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Why this top broker has upgraded Inghams shares to ‘Buy’

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Goldman Sachs has upgraded Inghams Group Ltd (ASX: ING) to a ‘Buy’ rating with a 12-month price target of $4. Inghams shares are currently trading at $3.38. Goldman Sachs says Inghams has an attractive valuation with a pending earnings recovery in FY21. 

According to the brokerage, there is an increased likelihood of lower input costs for Inghams over the next 12 months. Earnings recovery will also be driven by management working through cost overruns and processing bottlenecks over the next year. 

Inghams operates in a stable duopoly in Australia and New Zealand and, according to Goldman Sachs, is trading at a 25% discount to its food and agriculture peers. Goldman Sachs expects new management to extract operating efficiency over time and believes this will become evident in second half earnings. 

Despite the ongoing drought in Eastern Australia, recent rains mean there is a better chance of a large winter grain crop which would lower Inghams’ input costs. Goldman Sachs estimates a 10% decline in feed costs would increase earnings per share by +4%. 

Capital expenditure is expected to be higher in the short term, however Goldman Sachs is confident Inghams can deliver a return above the weighted average cost of capital. New hatcheries will reduce bottlenecks as demand grows. 

Inghams has forecast second half earnings before interest, tax, depreciation and amortisation (EBITDA) to be above those of the first half and for FY21 to grow on FY20. For the first half, Inghams reported earnings in line with expectations with EBITDA of $91.7 million. 

Underlying net profit after tax declined 24.2% in the first half, resulting in a decline in earnings per share. The dividend was cut 19% in line with this drop, with a 7.3 cents per share dividend declared.

Key risks are centred on higher feed costs, which represent a significant proportion of Inghams costs.  An inability to negotiate high prices with key customers to offset higher costs is also a risk, with Inghams counting the large supermarkets as customers. Customer concentration remains a risk, as do adverse changes in the terms and conditions of contracts with major customers, which could include lower volumes or unfavourable price movements. 

Increases in competition and irrational market behaviour by key competitors could eat into margins, as could further operational issues and equipment efficiency. Biosecurity and food safety issues also represent a risk. 

Foolish takeaway 

Inghams has struggled with operational bottlenecks and inefficiencies, however Goldman Sachs is predicting these will improve. If so, earnings and profits should also rise. 

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Motley Fool contributor Kate O'Brien has no position in any of the stocks mentioned. 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 Scott Phillips.

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