Dairy Crest (DCG)

Under Pressure

In my last post I took a look back at some of Dairy Crest's long operating history (long by this blog's usual standards, anyway!) in the hope of finding a company with a record of long term profitability and strong cashflow. I think it's safe to say I more or less found that, with Dairy Crest reporting long-term consistency if not particularly exciting growth. One correction I should make, though, is in the table to the right. In the first post I incorrectly reported the price to tangible book as 1.18; the price to tangible book is actually negative, as the group's debts outweigh its tangible assets. The figure of 1.18 is the group's price to book value, which includes a large amount of goodwill and intangibles for a few of their brands. Since I use price-to-book value as a measure of an investor's margin of safety in assets and then seek to apply a valuation to the operations of the business myself, it'd be foolish to keep these figures in.

Anyway, in the time between last post and this, I sought to dig up more about why the business was so cheap and whether the market was mispricing it. A slap on the forehead for the above, but that is the first and most obvious answer; the group's debt burden, which I had just glanced at in the first instance, is worse than I had thought. Matching off lines against each other, we find that the group's current assets and current liabilities roughly net off to zero. The same is true of the company's long-term borrowings and what I like to think of as their 'long-term fixed assets' - property, plant and equipment. The problem arises, then, from the fact that the company has deferred tax liabilities of £41.3m (taking away the tax on goodwill, reasonable since I've deducted goodwill from the balance sheet anyway) and a pension pot in deficit by £60.1m.

Consider that problem number one, then; £86m of future cash flow must go to pay off debt simply for the company to have a tangible value of 0. That said, it's a rather arbitrary measure, and perhaps only really relevant if we see the company liquidating soon. After all, everyone knows the real value in any business - at least, any business which has a reasonable future - is in the actual operations. It's the value they add by being efficient, providing customers with what they need and adding value by branding.

The pension scheme is a more immediate thorn as the management are making cash contributions into it to close the valuation gap and, while it may help the situation, it's money that either could've been returned to shareholders or reinvested in the business. I don't think anyone really likes seeing these onerous, open-ended liabilities on company books; they sway around with the markets and can have a marked impact on the value of the entire company, so it's just another complicating factor. The accounting is also rather tedious and sensitive - one of the most worrying factors is always where there is a rundown of how the scheme's liabilities would change if the underlying assumptions in the model were changed.  A change in inflation of 0.1%, for instance, would increase the scheme's liabilities by approximately £11m - and, as a private investor, I have no particularly strong opinion whether inflation will be 2.8% (as their assumptions use) or 2.9% in the future. In fact, I don't suppose many people really have that much of a clue beyond 'it'll be somewhere around 2-3%'. That long-winded explanation aside, the result is that it's prudent for me to demand even more obvious value elsewhere if I'm to invest.

Most obviously, that value could come from the valuation of the business in earnings terms - the two figures on the top left of my table above. It does indeed look very cheap on that basis, and the company has a pretty good record of converting those accounting profits into cash. With the seemingly neverending pinch on consumer budgets, though, the market isn't looking too favourably on the prospects for Dairy Crest. They are, in many sense, caught between a rock and a hard place; the rock being the might of the supermarkets and the hard place their suppliers, the milk producers, who hardly enjoy sports car lifestyles themselves.

Thanks to Calum who commented on last post and whose piece on Dairy Crest back in last July sparked off a few thoughts and ideas. Above left shows a chart (data source: dairyco.net) with average yearly farmgate prices; the prices paid to farmers, per litre, for their milk. Interesting, basically, because it shows far larger swings than certainly I would have imagined if I had been asked about the market. They currently sit at a 15 year high, which chimes with Dairy Crest's line of 'paying more to their suppliers'. This is the hard place, though, and the flip side of the coin which DC's margins have to contend with. At least on a basic level, though, farmgate prices are up (as well as a measure of farmers' margins I saw) significantly from 2007 when the wider public interest about the fortunes of farmers erupted. Perhaps these levels are more sustainable in the long term.

The graph to the right shows statistics pulled from annual reports - Dairy Crest's 'net' capital expenditure, if you'll call it that. It's different from the net capex you might see in a cash flow statement, though, in that it basically aims to eliminate maintenance capex in the long term and simply look at how much money Dairy Crest have been putting in over and above what's needed to maintain current equipment by taking out the impact of depreciation. Theoretically, over a long enough time period, depreciation should match capital expenditure if the company is simply maintaining its capital stock. What's immediately obvious is the spike in 2011 - as Dairy Crest continue their £25m per year program aimed at improving margins and efficiencies in the dairies business. Still, barring a capex program probably brought about by the bad consumer environment of a recession - tough times tend to focus the mind, and all - net remained relatively stable for a long period of time, with capex about matching depreciation. This should mean cash flow is similar to accounting profits, if this trend continues after what we could call their £75m 'exceptional' plan to rejuvenate milk's margins.

Since I've already passed the word limit I've set myself to keep posts relatively brief (I wish!), I'll wrap up with bullet points. I like the company, so it gets added to Marston's for the potentials list if I sell one of my existing shares:

Pros:

Strong, long-standing brands enjoying good margins.
Milk margins are squeezed. Upside if margins are mean reverting.
Cash flow is potentially strong, and dividend signals commitment to shareholders.

Cons:

Running to stand still? Extremely competitive sector, in which Dairy Crest have been accused of under-investing.
Open ended liability - pension scheme!
Consumer facing, with all the implications in the current environment.