Coles has acquired two automated milk processing facilities for $105m that currently supply COL with its own-brand milk.
The facilities are located at Laverton North (VIC) and Erskine Park (NSW) close to COL’s distribution centres. Each facility has capacity to process around 225m litres a year, mostly for COL’s 2L and 3L milk requirements. The milk is supplied by about 90 dairy farmers on a direct-sourcing agreement with COL since 2019.
The deal is subject to ACCC approval.
Investment View
The size of this deal is not material to COL, but the concept is a step down the supply chain that, on its own, makes sense. COL pointed out that it already has other in-house manufacturing capabilities in meat and poultry and its ready-made meals facility. But this deal has a different flavour.
COL will need to convince the ACCC it will not impact the farmgate prices paid to source the milk supply it will need to optimise the production of the processing facilities. We think the ACCC will wave this through as it is not in COL’s interest to pay farmers less when they could potentially supply other processors. Indeed, COL may wish to secure more milk supply if it wants to expand production into higher value products. Branded milk enjoys a 70% price premium in supermarket sales of which branded represents 42% of sales by volume.
COL will still be feeling the warmth of inflation boosting prices and sales, offsetting any volume weakness from pressured consumers. Higher gross margins were a feature of the interim result in February. We expect comparable store sales growth to remain elevated in 2H23 but will eventually fade as inflation does.
Australian Dairy Industry
The Australian dairy industry has been gradually changing since it was deregulated in 1999-2000 with consolidation a key theme for many years. Herd sizes have increased (average now 303 cows) while the number of farms has shrunk (12,896 in 2000, 4,420 in 2022). Production of farmgate milk has declined (10.8m litres in 2000, 8.5m litres in 2022) although this is partly a function of changing consumption habits. The average Australian Holstein cow produces just over 6,200 litres of milk per season. Good girl, Daisy. Per capita consumption of milk in 2022 was 93 litres, cheese 15kg and yoghurt 9.6kg.
When Australia was in the grip of severe drought a few years ago, supermarkets were accused of hurting farmers through the ‘$1 a litre’ milk period. In reality, it was the intermediate milk processing companies (Saputo, Fonterra and others) that were responsible for paying unfair farmgate milk prices through onerous contracts with farmers. This situation has since been remedied by the 2020 Dairy Code of Conduct forcing minimum farmgate prices to be set by 1 June each year. Now, farmers are receiving much improved farmgate milk prices of $7.52 per kg of milk solids in 2022 (56.9c/l) compared to $5.45/kg milk solids in 2017 (40.9c/l). Victorian farmers, representing two-thirds of Australian milk production, had an operating surplus of $2.71 per kg of milk solids, double the level from 2016.
The ACCC last investigated the dairy industry in 2018 when it found the milk processors to be the culprits of a lopsided relationship with farmers. Farmers were generally getting between 40-60c/l of revenue on branded and private label milk, while the processors were getting more. The supermarkets were barely making anything on private label milk while branded milk was making as much as the farmers (see Figure 1). The ACCC concluded that supermarket pricing ($1/litre milk) had no influence on farmgate milk prices. But it did find that supermarkets leveraged their buying power to reduce the profit margins of the processors and then mostly passed the gains through to customers.
In 2022, supermarket milk sales totalled 1.42m litres with an average price per litre of $2.36 for branded milk and $1.36 for private label.
Risks to Investment View
Inflation is highly topical at the moment, but it is likely benefitting COL. Most households have plenty of savings but may begin to cut back on volumes if price increases get too sharp.
Recommendation
We have retained our Buy recommendation.
Figure 1: Distribution of milk revenue
Figure 2: Supermarket private label milk contracts
