How to milk the rise in dairy prices

It's going to make your Dairy Milk and your Domino's pizza more expensive, but the rising cost of milk is also creating great investment opportunities. John Stepek looks at the likely winners.

BAD news for chocoholics: servicing your habit looks set to become a lot more expensive and it's all down to the soaring cost of milk.

Cadbury Schweppes (CBRY) announced this week that rising milk prices were behind a slump in its pretax profits for the first six months of this year.

Cadbury is not the only company to suffer. US chocolate giant Hershey warned earlier this year that rising dairy costs would hit profit growth, while rising cheese prices are hurting companies like Domino's Pizza.

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It's no surprise they are feeling the squeeze. Since February, the benchmark skimmed-milk powder price has risen by a staggering 60%. This year is likely to see the highest average dairy prices on record.

Even the European Commission has ended subsidies on milk-product exports for now, because rising prices mean they simply aren't needed anymore.

So why has milk suddenly become such a scarce resource? Well, at a local level, the floods haven't helped. Over the past couple of months, farmers have had to keep their herds indoors and feed them silage, rather than grass, which has seen their yields slip from about 20 litres a cow to around 17 to 18 litres.

Already one distributor First Milk has warned it won't be able to fulfil orders to customers this month due to a shortfall in supply.

If it was just a matter of the damaging but ultimately short-term impact of the floods, then that wouldn't be such a problem. But it's not just the British weather. A catastrophic drought in Australia has battered the country's milk production. Meanwhile, in New Zealand, the property boom has put so much pressure on land prices that dairy farmers are finding it hard to expand.

In the UK, the sorry conditions dairy farmers have worked under in recent years have taken their toll on our own milk supplies. According to the Royal Association of British Dairy Farmers, last year milk prices averaged 18p a litre, but the cost of production was about 20.5p. With figures like that, it's no surprise to learn that while the UK had 28,000 dairy farmers in 1995, more than half had left the business by 2006, and many more plan to leave within the next two years, according to the Milk Development Council.

So supply is being squeezed, but at the same time demand is rocketing.

Developing countries and particularly China are seeing a boom in demand for dairy products. China's government has started sponsoring school milk programmes, in a country where dairy consumption is not traditional. President Wen Jiabao has said he wants to provide every person with half a litre of milk a day.

Mark Voorbergen, dairy analyst for Rabobank, the world's biggest agricultural lender, reckons that demand in the country will grow by 15% annually for the next three years.

In other words, the situation with milk is no different to the story behind the oil and commodities boom. A long period of low prices has led to a lack of investment, which has meant that when demand from a massive, new market China, essentially picks up, prices jump sharply.

So who's benefiting? Well it's certainly not bad news for dairy farmers some milk processors are paying bonuses to farmers to encourage them to produce more.

But there are plenty of reasons for farmers to hold off celebrating for the moment. Farming costs are also rising tractors don't run on air, and maintaining a dairy herd is becoming increasingly expensive. Corn prices have also surged by around 60% in the past year, which has raised the cost of feeding a herd.

A better bet for investors is the milk-processing sector. These companies buy the milk from the farmers, then turn it into an increasingly wide range of products.

They might have to pay farmers more for their milk, but as supplies tighten amid rising demand from Asia, they should also be able to charge the super-markets more.

They are also benefiting from the ever-increasing popularity of higher-margin products such as organic brands, and milks "enhanced" with omega three fatty acids.

One processor that looks particularly interesting is Dairy Crest (DCG) the UK's largest branded dairy-foods company, which has the biggest share of the butter and spreads market.

Dairy Crest negotiated higher payments from retailers this spring, and it also sells raw ingredients, such as skimmed-milk powder, which should continue to rise in price.

On top of this, it's also the biggest "milkman" in the UK, with a 50% share of the home-delivery market. The group trades on a reasonable forward price/earnings ratio of 12.8, and pays a solid 3.2% dividend yield.

Another, more speculative, company that could also be worth looking at is Genus.

The group specialises in "bovine genetics" (though it has also expanded into other livestock recently).

As dairy farmers respond to demand and expand their herds, it can provide "breeding solutions" bull semen, basi-cally which will improve milk yields from their cattle.

The stock trades on a pricey-looking forward p/e ratio of 24, but it has a very dependable track record and is also a market leader in its field.

First published in The Sunday Times 5/8/07

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.