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Morningstar | Ingham's Cost-Cutting Initiatives Offset Higher Feed and Energy Prices During Fiscal 2018. See Updated Analyst Note from 22 Aug 2018

Ingham's reported a relatively strong fiscal 2018 result, with underlying net profit after tax, or NPAT, up 10% to AUD 113 million, albeit in line with our expectations. The main driver of the earnings improvement was cost savings through Project Accelerate, which offset rising feed and utility costs, modestly higher Australian poultry volume (up 1.6%), an estimated 3% decline in the average selling price, and oversupply in the New Zealand market. On a more positive note, the balance sheet strengthened considerably, reflecting divestment of noncore assets and strong cash conversion. The board declared a final dividend of AUD 11.6 cents per share, taking the total for fiscal 2018 to AUD 21.1 cents per share (fully franked), equivalent to around 70% of underlying EPS. We maintain our AUD 3.50 per share fair value estimate and our no-moat rating.

The higher feed prices, owing to the drought in Australia, and rising energy prices are likely to remain headwinds in the near term. During fiscal 2018, the company offset this through operational improvements, and more recently with price increases. While Australian revenue was fairly flat, EBITDA grew by 10%, mainly reflecting the cost-cutting initiatives. While the higher feed prices are also likely to affect the production cost for other proteins, we don’t expect a rapid shift in consumer preference towards chicken. During the past 25 years, poultry consumption per capita has increased by 2% per year on average, despite the chicken feed conversion ratio falling by an estimated 30-40% (cumulatively) to approximately one fifth of the cost to produce the more expensive proteins beef and lamb. As poultry currently costs only a fraction of the other proteins, this cyclical spike in feed costs is unlikely to stimulate a acceleration of the shift to poultry. In any case, we expect feed prices will fall as rainfall eventually reverts to more normalised levels.

We expect core poultry volume (excluding ingredients) to continue growing on a per capita basis, owing to chicken’s attractive price relative to other proteins, albeit at a modest pace of around 1%-2% per year. Core poultry volume grew by around 3% in across both Australia and New Zealand, although this was offset by a decline in average selling price, which drove total poultry revenue down 1%. In our opinion this pricing pressure is a reflection of the major supermarkets' bargaining power, along with the intense competitive environment, both of which prevent the company from earning a narrow economic moat rating.

We project group EBITDA margins to expand by around 150 basis points from fiscal 2018 levels to just over 10% by fiscal 2021, supported by the ongoing cost-cutting initiatives. The group’s underlying EBITDA margin grew by 60 basis points during the year, reflecting benefits from Project Accelerate, driving automation, labour productivity, and network rationalisation.

New Zealand remains challenging, and the oversupply that hit poultry prices in the second half is likely to linger for at least the first half of fiscal 2019. Revenue and EBITDA grew by a modest 2% amid excess price competition, which the company was unable to fully offset through operational efficiencies. The silver lining is that feed volumes grew by over 10% on the back of improved demand for dairy feed and strengthening milk prices. The weakness in New Zealand, contributing only around 17% of group EBITDA, was offset by the 10% EBITDA growth generated in Australia.

The balance sheet improved considerably during fiscal 2018, as net debt fell to 0.7 times EBITDA, down from 1.5 in the prior year. This is driven by a combination of the sale of noncore assets, which liberated around AUD 68 million, along with extremely strong operating cash conversion that exceeded 120%, compared with around 100% in the prior year. This cash conversion improvement reflected improved working-capital management This level is unsustainably high, and likely to remain at around 100% on average. In light of the improved balance sheet, the board has approved a capital return of AUD 125 million, equivalent to AUD 33 cents per share, although this is subject to approval from the Australian Taxation Office. The board also plans to commence an on-market buyback of up to 5% of issued capital. If both of these capital management initiatives were to proceed during fiscal 2019, net debt would increase to around 1 times EBITDA (from 0.5). Adjusted for lease commitments, net debt would increase to around 3 times (from 2.5). These debt metrics are within tolerable levels, given the relatively stable demand for poultry.