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How to milk gains out of the dairy industry

With the global dairy industry gearing up for a number of changes, this week's sector focus takes a look at how and where investors can gain exposure to this fast-growing market.
August 20, 2014 and Mark Robinson

The dairy industry in the European Union is on the cusp of a massive shake-up. Come April 2015, a quota system that has limited milk production in member states for nearly 30 years is to be scrapped. As if that weren’t enough, Russia's mercurial leader Vladimir Putin has kicked up a storm with a trade embargo on EU dairy products. To top it all off, stockpiling in China, coupled with bumper milk production, has sent global dairy prices tumbling since February. In this week’s sector focus, we're looking at the implications for UK dairy, as well as how investors might gain exposure to this big - and growing - global food business.

Weaning off the EU teat

Under the EU milk regime, every member state has a national production quota, which it in turn distributes to farmers. When a member state exceeds its quota, it has to pay a penalty. This system distorts the market mechanism: less competitive farmers who own quota rights produce too much, while more efficient producers are restrained. Equally, the quotas keep milk prices high and European dairy exports more expensive.

"Quota abolition is long overdue and will lower dairy prices in the EU and elsewhere, at least in the near term," says Jonathan Feeney, an analyst for US-based Athlos research. “We've seen it in bananas, sugar, and now dairy. In the former two cases, lower prices were the result."

Large, efficient dairy companies stand to gain from the changes. "The market is set to bifurcate between volume producers and smaller producers," explains Richard Dillon, a dairy market analyst for Informa. He says countries and companies with scale, streamlined operations and established relationships with buyers and distributors outside the bloc are preparing to ramp up production.

Over the next decade Mr Dillon expects to see a "complete re-making of the market", resulting in a "dairy belt" stretching from the Baltic states and Scandinavia through the Benelux countries to Brittany, Ireland and Britain's South West. Many large dairy groups in these countries, such as Denmark's Arla, already supply foreign companies, while others are getting ready to seal contracts with new overseas buyers - looking east to China in particular. There, dairy consumption is rising fast, driven by demand for milk and yoghurt, and also milk powder and whey to service the burgeoning infant formula market.

England's green and pleasant land

Perhaps surprisingly, the UK is a relatively small player on the global stage. "In a way, the UK is the odd man out," explains Mr Dillon. "It has potential but hasn’t quite realised it yet, because its companies and co-ops have focused on the domestic market. Incredibly, there is very little drying capacity. Instead, milk powder has been viewed as something to be produced when production is running too strongly."

But this is starting to change. Dairy Crest's (DCG) recent partnership with Fonterra marks a first, historic foray into the global market. Since its foundation in 2001, New Zealand co-operative Fonterra has become the world’s biggest dairy exporter, accounting for over a fifth of the international trade. Under the partnership, Dairy Crest is investing £45m in the manufacture of de-mineralised whey powder, the base ingredient in infant formula, from its cheese factory at Davidstow in Cornwall. It is ploughing a further £20m into the production of galacto-oligosaccharide, a lactose-based prebiotic widely used in infant formula. Fonterra will offer technical support and market and sell both products.

The two other big players in the UK dairy industry are privately owned foreign groups, Mueller and Arla. Both should thrive when the quota system is abolished, but more interesting from a UK point of view is that Arla is keen on the export market. It recently announced that part of its production would come from the UK. "That's significant because it means Arla is counting the UK as an important international supplier of milk," says Mr Dillon.

Global markets

Quota abolition comes as global dairy prices have sunk 40 per cent since February on the back of stockpiling in China and bumper production in Europe and the US (see graph). This shows that the end of the quota system does come at a price: market volatility. In response, British producers have called for a UK dairy futures market to help regulate cycles of boom and bust. Whatever the short-term hiccups, however, the long-term outlook is encouraging, with dairy consumption set to rise across Asia and the Middle East.

Russia's dairy freeze

Russia is a huge market for exports from the EU, receiving 1.5 per cent of total milk production. That sounds small, but in light of the recent trade embargo it adds up to a billion-euro headache for producers. Dairy experts such as Mr Dillon believe the ban has two purposes: to penalise the West and to encourage investment in domestic dairy production, which has been chronically under-invested. "I think the Russians are calculating that the ban will invigorate their own industry, on the milk production and processing side,” he says.

But given that Russia barely supplies half its own cheese consumption - the country accounts for about a third of all EU cheese and butter exports - filling the gap left by EU imports will take time. Shops in Moscow are likely to be short of dairy products by mid-September. Whether the ban will survive the anger of Russian shoppers remains to be seen.

 

Companies on the milk float

Despite news of the partnership with Fonterra, shares in Dairy Crest have lost a fifth of their value since February amid concerns over cheap Irish cheddar flooding the UK market. We believe the share price weakness presents a buying opportunity. Across the sea in Ireland, dual-listed Glanbia (GLB) is a heavy hitter with a well-diversified portfolio of products. In addition to supplying milk, butter and cream, Glanbia counts itself a world leader in cheese, whey proteins, sports nutrition and micronutrient mixes, and operates an agri-business.

Thinking outside of the carton

Perhaps a less risky way of gaining exposure to the dairy industry is through agri-businesses that support dairy farmers. Carr’s Milling (CRM) is one. This diversified global agriculture, food and engineering group supplies feed blocks to dairy farmers in the US and UK, and - potentially more interestingly - recently entered the huge New Zealand market. Sales in the country are growing so fast that a feed block manufacturing facility is being built there this year. Meanwhile, agri-business Wynnstay (WYN) offers technical support to UK farmers, supplying feed, fertiliser and seeds as well as operating a chain of retail country stores. The more professional, scalable and efficient farming becomes, the better for Wynnstay.

The most important player in the global dairy export market is undoubtedly New Zealand’s Fonterra Co-operative Group, which is owned and supplied by around 10,500 Kiwi dairy farmers. It is now possible for retail investors to gain indirect exposure to Fonterra through what is in effect an income bond. Listed on the NZX Main Board (FSF.NZ), the Fonterra Shareholders’ Fund gives investors access to the economic rights (ie, dividends) that they would have received if they were allowed to own Fonterra shares directly. The gross yield for the 2014 year-end is forecast to be 5.2 per cent.