Can Bega Cheese Ltd shares grow with the baby formula boom?

Credit: Steel Wool

As a result of the shares of Bega Cheese Ltd (ASX: BGA) being up by over 42% in the last 12 months, the company is trading on a much higher than average multiple of earnings. I feel this may have investors questioning whether the shares have become overvalued and are at risk of declines now.

The shares have risen in part on the back of infant formula. Many readers will have no doubt noticed near-empty shelves at their local Woolworths Limited (ASX: WOW) stores in the baby aisle, where demand for infant formula coming from mainland China has been rampant.

The demand stems from a terrible incident in China in 2008 where contaminated milk caused the deaths of six infants and the hospitalisation of 54,000. Since this incident there has been a noticeable and understandable distrust of Chinese manufactured milk from consumers. The middle-class in China has risen rapidly in recent years, and its rising income levels support the purchasing of products like infant formula from trusted manufacturers overseas.

As well as infant formula, China has been developing a taste for non-traditional foods in recent years ranging from cakes to cheese. So much so Euromonitor International expects the China cheese market to have been worth US$547 million in 2015, after growing by 23 percent year over year.

This rapid growth looks set to continue in the coming years which will be music to the ears of Bega Cheese’s management. At present Bega Cheese is pulling in approximately $100 million of revenue from the South East Asia region, which I believe has the potential to grow at a high rate in the future.

In respect to infant formula, the company’s Tartura business has agreements with Bellamy’s Australia Ltd (ASX: BAL) and Blackmores Limited (ASX: BKL) to supply them with its infant formula product. This is a great way for Bega Cheese to piggyback on the incredible infant formula demand and should provide the company with growing revenue streams for many years to come.

Bega Cheese does trade on a high forward price-to-earnings ratio of almost 38. Compared to the consumer staples industry, which trades on an average forward price-to-earnings ratio of 20, this is incredibly high, but of course its growth prospects far outweigh many of its industry counterparts and the broader market as a whole.

On a price-to-sales basis the shares do look comparatively cheaper than the market. The shares are trading on a price-to-sales ratio of 0.98, compared to the market average of 3.3.

If the demand from China does not continue then there is a danger that the market will react negatively and this could lead to a major share price decline.

At present the demand from China does look to be very solid, but it is worth noting that the Chinese government is not a big fan of infant formula. It has set targets to raise the exclusive breastfeeding rate to 50 percent by 2020 from under a third today. The early signs haven’t been too positive for the government though with exclusive breastfeeding rates sliding. But should the Chinese government make a success of it then demand for infant formula could subside somewhat.

Foolish takeaway

Bega Cheese and the numerous public companies exposed to the incredible infant formula demand are trading at increasingly higher multiples at present. If earnings growth continues at the strong levels we are witnessing today then this will not be a problem and I see share price gains ahead. However, should it steady or slow then investors could get caught short and significant share price declines could happen very quickly.

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Motley Fool contributor James Mickleboro has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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