Milking Value Out of the Dairy Industry
Got milk? We’ve all heard the ubiquitous tagline, but many aren’t aware that for the past few years the world’s answer has been, “Too much.” A significant glut of milk, created by increased supply and temporarily reduced demand, drove milk prices down approximately 60% from early 2014 to early 2016. This led to dramatically reduced spending by both dairy farmers and the processors who convert raw milk in to various consumer products such as yogurt and dried milk powder. This reduction in spending naturally resulted in an extremely tough environment for companies that manufacture the pumps, valves, and even robots used by the dairy industry. While it has not yet completely emerged from the downturn, the selloff in dairy industry stocks has created an opportunity for value investors with a long-term time horizon, like Diamond Hill, to find attractive investment opportunities offering significant upside potential.
Dairy Boom and Bust
The global dairy industry enjoyed five years of strong growth from 2009 to 2014 as emerging market consumers saw their incomes rise and increasingly adopted more Western-style diets. This growth was most dramatic in China, which imported massive quantities of dry milk powder and baby formula in the wake of a 2008 scandal in which 50,000 children were hospitalized when one of the largest Chinese dairy producers added melamine to its formula, significantly weakening consumer confidence in the local dairy industry. Chinese imports of whole milk powder increased from 177,000 metric tons in 2009 to 671,000 metric tons in 2014. By the end of the boom, dairy industry participants all over the world were investing heavily in milking robots and milk dehydrating machinery in order to meet what seemed to be an insatiable demand for dairy in China. This was especially true in Europe where farmers and processors invested aggressively ahead of the March 2015 repeal of the European Union’s dairy quota system, which had limited production for the past 30 years.
Unfortunately for the dairy industry, just as the increased supply was coming online, demand from China collapsed, with imports falling by 48% to 347,000 metric tons in 2015. By then, the Chinese had reportedly stockpiled more than 300,000 metric tons of milk powder. To make matters worse, Russia, which had historically been a very important market for the European dairy industry, banned agricultural imports from the EU in response to the sanctions imposed against them in response to their support for rebels in Ukraine. Furthermore, the severe decline in oil prices also hurt the price of milk because Middle Eastern countries were forced to cut back on milk imports as they struggled with lower oil revenue. All of these headwinds combined to cause global milk prices to fall by more than 60% between February 2014 and February 2016, as seen in the chart below.
International Farm Comparison Network Milk Price
However, a wise oilman once said that the cure for low prices is low prices, and while arguably that might not be as true as it used to be for oil, it is still true for the dairy industry. Farmers responded to the lower prices by reducing investment spending, cutting production, and culling herds. New Zealand, which is often called “the Saudi Arabia of milk,” culled 5% of its herd; The Netherlands, a top-five global exporter, culled 8%; and the EU created a program which payed 52,000 farmers to cut production. Many farmers went bankrupt and left the industry – over 1,200 dairy farms in the United States shut down in 2015. And while reliable information about the Chinese stockpile is hard to come by, their stash is likely to be significantly smaller at this point due to consumption and spoilage, as evidenced by the 8% rise in China’s whole milk powder imports in 2016. Milk prices have recovered somewhat from their dramatic decline and are now back above levels that farmers generally need to be profitable. While it will take some time for farmers and processors to regain confidence and repair their balance sheets, the higher dairy prices will eventually lead to renewed growth in dairy equipment sales.
Long-Term Industry Growth
The boom and bust phases that are common in cyclical industries often create compelling investment opportunities, but as long-term investors it’s important to be certain that the secular growth trend is still intact. We believe the long-term outlook for the dairy industry, and therefore its suppliers, is quite attractive. The growing middle class in emerging markets will continue to be an important growth driver as increased wealth leads to changing diets and, in particular, increased dairy consumption. Dairy consumption has proven to be highly correlated to GDP growth since it is not restricted by religion, unlike meat and alcohol consumption. Per-capita dairy consumption in China, India, and other emerging markets is still less than half that of developed countries, and is expected to continue to rise at roughly 4-6% per year for the foreseeable future.
While liquid milk consumption in developed markets has been falling, total dairy consumption has been increasing, albeit at a very slow rate, driven primarily by increased sales of yogurt. Per-capita yogurt consumption in the U.S. grew at a 6% rate from 2000 to 2014, and the market is expected to continue to grow as yogurt consumption in the U.S. is significantly lower than that of other developed countries. Furthermore, the dairy industry should continue its rapid pace of innovation, introducing different variations on existing products, such as Greek yogurt, as well as new flavors and innovative packaging. Both the increasing consumption and the increasing variety of products offered create a need for new dairy processing equipment.
While the dairy industry holds the potential for attractive long-term growth, the decline in prices and the resulting contraction in equipment spending caused the shares of companies that supply the dairy industry to drop dramatically. We believe this cyclical weakness, combined with some company-specific issues, has created a compelling opportunity to own shares of SPX Flow, Inc. (FLOW) and GEA Group (G1A-DE).
SPX Flow supplies a wide variety of flow control systems and components such as pumps, valves, and mixers used to process various types of fluids and powders for the food and beverage industry as well as industrial and energy end markets. The company earns roughly 37% of its revenue from the food and beverage industry, primarily dairy products and non-dairy substitutes. Sales of non-dairy substitutes such as soy milk are growing even more rapidly than dairy products due to the increasing prevalence of lactose intolerance. SPX Flow was poorly run for many years under its prior management, creating a bloated cost structure which a new, more operationally focused CEO has already made great strides in improving.
GEA Group is a German manufacturer of equipment and systems for food and beverage producers, dairy farmers, and the pharmaceutical and chemical industries. GEA is a leading provider of milk drying equipment and milking robots, and generates roughly 37% of its revenue from the dairy industry. GEA underwent a badly needed restructuring too quickly, hurting lines of communication within the company and creating temporary inefficiencies; however, management is correcting its mistakes and should have significant room to cut costs and improve margins once the company’s highly profitable dairy business improves.
With these firms successfully working through their company-specific issues, both are emerging as leaner, more efficient equipment suppliers in excellent positions to benefit from the long-term growth opportunity presented by the dairy industry. When investing in a cyclical industry, it is important to take a long-term view and not be distracted by near-term headwinds that inevitably occur from time to time. When that weakness occurs in an industry that is enjoying a long-term growth trend, like dairy, it can create attractive investment opportunities for patient value investors.
As of May 31, 2017, Diamond Hill owned shares of FLOW and G1A-DE.
Originally published on June 20, 2017.
The views expressed are those of the research analyst as of June 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.