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Egypt dairy stocks | Overweight cheese producers

Lower SMP prices add to the volume recovery story. CPI and core inflation rates in Egypt declined for the sixth consecutive month in January 2018, to 17.1% and 14.4%, respectively. This is closer to our 2018 year-average estimate of 15% (factoring in the impending energy subsidy removal), easing spending pressures and reviving demand. Volume growth prospects for cheese players now coincide with lower SMP prices (c50% of CoGS is SMP linked), falling 20% to USD1.7k-1.8k/t over the past 6 months and vs. USD2.5k/t in 1H17, thanks to increasing supply, mainly from New Zealand and the EU. In the latter’s case, this is most likely on the April 2015 decision to remove a 30-year milk production quota across the 28 member states, which FAO expects will continue to drive SMP export supply. We upgrade our rating on Domty to Overweight from Neutral, as we turn more upbeat on the pace of margin recovery, and reiterate our Overweight call on Obour Land.

Rerating warranted on valuation gap to peers. We raise our 12M TP for Domty by 30% to EGP13.0/share, and for Obour Land by 26% to EGP29.0/share, factoring in better margins on lower raw material costs and a faster than previously expected pace of volume recovery. Domty and Obour Land trade on 2019e P/Es of 10.6x and 9.7x, respectively, well below the peer average of c18x. Domty offers higher growth compared to Obour Land, coming from a lower base, and more diversified product offering, while Obour Land’s edge remains its superb balance sheet and cash cycle.

Diversification is a theme being considered. We believe adding revenue sources is crucial for both players to sustain long-term growth, given conversion from loose to packaged cheese is fading (packaged cheese is 80% of the market). Focusing on growing exports is at the core of Domty’s strategy (7% of 9M17 sales), while Obour Land moves forward with its plans to penetrate the juice and milk markets. Relieved competition between Juhayna and Almarai (48% combined market share) should offer room for Domty to recover its juice segment margins. We see non-cheese channels generating sales of 14% for Domty and 12% for Obour Land by 2019.

Irrational competition is a key risk. Juhayna, in partnership with Arla, launched ‘Puck’ packaged cheese in 4Q17, offering a premium product to the market, but pricing it at a slight discount, effectively aligning it with Domty and Obour Land’s products, aiming for market share gains. Our forecasts for both stocks factor in gradual loss of market share, but a further downside risk would be any irrational behaviour on pricing and, by extension, margins. The drop in volumes and margins seen in Domty’s fighter brands during 2017 is a case in point.