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Marketing Costs Confront Bega Cheese

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A setback to targets for FY18 put Bega Cheese ((BGA)) on the back foot at its first half result release, although brokers expect the strong position of most of the company's brands will help maintain momentum.

First half results may have been stronger than many expected, but full year guidance was weaker. The company is targeting underlying EBITDA (operating earnings) of $105-115m, below consensus expectations prior to the first half result.

Guidance incorporates all expenses relating to the integration of the Mondelez Grocery (now Bega Foods) business and the transition to the Bega brand from Kraft in the spreads business. This is expected to be more material in FY18-19 than many brokers previously allowed for.

UBS suggests the performance of Bega Cheese and Bega Foods is not as bad as it looks and upgrades to Buy from Neutral. The broker's target falls to $7.90 from $8.30. Brand positioning is now stronger and the broker suspects material legal costs which may have occurred have not been removed from normalised earnings.

Heightened competition for milk supply is mitigated by the company's 25% increase in milk intake, allowing Bega Cheese to choose supply without materially affecting estimates for earnings.

The acquisition of Murray Goulburn by Saputo also signals a more rational pricing environment for milk, UBS asserts, which supports a long-term earnings profile and dairy earnings margin expansion of 150 basis points by FY20.

The loss of the Coles ((WES)) private-label cheese contract and pressures on margins in consumer packaged goods affected the base business. However, the broker estimates that if the contribution from Bega Foods is excluded, the fall in related revenue in the first half was partly offset by the gain from the smaller Woolworths ((WOW)) contract.

Following the result, Bell Potter downgrades forecasts by -3% for FY18 and by -6% for FY19. Major changes include an uplift in milk intake, countered by higher milk costs.

Bega Foods

The Mondelez Grocery business acquisition is not expected to deliver its original FY18 earnings target until FY20. Segment reporting is under review and the newly labelled Bega Foods business is likely to report alongside other company branded products.

Morgans observes the division was impacted by “channel stuffing” from the vendors and an increase in competitive pressure, particularly in peanut butter, which then required significant marketing to maintain share. Consolidation of the acquisition is highly dependent on the returns of the peanut butter segment.

Yet the Bega Foods business is performing below the original investment case and will require a pulling forward of expenditure to stabilise market share.

UBS estimates the peanut butter business will contribute around $10m in earnings in FY20, or 7% of group earnings, after significant investment to protect the brand's position in major retailers. The broker's proprietary survey is highly supportive of the view that an informed Australian consumer would prefer Bega peanut butter over Kraft.

Given the company paid a large price for the acquisition – $452.7m – and it is underperforming, Morgans suggests an impairment to goodwill cannot be ruled out with the full year result. The broker has a Hold rating and $6.50 target.

The cost to transition and defend the market position of the Mondelez business is now front loaded and likely to extend beyond FY18 and Kraft also intends to re-launch in Australia. Hence, Bell Potter includes higher up-front brand investment costs for the business and, while retaining a Buy rating, lowers the target to $7.85 from $8.24.

Milk Supply

UBS estimates dairy intake can lift operating earnings by $16m, yet Morgans points out the dairy business is skewed to the first half and suspects earnings will be affected by reduced milk supply growth.

Bell Potter considers the drivers of earnings for FY18-20 will be the extent to which returns exceed movements in farm gate milk prices, as well as the extent to which the company can sustain its milk supply.

The company's nutritionals business has stabilised because of a more supportive regulatory environment in China. The company expects infant formula canning volumes to recover and has started to invest in additional capacity. For the first time, Bega Cheese has secured commercial volumes of domestic organic milk for use in infant formula.

Bell Potter also observes that the company has already secured shareholder approval for the issue of stock, effectively allowing it to take advantage should an acquisition opportunity emerge.

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