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Morningstar | WH Group - Bring Home the Bacon; Initiating Coverage With a Fair Value Estimate of HKD 8.10

We initiate coverage of WH Group, the world’s largest hog producer and meat processor, with a fair value estimate of HKD 8.10 and a narrow moat rating. We see the company’s share price retracement in 2018 and ongoing overhang on concerns over rising tariffs of U.S. pork imports into China as an opportunity to acquire shares at a relatively attractive level. Our narrow moat rating is primarily based on the group’s cost advantage in China, where its average processing plant utilization rate at over 60% is well above estimated industry average of 35% and it enjoys superior working capital efficiency.

WH Group’s earnings are composed mainly of packaged meat sales in China, via 73% owned Henan Shuanghui Investment & Development Co., or Shanghui, and the U.S., through wholly owned Smithfield Foods. Profit growth is expected to be driven by packaged meat sales, which is largely coming from China where rising wealth is leading to a growing interest in western-style raw packaged meats products such as bacon. Increased sales will help improve operating leverage, and the group has limited reinvestment needs leading to our forecast for free cash flow to grow at a five-year compounded annual growth rate of 24%.

2018 is likely to represent the trough in WH Group’s earnings in the fallout from the rising U.S.-China trade tensions, with hog futures prices suffering from reduced exports to China after the imposition of up to 71% import duties on U.S. pork. The drop in hog prices is reflected in lower fresh pork revenue and profit in the second and third quarters, which should send WH Group’s 2018 EPS down 17% year over year. However, we expect slightly better average hog prices in 2019 to help lift fresh pork profit, although this will probably remain below 2017 levels for our explicit five-year forecast period. The outbreak of African Swine Flu in China has lifted prices recently.