The milk industry has never been for the faint-hearted. Returns are characterised by high volumes and thin margins. But recently all hell has broken loose at the tills. Asda kicked off the latest battle in July by slashing the price of four pints of milk to 125p. That forced Tesco to follow suit on this important “known-value item (KVI)”.
Unfortunately for Robert Wiseman, with 30% of the fresh-milk processing market, the timing couldn’t have been worse. This ferocious battle happened right in the middle of its biannual contract negotiations with Tesco, its largest customer. With the retailer threatening to switch suppliers, Wiseman was compelled to accept lower terms to maintain its 50% share of the account.
The upshot is that on 16 September the board released a shock profit warning that sent the shares into a 30% nose dive. It said that £7m would be skimmed off operating profits in the first half of the year, and £16m for the 12 months ending March 2012 – a 37% decrease on 2009’s performance. Yet despite “intense competitive pressures”, the situation is nowhere near as bleak as the sell-off suggests.
First, once the huffing and puffing has died down, I’m sure milk prices will recover. It doesn’t make sense for any supermarket to sell a KVI at overly low levels for more than six months. This would run the risk of permanently adjusting consumers’ expectations, so when the price does rise, the customer perceives the increase to be unfair.
Tip of the week: Robert Wiseman Dairies (LSE: RWD), rated a BUY by Investec
Next, Wiseman will undoubtedly want to cut costs to the bone in order to lift margins from 1.6p per litre (after the contract changes) closer to the historical norm of 2.3p per litre. Indeed, “stiff targets” have already been set – such as using less plastic in its cartons, improving the fuel efficiency of its trucks and consuming less water at its factories.
Lastly, the firm still expects to churn out a healthy 18p dividend (representing a 5.4% yield) for income investors this year. House broker Investec is predicting a 2010/2011 turnover and underlying earnings before interest, tax and amortisation (EBITA) of £918m and £37.5m respectively, rising to £936m and £29.4m in 2011/2012.
I would rate the stock on a through-cycle EBITA multiple of nine, assuming a sustainable milk margin of 2p per litre. On this basis, after deducting net debt of £31m, I arrive at an intrinsic worth of approximately 400p per share.
So what are the possible downsides? Another brutal price war certainly wouldn’t help. However, this seems unlikely as it’s not in the long-term interest of either of its rivals (Arla and Dairy Crest) or the supermarkets. Another factor to watch is the inherent volatility of by-product sales (for bulk cream, for example). Although in the broader context of a food inflationary environment, prices look more likely to harden than decline.
All in all, with expanding volumes, Wiseman looks like a good place to park some money and pick up a tasty dividend (twice covered). Interims are scheduled for 15 November.
Recommendation: BUY at 322p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments