Stockwatch: A mid-cap for income and growth

At about 560p, is mid-cap dairy processing stock Dairy Crest (DCG) poised to break out of a volatile-sideways trend between 500p and 700p over the last two years?

Dairy Crest is off many people’s radar in a mature bull market, dairy cheese/spreads being hardly cutting-edge growth, also with debt and capital expenditure weighing on the cash flow profile.

The group originated in the processing side of the Milk Marketing Board: floated in 1996 and which went on the acquisition trail accumulating debt. Milk production/supply was divested to Muller Wiseman Dairies in November 2014, positioning the stock to recover from 440p to near 700p in 2015. However, the table shows underlying performance bumping along at best.

Stock buying after early signs of better revenues

More positively, a strong set of interims to end-September 2017 has been followed by the appearance of a 5.1% shareholder – nearly £42 million- in December: Paradice Investment Management, an Australian institution which professes “a solid track record of producing outstanding returns across its products”.

And Dairy Crest’s chairman has just bought £7,188 worth of shares at 575p. Is it possible to join the dots of these big/small trades to define or at least anticipate value in an area which most other British investors lack enthusiasm for?

On the face of it, the stock is no compelling buy: on a forward price/earnings (PE) ratio in the mid-teens for a business in relatively high-quality produce, albeit competitive markets and where UK wage/inflation pressures may ingrain tempt discounting.

Visit any major supermarket nowadays and it’s possible to find at least one brand of quality cheddar “reduced” from £3.99 a 350g packet, to £2.99. It’s hard to say whether supermarkets play such pricing games themselves where they advertise cuts versus the “regular” price (held for the minimal legal period), but quite often it is manufacturers who sponsor discounts.

Such lack of transparency of the relations between supermarkets and suppliers hides margin risk and a debt/goodwill-laden balance sheet. This likely explains the stock being priced for a 4%-plus yield. Yet the marketing story is robust: leading brands of cheese and spreads doing well, and sugar not saturated fat in the firing line for New Year dietary advice.

Strong sales growth in cheese and spreads

Interim group revenue on continuing operations advanced 16% to £220 million and normalised pre-tax profit by 8% to £20.6 million, on an operating margin of 11.3% which is in line with the last two years’ margin trend (see table).

A big advance in headline interim profit to £151 million reflected a £131 million reduction in pension liabilities scheme after a change in their inflation benchmark. The consensus normalised profit forecast of £64.7 million for the full year to end-March therefore looks ambitious, but is based on five brokers since last September and, as of 9 November, management declared itself “confident” of meeting expectations.

Privatised in 1996, Dairy Crest proceeded to acquire cheese brands Davidstow and Cathedral City, and spreads such as St Ivel and Country Life, together with several leading brands in France and Italy. Despite exiting milk operations, the group remains affected to an extent by dairy price volatility – e.g. their surprise sharp rise recently hiking input costs for butter-spreads especially.

Yet this is being absorbed as Cathedral City cheese hits the spot for British taste buds, with sales volume growth of 10% during the six months to end-September. Note that value growth was 7%, which may illustrate my point about subsidised discounting.

Cathedral City enjoys a 56% share of the UK branded cheddar market, and management sees plenty scope for growth. Sliced packs and snack bar multipacks – “snacking remains a core focus for our innovation pipeline” – appear useful for adults trying to lose weight as cheese satisfies appetite, if questionable how effective an alternative to confectionery for children.

Another notable performer is Frylight spray-oil, with 10% volume growth and 9% value growth, based on a 24% uptake by UK households – the ongoing opportunity for cooking sprays shown by their 73% usage by US households.

The Clover branded spread is also growing market share, 2% ahead in volume/value growth alike, if nowadays a competitive area as various manufacturers market a similar compromise product that’s half buttermilk-based, but also using vegetable oils so it spreads from the fridge and appeals to those still living in fear of cholesterol.

The spreads also include Willow, an economical alternative to butter, up 45% in volume/value terms, and Vitalite, which is the leading dairy-free spread, achieving double-digit growth helped by a coconut version. Utterly Butterly is another spread said to be “growing volumes strongly.” Barring further claims that hydrogenated vegetable fat harms health, and sudden outbreak of veganism, such a mix of quality cheese and everyday spreads implies pretty secure revenues.

Yet a slug of debt/goodwill impedes cash flow

The downside of acquisitive development is a balance sheet that at end-September 2017 had £104 million goodwill/intangibles, £298 million long-term debt, £0.9 million short-term debt and only £7.6 million cash. The interim cash flow statement showed £10.8 million cash generated from operations (down from £15.6 million like-for-like) clipped by £4.5 million interest paid in the period. There’s also £16.8 million capital expenditure in the period (most likely linked materially to depreciation), and £22.8 million of dividends were effectively paid via a £31 million resort to credit.

In its financial review, management proclaims it is on course to reduce net debt in the full year and reduce it below 2x EBITDA in the next 2-3 years – although this quite shows why “earnings before interest, tax, depreciation and amortisation” can be a perverse measure for shareholders. While of help to bankers looking at a business’s raw ability to service debt, interest costs and capital replacement costs gnaw at what’s left for owners.

A note also on the group pension which can be as hard to grasp as a well-buttered pig: its accounting valuation has improved from a £120 million deficit to a £39.9 million surplus, while its more relevant actuarial valuation shows a reduction in deficit from £100 million to £50 million.

Dairy Crest Group – financial summary               year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019                 Turnover (£ million) 1,382 1,391 448 422 417     IFRS3 pre-tax profit (£m) -10.7 54.2 36.8 45.4 40.3     Normalised pre-tax profit (£m) 52.0 48.2 74.2 41.1 39.6 64.7 70.3 Operating margin (%) 5.1 4.2 18.4 11.7 11.4     IFRS3 earnings/share (p) -5.9 35.4 21.4 27.7 23.4     Normalised earnings/share (p) 35.8 28.3 48.6 24.5 22.6 37.2 39.2 Earnings per share growth (%) 3.4 -20.8 71.7 -49.7 -7.8 64.9 5.4 Price/earnings multiple (x)         24.8 15.1 14.3 Cash flow per share (p) -2.7 -18.8 18.1 13.4 14.7     Capex per share (p) 30.3 19.3 42.1 44.5 -12.0     Dividends per share (p) 20.4 20.9 21.4 21.8 22.2 23.4 24.4 Yield (%)         4.0 4.2 4.4 Covered by earnings (x) 1.8 1.4 2.3 1.1 1.0 1.6 1.6 Net tangible assets per share (p) 148 137 138 26.2 -20.4                     Source: Company REFS               Curdled story if potentially attractive

Dairy Crest, therefore, comes across well in marketing terms: quality products, daily essentials; the paranoia against saturated fat waning; if challenged in respect of its debt profile and cash flow after management geared up in pursuit of acquisitions.

So the market has struck a balance in pricing the stock to exact a 4%-plus yield as appropriate return for holders until management improves the balance sheet like it says it can. This looks like a 2-3 year play in line with their debt reduction timescale, thus a bit of a gamble on British buying habits remaining in Dairy Crest’s favour.

Yet, with a serious institution and the chairman buying, it could be an early turning point for sentiment. It’s also possible a major international foods group considers it worth buying outright, anytime, with sterling low.

Accumulate according to your risk tolerance, or watch for continued signs of improvement.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.