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Morningstar | Saputo's Profits Sour in Face of Mounting Cost Pressures

As one of the largest global dairy processors, Saputo benefits from an attractive cost position formed by substantial economies of scale, in our view. This cost advantage underpins our belief the firm has a narrow economic moat, allowing it to generate solid economic profits over the past decade, with adjusted returns on invested capital averaging 14%--well above our 8% cost of capital estimate--over this time frame. This is despite volatile raw material costs--which contribute up to 85% of its production costs--and price-sensitive dairy consumers. We see little to suggest Saputo will amass pricing power over the long term, given limited differentiation in the dairy aisle (we estimate private-label fare accounts for above 40% of milk sales in developed markets). However, we think the firm’s cost-savings initiatives, which target above CAD 20 million in annual savings, or 2% of operating income, and operating cost leverage should help insulate its returns on invested capital from short-term fluctuations in commodity prices.Saputo’s leading position and economies of scale in Canada (where it accounts for roughly one third of cheese and fluid milk/cream production) have been protected by regulatory measures that allocate a certain quota of fluid milk to each of the nation’s three largest processors, a dynamic we think has modestly supported its historical returns. In the United States, where dairy processing remains fragmented (Saputo produces 9% of cheese), we surmise the firm still benefits from a cost edge. We posit the firm has been able to consolidate its manufacturing facilities and acquire regional players to maximize its capacity utilization, which we estimate was 88% in fiscal 2019. This has helped mitigate the effect of unfavorable commodity prices on its operating margin (averaging nearly 9% over the past five years, just 80 basis points below its Canadian business). Saputo has acquired over 30 companies since 1997, and we expect its bent toward acquisitions to continue longer term, affording the firm opportunities to prop up its top line if faltering per capita dairy consumption were to further weigh on its organic growth prospects.