A2 Milk Company Limited (A2M) and Fonterra Co-operative Group Limited (NZ:FCG), two major dairy producers, showed reasonably good earnings reports today, however, failed to provide clarity over the potential impact of the coronavirus…
To shed light on the possible effect of the coronavirus, I thought it was essential to look at the results posted in contrast of best- and worst-case scenarios currently being formulated by global dairy analysts.
The results
A2 Milk Company Limited (A2M) reported a 21% increase in first-half net profit, on the back of strong growth in the US and China, a 31.6% increase in total revenue to $NZ806.7 million and a 20.5% advance in earnings before interest, tax and amortization (EBITDA) while net profit after tax (NPAT) rose to $184.9 million. Its China label infant formula saw sales double to $146.7 million as did its US milk revenue and in total the strong figures allowed A2M to provide a better-than-expected EBITDA margin of 32.6%.
A2M said it anticipated further strong revenue growth across its key regions; however, there was some uncertainty around the potential impact of coronavirus. As indicated in its report, it sees the current situation as “dynamic” and while a full-year EBITDA margin range of 29 to 30 per cent has been maintained they are “unable to accurately quantify the impact of the coronavirus for the full year”.
Similarly, Fonterra Co-operative Group Limited (NZ:FCG), New Zealand’s biggest dairy producer, showed that while it was able to maintain its underlying earnings guidance of between 15 and 25 cents (NZD), it reduced forecasts for milk solids from 1.53 billion to 1.515 billion kilograms.
While it kept the price of its farmgate milk price forecast range fixed at $7 to $7.60 per kg, the closure of restaurants and food outlets is having a “major” impact on the operations of foodservice customers. Chief executive, Miles Hurrell, indicated that the potential risks faced by the coronavirus are significant and, in an effort to manage the impact of the coronavirus, FCG has contracted a high percentage of its 2020 fiscal year milk supply.
FCG has already seen a slow-down in processing of containers at ports and since increased inflow management efforts to avoid congestion upon entry into China, where they are continuing to be cleared by customs and quarantine officials.
Despite the strong results of both producers, it appears markets are paying closer attention to commentary related to the outlook for 2020 and the impact of the coronavirus with independent reports indicating a potential slow down in Chinese dairy supply chains.
The global reality
The coronavirus outbreak has affected all areas of China’s economy, with halted transportation and labour shortages impacting manufacturing and trade on a national scale. Senior dairy analyst, Sandy Chen, said “while the impact on demand for dairy should be short term, the uncertainty over the actual duration of the impact and the lingering psychological impact could potentially bring meaningful damage to consumption, which then affects processing, production and import”.
So far, we have seen retail outlet closures and falling foot traffic at grocery stores have a material effect on sales figures that otherwise would have been strong during the beginning of the outbreak, as it fell around the Chinese New Year.
Looking at individual dairy products, premium liquid milk products, which typically see a spike in sales during that period, were severely impacted. Following on from these results, some forecasts showed that a 30-day period of coronavirus ‘impact’ features could reduce China’s liquid milk consumption by 2 to 4 per cent year-over-year, assuming part of the loss was made up in increased online sales. Similarly, Chinese cheese consumption could see imports reduce by 5% for the full calendar year.
Another issue that has occurred as a result of a tightening in road traffic control and a shortage in post-Chinese New Year labour, is that raw milk shipments and restocking from processors has been delayed and this is expected to impact small to medium-sized farms the most.
Prior to the outbreak, analysts had forecasted imports to drop by 3% in the first half of 2020 but to grow by 1% for the full year. In recent weeks, however, those figures have changed with full-year dairy demand now expected to drop by 1% and imports to drop by 11% potentially. A worst-case scenario currently is projecting that if demand were to drop by as much as 5%, it would lead to a 25% fall in imports in 2020.
Similarly, director of dairy market insight at INTL FC Stone, Nate Donnay, indicated that there could be a 3 to 10 per cent drop in Chinese dairy prices over the next 12 months and that the best-case scenario is that prices drop 4% for the year and are potentially 8% below current level in the early part of 2021.
Despite the gloomy outlook, North Asia region dairy volumes have not yet dropped significantly, and production remains reasonable in the EU and is expected to improve in the US. Dairy is a staple ingredient of most diets, and over the past 10 to 15 years, Asia’s consumption has climbed dramatically and currently represents 31% of global production. One only needs to visit Inner Mongolia, often seen as the “cradle” of China’s dairy industry, to understand why there are such significant import levels. Water and fertile land are scarce, and forage is imported from overseas. I say this to visualize the fact that, in the long run, unless dietary habits drastically shift, Asia’s dairy consumption should grow at a per-capita level. It is the competitive pressures that are not currently obvious. Much like oil, production is a key impactor on price and with the global dairy industry having only just recovered from a 5-year price slump, a 6 to 12 month falter in China’s consumption would drive prices lower as competition increases and producers seek to sell across other regions.
This article was written by Thomas Brunton – Senior Equity Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via [email protected] or by phoning +612 8302 3633.
