Huge potential in dairy growth

TIM HUNTER
Last updated 05:00 05/05/2013
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DAIRY DEMAND: The awakening of China's thirst for dairy products has been widely anticipated, particularly by Fonterra.

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The headline in a dairy trade newsletter a few days ago was "China's demand for WMP relentless".

WMP is short for whole milk powder, the dried form of standard milk and one of the most traded dairy products in the world. The latest statistic was that Chinese WMP imports were up 49 per cent in the three months to March compared to the same period a year earlier.

The awakening of China's thirst for dairy products has been widely anticipated, particularly by Fonterra, the world's largest exporter of milk powders. The potential demand growth is huge - China's annual per capita cheese consumption, for example, is about 260g, just a fraction of the average even in the developed countries of Asia, which is about 2.2kg. Europeans gobble an average of more than 15kg each a year.

These market trends are manna for sharemarket investors and it's probably no coincidence that two dairy-related securities hit new highs last week - the Fonterra Shareholders Fund and A2 Corporation. However, although in the same industry they have different characteristics from an investment point of view.

Units in the Fonterra Fund topped $8 on Wednesday, having floated at $5.50 a mere five months ago. The immediate catalyst for the fund's latest surge - it was trading at $7.05 only 10 days earlier - is not clear. Fonterra itself has made no obvious price sensitive announcements over the period, save for a plan to axe up to 300 jobs.

Fund manager Andrew Bascand, of Harbour Asset Management, said there was general enthusiasm for quality New Zealand and Australian stocks.

"There is a lot of cash looking for a home around the world . . . many companies touched new share price highs in April. Investor interest in equities seems unlikely to wane soon."

The tricky bit here is guessing how much upside remains when the units are trading around $8. At its interim results announcement in late March, Fonterra lifted its forecast payout to farmers to $6.12 a kilogram of milk solids, up from the previous $5.90-$6 forecast in late February.

"The new forecast reflects a recovery in global dairy commodity prices over the past two months," said Fonterra chairman John Wilson at the time.

However, the payout increase was purely for farmers in the form of a higher price for their milk. The forecast 2013 dividend - which is the return available to fund investors - remained at 32c.

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An important issue is that higher commodity prices, such as for WMP, tend to flow through to a higher milk price for farmers more than higher profits and dividends for fund investors.

At a unit price of $8 the implied yield on the Fonterra fund is 4 per cent. That's well down on the 5.5 per cent or so at the float price and not huge if market growth leads only to commodity gains, but it's OK if you think the business can increase its profits in consumer brands such as Anmum, its infant formula set to launch in China this year.

Presumably some investors think it has a good strategy to do that.

Another dairy-related business on the rise in the last 10 days has been A2 Corp, which hit new highs around 75c. At that price it has a market value of about $480 million.

In A2's case it is easier to see the probable catalyst for the recent gains because on April 22 it announced the imminent departure of its first shipment of premium infant formula to China.

The product is called a2 Platinum and is produced under contract at Synlait's processing plant in Canterbury using milk from local A2-certified dairy herds.

A2 milk is distinct from standard milk because it contains only the A2 form of beta casein protein and does not release a particular protein fragment when digested. Although the science is so far inconclusive, some believe A2 milk could be healthier for consumers than the standard product.

A2 Corp has strong intellectual property rights around the marketing of A2 products and has carved a powerful niche among health-conscious consumers, particularly in Australia.

Its launch of infant formula sales to China State Farm Holding Company of Shanghai, its exclusive Chinese distributor, looks a smart strategic move, tapping into a growing market with clear demand for New Zealand-sourced product.

By June 2016 A2 is aiming for revenue from infant formula sales in China of $60m based on a market share of less than 1 per cent - a projection that can look ambitious or conservative, depending on which side of the bed you get out of in the morning.

Overall revenue for that year is projected at about $280m. That's about three times expected revenue for the year to June 2013.

However, the company has not indicated how profitable it expects to be by then, which leaves investors with some work to do in figuring out how much A2 shares could be worth. And unlike the Fonterra fund, A2 doesn't currently pay a dividend so its potential for capital growth is important.

Granted, neither Fonterra nor A2 are trading at bargain prices, but for investors interested in getting some dairy exposure they represent quality options we didn't have a few years ago. Maybe quality doesn't come cheap.

Tim Hunter is deputy editor of the Fairfax Business Bureau.

- Sunday Star Times

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