This article was first published in The Investor here.
Quantum Foods‘ unbundling from Pioneer Foods seem to have breathed life into the poultry producer as it bounces back to profitability on its debut half-year results. Though much of the improvement in profitability came from the easing up of market conditions.
In our review six months ago we issued a sell recommendation on Quantum shares. Since then its management has put measures to change the product mix by revising its broiler business. This included the sale of Hartebeespoort abattoir and remodelling of the of the Western Cape broiler operations which curbed the contribution of broiler operations to just a third of revenue from 35% in the comparable period. This coupled with lower raw material input costs has seen the group exceeding market expectations.
In the light of these developments and other supply chain and cost savings initiatives in the pipeline, we revise our recommendation from sell to hold.
We think the group is in a much better position but its prospects will largely depend on the market conditions.
Results for the first semester to end-March show revenue fell 3.7% to R1.67bn (1H14P: R1.7bn) largely due to the 15% decrease in revenue from the broiler division following the business model change. Headline earnings leaped 182% to 26.3c(1H14P:9.3c) on the back of margin expansion to 4.9% from around 1% the previous half.
The results are promising enough but our valuations are affected by our forecasts on the market outlook.
The Safex futures curve implies that domestic prices are likely to move sideways to upwards in the short to medium term. This is likely due to an expected slump in the domestic summer crop. According to the Crop Estimates Committee’s third production forecast for summer crops for 2015, the combined output for yellow maize and soybeans (major inputs in poultry feeds) is likely to be 19% lower than the final crop for 2014. While this paints a gloomy picture for chicken producers, prices are more likely to be capped at import parity prices given that international corn prices are expected to continue trending down.
The pricing power for local producers will more likely remain constrained given the prevalence of imports in the market. While the anti-dumping and the new tariff system might have helped in trying to level the playing field , it hasn’t done much to reduce the level of imports. Figures from the South African Poultry Association shows that SA imports increased to 393 000t (2013: 390 000t )
The sector is also bracing itself for an influx of duty free US chicken after the ending of the punitive duties on US chicken imports under the new agreement of the Africa Growth and Opportunity Act (AGOA). The deal will allow an initial 65 000t a year into SA.
Another risk comes from government proposal to cap brine levels in chicken pieces at 15% and at 10% for whole chickens. Brine is a preservative salt solution but producers inject excess brine to add weight in order to get higher selling prices. Industry margins will come under more pressure if brine levels are capped.
Quantum has an additional advantage of diversified revenue streams from its animal feeds and African businesses, which are doing reasonably well. Its operations in Zambia and Uganda, which are not exposed to the broiler meat business, show more promise.
From a valuation perspective, we think the counter is trading closer to its intrinsic value. Using our enterprise value: operating profit model we revise our 12-month target price to 378c/share with a forward PE of 7 times.
- Decrease in input costs of grains and other key inputs to improve margins
- New tariff regime eases pricing pressures from imports
- Continued rand weakness to increase landed price of imports
- Subdued consumer spending
- Regulatory uncertainty regarding brine levels
- The product mix with a bias towards broiler meat is vulnerable to the industry cycle
Nature of business: Quantum Foods is a primary agriculture business with three focus areas: animal feeds, eggs & layer livestock and broilers. It operates in SA, Zambia and Uganda.
Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view. For Intellidex’s full disclaimer, methodologies and definitions please click here.