January 14, 2015

By Gerelyn Terzo

The investment opportunity for the global dairy industry has taken the spotlight of late amid an imbalance in the supply and demand dynamic that has shifted away from producers and investors. Nonetheless, yield-hungry institutional investors have not abandoned dairy, evidenced by the billions of dollars being committed to the sector in recent months.

Conditions in the dairy industry have formed a perfect storm of sorts, illustrated by plummeting international commodity prices, waning demand stemming from import nations such as China and Russia, and an oversupply in key export nations including the U.S. and Australia. This, in turn, has put the squeeze on the profit margins of producers, which has put pressure on investor returns. Deal activity, however, has kept apace.

Rabobank Global Market Strategist Tim Hunt points to a five-year time horizon for an asset class that typically generates double-digit returns. “It will be difficult to make a strong return on milk production and processing assets in 2015,” Hunt told Global AgInvesting. “Despite short-term reductions in return on capital, this is still an industry where medium-term fundamentals are promising,” he added.

Headwinds

Dairy prices in December took a nosedive from September levels, with milk powder prices falling by as much as 15%, according to Rabobank. The price for whole milk powder in particular was slashed more than in half in 2014 to $2,300 per ton from $5,000 per ton, according to the U.S. Department of Agriculture.

New Zealand coop Fonterra in December revised its projection for the farmgate milk price for the 2014/2015 season by nearly 33% from its original prediction amid “considerable volatility in the global dairy markets,” according to Fonterra Chairman John Wilson in a statement.

Last year’s more robust pricing inspired a wave of dairy production that led to today’s supply glut, which coupled with weakened demand has fueled uncertainty in the industry.

Meanwhile, although Russian demand isn’t expected to resurface any time soon amid a dairy import ban, China, which has reduced its purchases of imports over the last six-to-eight months, is up against a very high base, according to Hunt.

China’s dairy industry became fractured in recent years amid a series of health-related scandals that crippled production in the nation, causing them to take from the coffers of dairy-rich nations.

“Coming off of phenomenal levels, [China is] still by far the world’s biggest importer of dairy products,” Hunt said. “We’ve had a temporary reduction from phenomenal peaks. But they will still continue to buy huge amounts going forward.”

Deal Activity 

Indeed, there has been a flurry of investment activity in the global dairy industry despite the near-term uncertainty. US dairy coop powerhouse Dairy Farmers of America is partnering with China’s Yilli Group to develop a milk powder plant in Kansas. DFA told GlobalAg Investing the cost of the project has yet to be finalized, although published reports put the price tag at USD 100m.

Meanwhile, Australia’s Freedom Foods and its majority owner Perich Group partnered with China’s New Hope Group – a function of a recent Australia-China Free Trade Agreement – to invest in Aussie agriculture assets. And the AUD 3bln Beijing-Australia Agricultural Development Fund, which is a product of the Chinese state owned Beijing Agricultural Investment Fund and Australia’s Yuhu, will include Australian dairy among its investments.

It’s not just the usual suspects participating in the global deals. “External capital is coming in at a greater rate,” said Hunt, adding that this includes private equity. “The scale of the opportunity is outpacing the ability of dairy farmers and coops to keep up with the capital requirements,” said Hunt.

Investment activity is being driven by a series of factors, not the least of which includes paltry yields in the debt capital markets and rising dairy consumption patterns originating from emerging markets in Northern Africa, the Middle East and Southeast Asia. These regions will help to fill the import gap left by China and Russia.

There are social factors at play, too. “In particular, supply security and supply integrity are very important in driving the investment in downstream dairy,” Hunt said.

And while the China-Australia FTA is a positive development for the Australian industry, somewhat at the expense of competitors, it’s not a deal breaker for investment in the U.S. dairy industry, according to Hunt.

This is especially the case given the regional challenges in Australia that are less present in the U.S. While climate issues present near-term challenges, Australia faces a host of other issues including a high cost of labor, water availability and environmental constraints on expansion, all of which threaten to dampen the pace of dairy production in the region, according to Hunt.

Conclusion

While it’s clearly not the best of times for dairy, it’s not the worst of times either. “The market will tighten up again and milk prices will return to where the right investments will make good returns,” surmised Hunt.