Moreover, it offers an attractive dividend yield. The broker has a target of $1.38, reduced from $2.30.
David Mallison, formerly the executive general manager of business operations, has been appointed interim CEO. Morgans believes the changes demonstrate the board's willingness to take action against underperformance, a first step in turning around the operations.
Still, there is a lingering concern new management may uncover other internal/accounting issues which have not been addressed. Macquarie accepts management uncertainty is likely to overhang the stock but believes the acting CEO is well regarded.
Meanwhile, farmers continue to be affected by depressed global dairy prices and below-average rainfall in key regions, which has reduced pasture growth. In an environment where many dairy farmers are losing money prices will need to rise at some point or Morgans believes supply will materially contract. Industry forecasting bodies are expecting a recovery in dairy prices later this year.
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