Small Caps | Sep 02 2019
Freedom Foods offers strong prospects for growth from its dairy and nutritional products but are expectations too optimistic?
-Specialist dairy products to underpin margins in FY20
-Strategy to avoid daigou channel appears vindicated
-Has peak capex occurred, or is more growth expenditure likely?
By Eva Brocklehurst
It's all happening for Freedom Foods ((FNP)), with strong growth across existing and new products, an expanded distribution profile and upgraded facilities. The company'sportfolio has significant leverage to healthy eating and drinking trends.
New product streams from nutritionals, such as lactoferrin, are expected to make a material contribution in FY20 and growth is expected to come from the scaling up of new facilities and production of higher-margin dairy products. The company has prospects from the organic opportunities derived from its dairy, plant-based and allergen-free foods.
Unlike past practice, Freedom Foods has not provided formal sales guidance, although expects revenue and operating profits to increase. FY19 sales were slightly below guidance, albeit up 35%.
Morgans was encouraged by the performance of dairy and plant-based beverages, which appear to be scaling up. Strong demand is expected to continue across Australia, Asia and the Middle East. However, the broker also suspects consensus expectations in the outer years are too optimistic and lactoferrin prices will remain high despite significant new capacity coming on line.
Margins, in particular, in FY19 were disappointing for Morgans as overheads rose 66%. Capital expenditure was 45% higher than expected, largely because of items brought forward from FY20. UBS expects a combination of operating efficiencies and the contribution from lactoferrin & cream should underpin margin expansion into FY20.
Exports to China and Southeast Asia are the drivers of growth, with around 80% of new volume to be exported. Citi highlights the company is in the last stages of transforming into a branded food manufacturer and high-value dairy ingredient producer from a low-margin contract manufacturer. Higher returns are expected going forward as a result.
Freedom Foods has, historically, resisted the temptation to leverage the high-margin daigou (local purchase of goods for China) channel in order to sell into China, with a focus instead on alternative channels supported by its office in China and local partnerships. Citi believes this strategy has been vindicated, given the adverse impact that China's new e-commerce laws have had on Bellamy's Australia ((BAL)) and Blackmores ((BKL)) in their sales to China.
The company has emphasised that price and volumes for FY20 milk supply are contracted and has managed to contract around 400m litres in milk supply for FY20. Freedom Foods has a direct sourcing model which locks farmers into long-term, fixed-price contracts, but will have to pay higher prices for new suppliers commencing in the second half of FY19.
Citi considers the company well-positioned in a higher price environment for milk, although points out competition remains fierce. There have been reports of some processors offering higher prices to attract farmers in Victoria and others have been offering advance payments.
Citi calculates a three-year rolling return on invested capital of 8% in FY19, in line with the cost of capital. This suggests the benefits from the company's expenditure are beginning to materialise.
Freedom Foods has largely completed the expenditure program to take UHT processing capacity at Shepparton to over 500m litres and yoghurt processing capabilities were completed at Ingleburn in the first half.
The production outlook has been helped by wetter conditions during winter in Victoria and southern NSW, with these areas now out of severe drought. These are the regions where the company currently sources the majority of its milk.
Yet this remains a capital-intensive business. While investors will be relieved that Freedom Foods is now through its peak capital expenditure cycle, Morgans suspects another growth opportunity may loom and require additional capital, a situation that has occurred previously.
Specific guidance may not have ensued but UBS notes the company's option packages show a target of $160m in aggregate operating earnings (EBITDA) over FY19-20. This implies that operating earnings of $105m are required in FY20 to hit this target. The broker forecasts $98m. Cash flow may have been weak in FY19 but UBS expects a marked improvement in FY20, given materially lower expenditure is likely.
There is no room for disappointment in the stock, Morgans suggests, given forecasts have been missed for a number of years. The broker assesses the extent of trade receivables that are past due rose to 22%.
While an improvement on the prior year, the magnitude is still considered too high. The broker suspects the receivables relate to Chinese and Southeast Asian customers and there is a risk these could continue to build as the company pursues growth in these markets.
FNArena's database shows two Buy and one Hold (Morgans) rating. The consensus target is $6.05, suggesting 13.4% upside to the last share price.
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