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Thursday, 6 April 2017
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BUY, SELL or HOLD (ASX:BGA)

Bega Cheese Limited (BGA) is currently a processor, manufacturer and distributor of dairy and associated products to Australian and international markets. Its products include natural cheese, processed cheese, powders and butter, packaged cheese, cream cheese, powders and nutritionals. BGA operates under the co-operative structure and has five production facilities.

  • Bega Cheese: Manufacturer of natural cheese, processed cheese, powders, butter and packaged cheese products.
  • Tatura Milk: Manufactures and packages cream cheese, butter, powders and nutritionals.

BGA operates 5 processing plants with capacity to process ~250kt of products (not including recent acquisitions). It also holds a 25% interest in CCFA, a fresh milk processor in Canberra. The figure below FY16 production volume, by category.

INVESTMENT CASE

Positive

  • RECENT EVENTS: Acquisitions and Asset sales
    • Acquisition of Mondelez Australian Grocery - This $460m acquisition includes Vegemite, Kraft peanut butter, salad dressings and cheese. The acquisition offers strong strategic alignment and is expected to generate $40-45m EBITDA in the first year of operations. Full details about the acquisition are contained in the attached presentation and it’s well worth a read to understand the significant impact the new business will have on the company going forward.
    • Mead Johnson Sale - The sale and 10-year service and access agreement with Mead Johnson relating to a spray dryer at Tatura and infant formula drying plant at Derrimut for $200m has also been well-received by analysts. BGA earns a fee for managing the assets as well as revenue from its continued use of the facilities, so there is no earnings dilution.
  • Strong brand – Bega is the number one Australian cheese brand. The new brands from the Mondelez acquisition are also iconic and market-leading...don't we all have a jar of Vegemite in the cupboard.
  • Growth Opportunities - Export opportunities – Currently 400 shipping containers are exported each month to over 70 destinations across Asia, Middle East and Europe. MDLZ extends the growth opportunities due to additional facilities (with expansion opportunities due to scalability) and products, as well as providing a platform for new products. 
  • Diversification - both over product categories and geography. The MDLZ acquisition further diversifies the business into complementary markets and categories.
  • Exposure to the infant formula market through its joint venture with Blackmores (BKL) and supply arrangement with Bellamy’s Australia (BAL) through its Tatura subsidiary. While Bellamy’s problems are well-reported, other manufacturers such as Bega haven’t reported the same magnitude of problems with Chinese demand. Unfortunately the sector has become tainted with sensationalist headlines and exaggerated management promises so that it is difficult to determine the exact potential of the exposure.

Negative

  • Commodity prices – Milk prices recovered significantly in 1H17, up 16%yoy in AUD terms and the near term outlook is generally positive. But falls in the future could have a significant, negative impact on revenue. Around 30% of revenue is exported so a rise in the Aussie dollar also reduces revenue.
  • Mondelez acquisition – The KRAFT brand licence ends in December 2017. Bega Cheese has a number of brand transition options, including brand rationalisation and a transition strategy to support the businesses post December 2017.
  • Financial risk – The Mondelez acquisition was funded by bank debt which the company expects to repay due to “near-term corporate opportunities.  But a capital raising may be considered at a later date if these opportunities are unsuccessful.
  • Contract risk – Bega supplies branded cheese and cheese for home brands with a number or major supermarkets and manufacturers. These customers exert significant pricing power and influence and could force a squeeze in margins.
  • Agriculture risk – Unseasonal weather can have an impact on milk production.
  • Supply risks – BGA purchases milk from dairy farmers. This supply could be interrupted by a variety of factors such as seasonal factors or competition from other manufacturers.
  • Regulatory risk – This has especially been the case in China, with regulations relating to infant formula having a major impact on sentiment and returns. A material reduction in the contribution from infant formula is expected in 2H.
  • Reputation risk – Such as from contamination or product recall.

