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Morningstar | WH Group’s 2019 Recovery on Track; Shares Fairly Valued

Narrow-moat-rated WH Group’s 2018 result matches our expectation with revenue up 1% and earnings down 17%. The large drop in profit was due to weak U.S. hog prices following the retaliatory tariffs on U.S. pork imports by China. We tweak our 2019 forecast to incorporate slightly higher hog and pork prices but our fair value is unchanged at HKD 8.10 after raising capital expenditure. We expect net income to grow by 26% in 2019 driven by a rebound in the fresh pork segment and we forecast five-year CAGR of 6.8%.

The packaged meat segment remains the key to our valuation of WH Group and it was good to see that it weathered the lower pork prices and African Swine Fever, or ASF, relatively well as expected with fourth-quarter operating income down slightly by 4.2% year over year leaving full-year segment growth at 7.8%. However, we expect flat earnings in 2019 due to increased raw material cost. In China, the company has stocked up six months of frozen meat. That should partially offset the current rise in hog prices. In addition, the sales price was raised by 2 or 3% for one third of the products last year-end. As such, we expect stable operating margin for this segment in China. However, we think Smithfield would still be slightly impacted by the higher pork costs, which should be offset by the rebound in its fresh pork segment.

The group’s geographical diversity helped its fresh pork business in 2018 with strong China performance mitigating a dive in U.S. contribution. Also positive and supporting our assumptions is that U.S. fresh pork profits are recovering with the rebound in hog prices after the initial knee-jerk reaction to the imposition of tariffs by China on U.S. pork imports. Our base case already factors in a rollback to the China tariffs on imported U.S. pork. While we see fresh pork operating margin improving to 7% for Smithfield, we think this will be partly offset by more normal margins at its China’s operations on higher hog costs.

China segment fresh pork operating profit jumped 74% year over year in 2018, as the company benefited from arbitrage opportunities across the country and increased utilization rate at its abattoirs. We think this demonstrates the company’s strong competitive position in China with nationwide slaughtering facilities and an extensive cold-chain logistics network which makes it possible to take advantage of the dislocation of regional supply and demand.

Based on industry estimate, current total inventory of live hogs in China is 20% lower than that of last year because of ASF. Due to severe undersupply, hog prices have rocketed up 30% in the first quarter of 2019 and we think the rally will continue into next year. We believe the wider price differential between the U.S. and China will encourage imports from the U.S. even if the tariffs remain in place. USDA data shows that 23,800 tonnes of pork was exported to China in the second week of March, making up almost half of total U.S. pork exports in the same period. We expect China’s pork imports from the U.S. to surge sharply if a trade agreement is reached that brings tariffs back to 12% and it is apparent that both sides want a deal. We think WH Group will be the main beneficiary of any uptick in exports to China as Smithfield makes up over 75% of total U.S. pork exports to China.