Dairy Crest - still a lot of bottle

The UK's dairy industry is characterised by a tripartite relationship. At the start of the chain sit the dairy farmers, who sell their output of raw milk to dairies for processing. Next, the dairies rely on supermarkets to get their products to shoppers. Unsurprisingly, with each group trying to secure the best deal for itself, the delicate equilibrium required to keep everyone happy is regularly thrown out of balance, and volatility in the price of dairy products has been a feature of the UK market for decades.

That problem has been exacerbated by too much processing capacity in the middle of the equation, a situation which affected the profitability of all of the producers and eventually led to the demise of Dairy Farmers of Britain last June. It had accounted for 10 per cent of UK milk production, and its collapse was good news for rivals, including Robert Wiseman and Dairy Crest, which picked up major new contracts as a result.

The removal of excess capacity has, for the time being, weakened the position of supermarkets who remain the most powerful player in the equation. The pause in the so-called 'milk merry go round' means dairy producers have more control of pricing, and this stabilisation of industry conditions has helped the price of shares in dairy producers to recover strongly from the low levels they hit in late 2008. Robert Wiseman's shares have climbed 60 per cent in the past year, and now trade on a rating of 13 times forecast earnings. The recovery of Dairy Crest's share price, by comparison, has been much more muted. It has fallen back since the company reported strong half-year results in November and the rating is just seven times forecast earnings.

We think that discount is far too wide. Admittedly, Robert Wiseman is the financially stronger company, with lower net debt, faster profit growth and wider profit margins - 5 per cent in its latest results compared with 2.7 per cent at Dairy Crest. But Dairy Crest, the larger company, has made significant progress in addressing its problems. In particular, strong cash generation is enabling it to pay off its borrowings at a rapid rate and, in its third-quarter trading update, it said that net debt would fall by at least another £30m by the year-end to finish at £350m.

Its bosses added that Dairy Crest had room to improve its working capital management. This should enable it to keep paying down debt even as it adds a further £75m to capital spending over the next three years to improve the efficiency of its dairies. Profitability also depends on sustaining sales to supermarkets and, after milk sales rose 10 per cent in the first half of 2009-10, the recent renewal of its contract with Sainsbury should allay fears that Danish rival Arla is making further inroads into its customer base in the east of England.

Milk processing is, in fact, far less important to profits these days thanks to strong growth of Dairy Crest's branded cheeses and spreads, which include Cathedral City, Clover and Country Life. Sales of these climbed 10 per cent in the first nine months of 2009-10, as the group took advantage of falling advertising rates to increase its marketing spend. In the first half of 2009-10, the group's foods division produced a third of group sales, but generated nearly three quarters of its operating profit. Yet stockbroker Shore Capital believes that investors are not attributing appropriate values to these brands, which are all market leaders in their respective categories. Dairy Crest's home delivery service, Milk & More, is also gaining traction despite limited promotion: 180,000 customers have now registered to take advantage of its next day delivery on a range of groceries, a service supermarkets can't yet guarantee.