This article first appeared in The Edge Financial Daily, on May 9, 2016.

KUALA LUMPUR: The depressed milk prices may not be good news for farmers but it is a blessing for food and beverages (F&B) companies with products that have milk as the key ingredient.

Lower milk prices will translate into better margins, and hence better earnings for dairy product manufacturers.

According to reports, global dairy prices have fallen around 60% since early 2014, mainly due to weaker demand from China after it stockpiled milk powder. The slower global economic growth has also weighed on the demand for milk.

Often seen as the darlings of investors seeking defensive investment in a turbulent stock market, Bursa Malaysia-listed F&B counters have been trending upwards since the beginning of the year. Year-to-date, Fraser & Neave Holdings Bhd (F&N) has risen 22.6%, Dutch Lady Milk Industries Bhd is up 13.27% and Nestle (M) Bhd has gained 2.13%.

However, the weak ringgit and soft consumer spending would also mitigate some of the cost savings from the lower milk price as this would mean higher cost of importing the raw material. Interestingly, analysts and fund manager are not too concerned about that. 

KAF Investment Funds Bhd chief investment officer Gan Kong Yik, who closely monitors essential consumer stocks, said the prospects of these stocks remain bright as most of the products they sell are not luxury  goods, although consumer spending has slowed down.

He said dairy products companies enjoy better margins due to the lower milk prices.

“The price of milk has declined significantly but there is no change at all in the average selling price, if you notice,” he said.

Gan noted that most of the milk is imported from New Zealand. The country’s central bank has cut interest rates in March, triggering a slide in the New Zealand dollar. This, in turn, would mean cheaper dairy products from the country.

“These counters are evergreen and safe. During challenging times, some of the funds will usually have some allocation in these defensive stocks,” he noted.

“As long as they continue to report improving quarterly results, there will be rerating of the stocks,” he said, when asked if there is limited upside for these counters.

Among the three F&B counters, Gan preferred Dutch Lady as it gives better dividends and for the branding it has. Dutch Lady, which saw its net profit almost double to RM33.89 million in the first quarter ended March  31 (1QFY16) from RM17.03 million a year ago, mainly focuses on dairy products such as milk and yogurt.

Kenanga Research analyst Soong Wei Siang, who covers Dutch Lady and Nestle, said the weakening of the ringgit and the cautious consumer sentiment may not have strong impact on the two companies, looking at their earnings growth.

“Their gross margins are expanding, it shows that they are enjoying better margins,” he told The Edge Financial Daily via telephone.

As for the weakening of the ringgit, he noted that these companies usually hedge their foreign currency requirements.

“The current low milk price environment is benefiting them and there is still upside for the current share price,” he said, when asked if these counters have already priced in the lower input cost scenario.

Soong said Kenanga has given Dutch Lady and Nestle “outperform” calls and his target prices for the two counters are RM59.20 and RM82.10 respectively.

“At this juncture, there is no big issue regarding the supply of milk, but the demand for milk is not strong due to weaker global economic growth. Unless there is a strong recovery in global economic growth, the price of milk would not rebound too soon,” he added.

CIMB Research analyst Kristine Wong noticed that milk prices have declined by about 11% year-to-date and 30% year-on-year. She noted that F&N hedges a considerable portion of its US dollars on its committed raw material purchases.

“Thus, we believe that it will continue to reap the benefits of lower milk prices and that margins should remain stable even if the US dollar were to strengthen against the ringgit,” she wrote in a note dated May 5. 

The stock is currently trading at attractive valuations of 18 to 19 times FY16 to FY17 price-earnings ratio (PER), which is below its five-year historical mean PER of 22 times, and on the back of healthy three-year earnings compound annual growth rate of 18.6%. She maintained an “add” rating for F&N, with a higher target price of RM26.50.

In her note dated May 2, Wong said the management of Nestle was “positively surprised” by the lower commodity prices and expects the low price environment to continue until the fourth quarter of 2016, during which it projects the prices of coffee beans and milk powder, particularly, to slowly inch up.

She maintained a “hold” call for Nestle, as she believes the company is fairly valued, with an unchanged target price of RM74.94. Nestle closed 50 sen or 0.67% higher at RM75 last Friday. Within the consumer staples sector, Wong said she prefers F&N.

Based on last Friday’s closings, Dutch Lady, F&N and Nestle are trailing 12 months PER of 21.51 times, 21.29 times and 28.02 times respectively.