Shares in Bega Cheese (ASX:BGA) have re-rated since mid-February. This was driven by the normalisation in profit margins for the Branded business and an expected recovery in the Bulk segment. Indeed, results for the six months to 31 December 2023 (1H24) were stronger than market expectations.

Having come off its recent high of $4.37 in late February, we consider whether current levels still present value.

About Bega Cheese

Bega Cheese has historically focused on dairy processing but has diversified into branded consumer foods through acquisitions. The Company has two business segments:

Branded: the manufacture of bulk ingredients into value added consumer products for internal or external brands;
Bulk: the manufacture of bulk dairy ingredients, nutritional and bio-nutrient products.

The Branded segment accounts for ~80% of group revenue, with the currently loss-making Bulk segment accounting for the remainder.

Key Fundamental Drivers

Revenue and Margin Growth in Branded Segment

A key positive of the Branded segment’s 1H24 result was that volumes still grew despite the large price rises. This highlights strong demand for its products and a loyal customer base. Revenue growth (+8%) also reflected mix benefits.

Further, EBITDA margin improved to from 3.1% in 1H23 to 6.5% in 1H24. The expansion in EBITDA margin was due to price rises more than offsetting inflationary cost pressures. BGA also benefited from its restructuring initiatives, which enabled cost reductions by removing duplication.

EBITDA margin is expected to continue improving in 2H24. The Company’s growth strategy (which centres on product innovation) has resulted in strong consumer uptake across the growth brands.

Recovery In Bulk Segment a Key Share Price Catalyst

The Bulk segment was loss-making due to the material fall in global dairy prices and Australian dairy processors overpaying for milk (i.e. higher farmgate prices). Bulk commodity products destined for international markets were unprofitable.

However, the Bulk segment’s earnings result was materially stronger than expected due to some opportunistic milk purchasing and the pull forward of sales. In response to a contraction in global supply, global dairy prices rose in 2Q24 (after reaching lows in 1Q24). Further, favourable seasonal conditions allowed the Company to opportunistically purchase milk.

With a key investor consideration being how long this disconnect will continue, the Company are optimistic that the disconnect will close in FY25, mainly via lower farmgate prices. This view is predicated on several factors, including:

i. Australia’s milk pool stabilising,
ii. Reductions in processor capacity,
iii. More rationality from tier 3 & 4 players given earnings/cash challenges, and
iv. A sharp recovery in Commodity Milk Value dairy export prices (+20% in the year to date). To this end, Rabobank is forecasting a gradual improvement in US$ global dairy prices throughout calendar year 2024.

Operating Leverage Set to Resume

As a result of losses in the Bulk segment, group EBITDA margin fell to 4.4% from 4.5% (FY23: 4.7%). We consider that there is scope for operating leverage over the medium term, given:

i. BGA’s business and organisational restructure has now successfully been implemented.
ii. The Company has been relatively successful in recovering most of the costs increases through price rises in most channels.

Gearing Levels Expected to Improve

BGA reported weaker operating cashflow given the higher level of working capital in 1H24. Despite this, gearing (on a net debt to EBITDA basis) reduced from 2.7x as at 31 December 2022 to 1.9x as at 31 December 2023. Gearing is expected to reduce further by 30 June 2024, as seasonal inventory is sold. BGA targets a gearing range of 1-2x on a ‘through the cycle’ basis.

Further reduction in gearing is likely given the potential for further asset sales. To this end, the Company has commented that it will continue to rationalise its footprint in the future.

Fundamental View

Bega Cheese shares are currently trading on a 1-year forward P/E multiple of ~28x. While this appears full, it does not appear demanding in the context of an EPS growth profile of 31% over FY23-26 on a CAGR basis. We consider that the Company may achieve its group FY28 EBITDA target of $250m by FY27 given that restructuring initiatives within the Bulk segment positions the latter well for when global commodity prices improve.

Charting View

BGA broke above its downtrend line in December and has been trading well since then. A little bit of heat came out of the share price a few weeks ago but the stock is back to trending higher. Current levels remain a buying opportunity as the next major resistance level is near $5.

 

Michael Gable is managing director of Fairmont Equities.

 

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