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Morningstar | Inghams Manages to Defend Margins Despite the Higher Feed Prices, FVE Unchanged

No-moat-rated Inghams reported a fiscal 2019 interim underlying NPAT of AUD 55 million, a 5% decline on the previous corresponding period, or pcp. However, this decline was primarily a function of a higher effective tax rate (increased to 29.5% following changes in New Zealand tax legislation), whereas revenue and EBITDA grew by 3% and 4%, respectively. At the current pace, the firm is tracking towards our AUD 111 million full-year NPAT estimate. The board declared an interim fully franked dividend of AUD 9 cents per share, down 5% on the pcp, albeit in line with the target 70% payout ratio which we expect the firm to maintain for the full year.

While demand for poultry remains strong, the elevated feed cost is likely to remain for at least the next 12 months. Additionally, the New Zealand outlook remains challenging, and we aren’t forecasting a material improvement in performance in the second half of fiscal 2019. We’ve trimmed our earnings estimates by around 3% on average during the next three years, reflecting the slightly higher tax rate, ongoing oversupply in New Zealand and slightly lower margins while feed prices remain elevated. However, our long-term projections are broadly unchanged, as is our AUD 3.50 per share fair value estimate, which sees the stock overvalued at the current price. Our long-term expectation for margins is primarily where we differ from the market, and while we expect the firm to capture some efficiency gains through its transformation project, a portion of these will be eroded through competition and pressure from the powerful supermarket customers.

Poultry volume remains healthy, growing by 3% (slightly higher at 4% in Australia) on the pcp, despite the higher selling prices, broadly in line with our expectations. We expect volume growth to moderate in the near term as the higher prices impact demand. This was demonstrated in this period where the BBQ bird price was raised by AUD 1 to AUD 10, which management indicated contributed to a single-digit decline in demand, showing the lack of pricing power. In any case, we continue to project low-single-digit volume growth on average over the long term, supported by around 1%-2% per year in population growth, and incremental increases in consumption on a per capita basis.

We forecast underlying EBITDA margins to increase by almost 100 basis points to 10% by fiscal 2022, as the firm realises the benefits of "Project Accelerate" which is targeting cost savings through increased automation, network and capacity improvements, consolidation, and improved efficiency. However, in the longer term, we believe these margin gains and excess returns on capital are unsustainable and will be eroded. In the near term, the higher feed and energy prices are a headwind for margins, although the company did a good job of offsetting this through cost-cutting initiatives and price increases (currently around 60% of poultry volume are covered by pass-through mechanisms). This helped grow the domestic EBITDA margin by 70 basis points to 9%, however this was offset by weakness in New Zealand which held the group EBITDA margin flat at 8.8%.

We expect the oversupply of poultry in New Zealand to linger and continue to weigh on performance in the near to medium term. During the first half, this dynamic hurt poultry demand which fell by 1%, especially in the retail and wholesale markets. The challenging competitive environment has also been a major headwind for pricing, which along with operating deleverage saw New Zealand’s underlying EBITDA margin fall by over 400 basis points to just over 7%--a disappointing outcome.

The balance sheet remains in reasonable health despite a AUD 89 million increase in net debt, which now represents 1.1 times underlying EBITDA, compared with 0.7 times at the end of fiscal 2018. We are comfortable with these metrics given the stable demand for poultry. We expect net debt to fall below 1 times EBITDA within the coming years as the firm’s capital expenditure program nears completion.