RECENT RESULTS

  • Cautious market environment commentary – Terms included “challenging market”, “competitive environment” and “volatility and uncertainty”, with the impact to be felt in 2H.
  • More positively, dairy prices improved significantly during the period, while growth in “own brand” business and higher sales in the nutritional business were the other key reasons for the rise in revenue and profit.
  • Normalised (adjusted for the inventory impairment) profit rose 39.2% to $20.7m on revenue up 10.6%.
  • Woolworths contract started earlier than anticipated.
  • Dividend was up to 5c, up 11% yoy.
  • There was a $7.1m inventory impairment related to the nutritionals business.
  • Full year guidance from the AGM was retained, which implies a deterioration in 2H.

You can review the results presentation here.

FUNDAMENTAL VIEW

Bega has a reasonable but not exciting ROE but it is trending up, and the growth profile post the Mondelez acquisition is impressive as it is immediately earnings accretive. There is no yield so it’s not really suitable for income investors, although the growth in dividends is impressive so it might be one day. The valuation metrics aren’t screaming buy “on paper”. Shares are trading at a 53% premium to the intrinsic value and from a relative PE basis, they are mid-range. But these measures are not so relevant because the Mondelez acquisition changes the nature of the organisation and the historical PE premium/discount rules no longer apply. More relevant is probably the analyst’s valuation, and on this basis the shares are are still reasonable value with lots of upside.

Debt remains high but manageable, partially due to the Mondelez acquisition being funded by debt. But management says it has near-term corporate opportunities to pay down debt and it is currently forecast to fall significantly over time. Other measures of financial health, including profitability and cash flow ratios, are healthy. The one cautionary note is that management warned that if the opportunities were unsuccessful, a capital raising may be considered at a later date.

OUR VIEW

We became very interested in the Bega story after the acquisition of Mondelez, but it rallied on the news and hasn’t really paused to catch its breath since. The move is a complete company-changing acquisition and warrants a re-rating of the business. Combined with the acquisition, the asset sale deal with Mead Johnson means BGA is able to capture existing earnings from the assets and earn management fees after selling the underlying assets for a significant profit. The two transactions suggest management has a clear focused strategy for the business going forward, giving us additional confidence in the outlook. One of our main concerns is the cautious market commentary at the 1H results and the fall in 2H earnings implied by the maintenance of guidance. But if this is a sign of cautious and conservative management who under-promise and over-deliver, then the company gets yet another tick. We missed an opportunity to add BGA to the portfolios after the Mondelez acquisition but the technical picture suggests that another opportunity to buy a newly-transformed, quality company at a more attractive price may be approaching. It’s an avoid for now but once the technical picture improves, it is definitely well worth another look.

TECHNICAL VIEW – Shares fell last October during the period when Bellamy’s (BAL) reported issues with demand for its infant formula in China, followed by a rally which started in January following the acquisition of the Mondelez assets. This rally now looks to be losing steam, with RSI turning down and the MACD indicator also turning down. Shares have moved off the upper Bollinger Band and the daily chart suggests further weakness ahead. It’s all great news for those investors who missed the rally in January and are waiting around for a better entry level. Look out for a sign that MACD is stabilizing and RSI is turning up before buying

BROKER VIEW

  • Bell Potter has a Hold recommendation with a target price of 558c. The 1H result was well above their forecasts. They have made a few minor changes to forecasts, which currently do not include the acquisition of MDLZ, which they think will result in high single digit to low double digit EPS accretion. They note that since acquiring MLDZ, BGA has gained ~$165m in market cap, despite what looks like a difficult 2H17e trading outlook. While positive about the MDLZ transaction and improved outlook for dairy ingredient prices, they think shares are reasonably valued.
  • Baillieu Holst has a Buy recommendation with a target price of 800c. The 1H result was in line with the analyst’s estimate. They are happy about the earnings potential from existing and recently acquired businesses and remains comfortable with the financial position post the extraordinary asset sale deal. They think shares remain attractive at current levels.
  • Morgans has a Hold recommendation with a target price of 490c. After a trading update last October, which Morgans thought was weak, the analyst commented on downgrades, noting that they struggled with the valuation but think it is a great business but struggles with valuation. Hold rating retained and target reduced to $4.90 from $6.20.
 

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