Dining out on a hot commodity

Food is replacing iron ore and coal as the boom commodity. The takeover battle for Warrnambool Cheese and Butter has heated up to the point where it is hard to see the bids making economic sense.

The four protagonists, or antagonists, depending upon how you see them - the Australian-listed dairy producer Bega Cheese, the Canadian firm Saputo, the dairy co-operative Murray Goulburn, and the Japanese-owned dairy, beer and wine group Kirin - have bid the Victorian dairy producer's stock up to more than $9 a share.

At this price, Warrnambool is priced at 12.5 times its cash-flow multiple (enterprise value divided by EBITDA) - and this is based on the pretty optimistic numbers its management issued for fiscal 2014.

Based on numbers from sector specialist Paul Jensz, of Phillip Capital, before the bid, it is trading on 15 times. The average multiple for the top 200 companies is 8.5 times. Referring to Bega's $9 bid, Jensz says: "At $9, you're pushing to break even, and you need to rely on the medium-term uplift in commodities prices and other things that Bega or Warrnambool can do outside of the box."

But when it comes to food stocks, valuation logic is often absent. This is what happens when arguably the world's most valuable resource is required in developing countries where supply isn't available.

The way we see it, industrialisation is producing for some food commodities a situation akin to iron ore and coal, where there is restricted supply. Consequently, Jensz believes there will be more frenzied buying of food companies.

"No matter how hard people have looked in the past 50 years, there is not much more arable land. Only so much of the forest can be burned down in the Amazon.

"I believe there is another big run to come. Another big issue with dairy is that there is a three to five-year cycle to get more dairy cows producing, whereas with iron ore, it might take two years to get a plant up and running," Jensz says.

Companies he likes in the "protein" space include almond producer Select Harvests, stock-feed supplier Ridley and Bega Cheese, which he admits is not cheap any more, trading on a PE multiple of more than 20 times compared with the average PE for industrials of 16.

There is a danger in paying up for stocks that are the flavour of the month, however. In late October this column wrote that Freedom Foods was way too expensive, trading at $3.36 a share, giving it a PE for fiscal 2015 of 34 times. The producer of allergen-free cereals and breakfast bars is definitely in the sweet spot of the food world, capitalising on the "gluten-free" trend, which has taken off in the US. But we argued that at 34 times many seemed to be forgetting that food-producing businesses are subject to big capital investment requirements and crop risks.

Fast forward three weeks and Freedom Foods is trading at about $2.90, which puts it on a FY15 PE of 29 times. Clearly some are getting the message.

Richard Hemming edits the fortnightly newsletter Under the Radar Report: Small Caps.

Flavours of the month