Small Caps | Jun 05 2020
The strong market position of the Freedom Foods brands should underpin the business going forward despite the short-term hit to profitability caused by the pandemic.
-Some stronger demand is starting to emerge as restrictions are eased
-High-margin channels, such as cream, severely hampered by pandemic
-Re-vamping of operations being fast tracked
By Eva Brocklehurst
The latest trading update from Freedom Foods ((FNP)) disappointed brokers, although understandably most of the concerns remain out of the company's control. Nevertheless, demand is starting to grow and strategies remain intact, such as improved facility utilisation and a focus on higher-margin nutritional sales.
The main risk stems from whether the recovery in demand turns out to be weaker than expected because consumers work from home longer, or there is a second wave of the coronavirus pandemic.
Goldman Sachs expects the decision to exit obsolete units, while painful in the short term, will result in a business with lower operating costs moving into FY21. Freedom Foods will write down around $25m in inventory in FY20 amid the rationalisation of the lower-margin units. Capital expenditure is expected to fall materially in FY21 as growth projects are completed.
Moreover, the fundamentals of dairy and plant-based beverages are largely unchanged and demand is in line with expectations. Goldman Sachs believes the nutritionals division is still on track to deliver returns of more than 40%.
Profitability in the second half was severely hampered by pandemic restrictions. The high-margin out-of-home channel has borne the brunt, with sales in April and May -75% and -50% below budget.
Additionally, dairy sales to the food service and hospitality sectors, particularly cream, were hard hit. Margins on cream sales are impacted by lower selling prices while there has been an oversupply and higher seasonal milk prices. The main positive is that demand for lactoferrin is strong, reflecting the application to infant formula.
The UHT/cereals margins were affected during the usually high-volume March period because of promotional activity and there was export channel weakness in the third quarter. Freedom Foods has invested around $620m in expanding its UHT capacity and establishing protein fractionation capabilities in Shepparton, with lactoferrin the key driver.
The company aims to produce 40t of high-grade 95% pure lactoferrin in FY21 which would make it one of the largest suppliers globally and around 80% of FY21 supply is contracted.
The impact was not unexpected but worse than UBS anticipated and second half operating earnings estimates are reduced by -36% and FY21 by -14%. The broker anticipates delivery on FY21 expectations will be required for the stock to re-rate and the upside in the short term may be limited.
Further afield, UBS questions whether cereals and snacks have reached maturity and doubts the segment will be a key growth driver going forward. Still, the strong market position of Freedom Foods in the high-growth "health" foods category, rapid development cycle for products as well as offshore opportunities should be supportive.
Morgans expects the business will still be affected by the pandemic in the first half of FY21 because of social distancing measures and a cautious consumer. The broker is disappointed with the update, downgrading to Hold from Add, but recognises the reasons are out of the company's control.
Well Positioned
When markets normalise, Freedom Foods is well-positioned because of the popularity of its brands and the potential in nutritional products. Still, the broker notes the balance sheet is stretched.
Goldman Sachs does not envisage Freedom Foods will need to raise capital in the short term despite elevated leverage. Banking covenants have been lightened for 18 months and earnings should grow significantly in FY21.
Capital expenditure is expected to fall materially in FY21 as growth projects are completed. While operating cash flow could be affected by provision releases taken FY20 the broker expects the performance will be much improved.
Citi forecasts Freedom Foods will utilise around $75m of its short-term borrowing limits to meet operating cash requirements in the second half of FY20. While gearing may be elevated there are no large expenditure requirements in the near term and the broker calculates gearing should fall to around 4x net debt to operating earnings in FY21 as demand ramps up.
Re-Shaping Operations
The pandemic has caused the company to fast-track the re-shaping of operations. FY20 capital expenditure is now expected to be $120-130m, driven by the early delivery of fillers, early bottle line payments and the warehousing and container capabilities at Shepparton. Warehousing and logistics will now be done internally with material cost savings expected.
Goldman Sachs, not one of the seven stockbrokers monitored daily on the FNArena database, has a Buy rating and $5.75 target. The database has two Buy ratings and one Hold (Morgans). The consensus target is $4.79, suggesting 29.2% upside to the last share price.
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