The long term thematic of having Australian primary industry “feeding the world” remains a compelling one. Here we discuss our analytical approach and focus on one stock that is trading on 12 times earnings, with high single digit earnings growth and a >5.5% fully franked dividend yield (FY19).
Feeding the world
The idea that Australia creates a “food bowl” to feed the Asian subcontinent has been around for decades, but only recently has the acceleration of the consumption trends in Asia been sufficient enough to start to change strategic decisions. The rising incomes associated with the Asian middle class has seen a correlated increase in diet and in particular protein requirements. One of the more pronounced changes in the past decade has been the 2008 Chinese milk scandal which saw 300k infants infected from drinking Chinese infant formula laced with melamine (used in the manufacturing of plastics). This was really the tipping point for Chinese consumers to look globally for FMCG goods they could trust.
Of course today the rise of A2 Milk and Bellamy’s has been well documented, and we have written previously on our holding in Synlait Milk, which holds the CFDA (Chinese Food and Drug Administration) license as the processor of milk for A2 to sell their products into China. We are still of the view that Synlait offers compelling exposure to this thematic, and has several high returning projects under development, one of which is a RTD (ready to drink) infant formula. We are of the view this could be quite material in terms of long term margin accretion.
We have included 14 stocks in our own research to fit this thematic, including Inghams (which we discuss in detail below), while we also have detailed work on the fertiliser and nutrient companies (Incitec Pivot, Nufarm and Orica) that are a derivative on this long term trend. Treasury Wine Estates would probably argue that it is now more of a consumer staple, but we still form the view that, while mitigated somewhat with geographical diversity, it still carries viticulture risk from one vintage to another.
A useful research strategy
We find it very useful to assess the relative value of each stock, its debt profile and growth rates in one summary page. We also use an internal assessment of the Financial Quality, Business Quality and Management Quality, which is effectively a qualitative assessment of our team to help rank the stocks that fit this framework. While valuation is still our focus, if two stocks are similar in terms of the valuation upside, then the assessment of these metrics will determine the more suitable investment.
We also ask whether we have a high conviction view that the market is mispricing earnings, or do we simply believe consensus earnings are wrong? Often our best investments (buying Synlait Milk at sub AUD3.50, currently trading at AUD8.90) combine the valuation upside, with our view on management and an insight that the market was at least 20% too low on the earnings trajectory. This is where the investment becomes a high conviction view.
We won’t delve into any more detail on the sector than what is already outlined, save to say we have generated strong alpha from the work done on this thematic, and we still see opportunity over the next 3 years, particularly on a risk reward basis.
Inghams, for example, in an industrial market that is relatively fully priced, is a stock that appears inexpensive on a range of measures, thus has a reasonable margin of safety, but still offers predictable cash flow growth
Stock in focus: Inghams Group
Established in 1918, Inghams Group (ING) is Australasia’s largest poultry producer with vertically integrated operations in Australia and New Zealand. ING’s facilities include 1 quarantine facility, 12 feedmills, 84 breeder farms, 11 hatcheries, 224 predominantly contracted broiler farms, 7 primary processing plants, 1 protein conversion plant and 9 distribution centres.
ING has approximately 40% market share in Australia and 34% in New Zealand within an industry that continues to experience strong demand growth and an attractive market structure. Demand growth of ~4% in Australia over the past 25 years has benefited from a consumer shift towards healthier proteins but more importantly affordability. Feed cost inflation for proteins with higher feed conversion ratios (FCRs), as well as a shrinking national cattle herd has seen alternative proteins experience material price rises while chicken prices have remained subdued. I.e. beef prices increased ~70% between 2000 and 2015 vs chicken’s 15%. From our industry discussions we don’t expect the cattle herd rebuild to occur for another 3 to 4 years which implies a prolonged period of elevated beef prices.
With two dominant producers in each country the Australasian poultry market is somewhat oligopolistic. Market structure is supported by biosecurity regulations preventing the importation of chicken into Australia (excluding New Zealand production). We are also seeing electricity price rises and feed cost inflation put further pressure on smaller producers, who without the scale or capital to drive efficiencies will continue to struggle against larger peers. Early April we saw Red Lea Chickens, a NSW based company with an estimated 2% market share placed into administration. ING meanwhile continues to expand its competitive advantage to improve efficiency (and margins) in the business via a AUD200m investment program entitled Project Accelerate.
Mick McMahon, Managing Director (MD) and CEO has an admirable track record as the previous MD of the Skilled Group and prior positions as COO of Coles Supermarkets Australia and MD of Coles Express. Mick’s experience leaves him well placed to run the company and deal with a multitude of stakeholders. Under Mick’s stewardship, ING has formalised its customer relationships with the signing of customer contracts, often with secured volumes and cost pass through provisions (including feed). Enterprise bargaining agreements (EBAs) at most of the key production facilities have also been renegotiated over the past 12 months. Furthermore, we understand there was a level of conservatism in the prospectus, which enabled ING to exceed expectations in their first year as a listed company.
Since listing in November 2016, ING has suffered from the overhang of its previous (private equity owner) TPG. With scars still lingering from recent failed or underperforming private equity IPOs like Dick Smiths, MYOB and more specifically TPG backed Healthscope we believe the TPG factor is keeping some investors at bay. If Management continue to deliver like the strong first half result the operational question will be answered. However, we still wait to see how TPG ultimately exit their investment of 123m shares (33% of ING) after selling 55m in March, a move that reversed some of the post result momentum.
We value ING using a discounted cash flow (DCF) approach to derive a reference valuation of AUD4.80/share. Key assumptions in our analysis of the company include: continued volume growth of 4% p.a. FY19 to FY22 (given continued elevated beef prices); flat poultry prices FY18 to FY22; and EBITDA margin expansion from 9% FY18 to 9.8% FY22 (Project Accelerate driven). We note that Management continue to target double digit margins and are investing time and money to achieve global best practices.
The cash flow profile of the company is strong with high cash conversion (110% of operating cash flow 1H 2018) and based on a share price of AUD3.50/share ING is on less than 12 times earnings for high single digit earnings growth and offers >5.5% fully franked dividend yield (FY19). Management also announced in February they were considering capital management initiatives given operational performance and balance sheet strength.
I really liked this article Rob, and should be mandatory reading for anyone. Cheers, Eric Wells