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Dairy Crest has the right formula

A period of capital expenditure to allow it to enter the infant formula market is over and now the benefits of this move and the sale of the lossmaking dairies business should start to emerge.
July 7, 2016

Food producer Dairy Crest (DCG) has been transformed by the sale of its lossmaking dairies business to rival Müller last December and can now focus on its four strong consumer brands and a new infant-milk formula operation.

IC TIP: Buy at 523p
Tip style
Value
Risk rating
High
Timescale
Long Term
Bull points
  • Resilient consumer brands
  • Free cash flow expected to surge
  • Moving into high-margin infant formula
  • Cheap versus peers
Bear points
  • Price deflation
  • High net debt

Before its sale, the dairies business had represented a major millstone on cash generation and profits (losses in the final nine months of ownership came in at £33.3m). The sale will not only boost performance by eliminating the losses, but it will also allow the group to focus on the much more enticing prospects associated with its established cheese and spreads brands: Cathedral City, Clover, Country Life and Frylight.

While deflationary end markets are providing a tough trading backdrop, the brands showed considerable promise during Dairy Crest's financial year to the end of March. Indeed, while sales fell 2.3 per cent, margins held broadly steady at 14.8 per cent and actually showed an improvement to 15.6 per cent if profits from property disposals are taken into account. The second half looked particularly encouraging with all the brands recording year-on-year volume growth and overall growth of 1.7 per cent. Given the market conditions, this represents a very credible performance. And the reduced price Dairy Crest is paying for its key input, milk, which fell 17 per cent last year, should help support profitability.

 

 

An important reason for the strong performance is that the brands survived a cull by supermarkets keen to stock fewer ranges. The success of the relaunch of Clover, following the removal of all artificial ingredients, also underlines Dairy Crest's branding nous. A similar relaunch of Clover Light is planned in the near future. And should fears of a Brexit-induced recession prove correct, comfort can be taken from the fact that the company's products are staples rather than discretionary items, which should make them more defensive.

And there is another major reason for optimism. The company has invested about £80m in its Davidstow plant to help move up the whey value chain by entering the fast-growing (see chart) global infant formula market. It can now make the key formula ingredients of demineralised whey (DWP) and galacto-oligosaccharide (GOS), which sell at a significant premium to the sweet whey the facility used to make. It has teamed up with New Zealand milk giant Fonterra to gain access to this market. The sales agreement will also free up management time to focus on the brands as well as finding alternative uses for GOS, which should be helped by the recent acquisition of the outstanding 50 per cent of Promovita Ingredients and the launch of an innovation centre at Harper Adams University.

  

  

With the investment in Davidstow coming to completion, and the cash-hungry dairies business sold, free cash flow should leap in coming years. Broker Numis expects free cash flow to rise from a meagre £6.1m last year to £52.8m this year, as capital expenditure tumbles to come in line with depreciation of around £20m, which compares with £67m spent last year and £80m the year before. This should help underpin the company's commitment to its progressive dividend policy by giving it ample scope to fund a payout of about £30m while also whittling down net debt, which got to an eye-catching £229m at the end of last year.

 

DAIRY CREST (DCG)
ORD PRICE:523pMARKET VALUE:£736m
TOUCH:522.5-524p12-MONTH HIGH:700pLOW: 503p
FORWARD DIVIDEND YIELD:4.6%FORWARD PE RATIO:12
NET ASSET VALUE:**NET DEBT:£229m

Year to 31 MarTurnover (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201444858.834.321.7
201542257.734.522.1
201642350.529.022.0
2017*45570.140.323.0
2018*47375.343.224.0
% change+4+7+7+4

Normal market size: 3,000

Matched bargain trading

Beta: 0.67

*Numis forecasts, adjusted PTP and EPS figures **Negative shareholders' funds