Barry Callebaut

Investors are far too downbeat about the effect of higher cocoa prices on the firm's top and bottom lines

Summary

Recommendation: Buy Barry Callebaut AG (SWX: BARN — SFr7bn) shares at SFr1,270

Thesis: Investors are far too downbeat about the effect of higher cocoa prices on the firm's top and bottom lines.

Valuation: Intrinsic value is closer to SFr1,900–2,100 per share, with a 58% upside.

Catalysts: The firm should release solid earnings in April, and a bumper cocoa bean harvest in the Côte d’Ivoire should trigger investors to re-rate the stock. Barring those, industry consolidation over the next year, as the firm takes market share through distressed acquisition or organically, will help the market change its mind.

Risks: The firm's top and bottom lines would fall if shipping routes seize up while the cocoa market remains tight and consumers reject chocolate for healthier alternatives. In addition, capital costs would rise as the business would become systematically riskier. In this worst-case scenario, the shares would fall to SFr862 for a 32% loss.

Company background

Industry: Food products

Description: Swiss-Belgian cocoa processor and chocolate maker. The firm produced 2.3m tonnes of cocoa and chocolate in 2023. The firm has 66 factories and 26 Chocolate Academy Centers worldwide. It’s the largest cocoa processor in the world.

Key products: Cocoa powder (54% of cocoa processed); Cocoa butter (46%)

Trailing 12-month financials: SFr8,471m of revenue; SFr1,349m gross profit; SFr826m EBITDA; SFr668m EBIT; SFr343m net income

Capitalisation: SFr6,952m market capitalisation (+) SFr1,797m debt (-) SFr516m cash and equivalents (=) SFr8,232m enterprise value

Enterprise multiples: 1x sales; 10x EBITDA; 12x EBIT; 18x FCFF

Operating segments: Food manufacturers (67% of sales volume); Cocoa products (21%); Gourmet and specialties (12%)

Geographic segments: Europe, Middle East, and Africa (45% of sales volume); Americas (27%); Asia Pacific (7%); Global cocoa (21%)

Investment thesis

Barry Callebaut shares have lagged the broader market for the past 18 months. Rapidly rising cocoa prices, a new boss, and a salmonella outbreak at one of the firm's factories in Belgium have put investors off. Uncertainty is high. The market reckons higher cocoa prices will pressure the firm's top and bottom lines by driving sales volumes down and squeezing margins. Investors have priced the chocolate maker's stock as though operating profit margins will contract from 8% to 5% over the next few years. They also expect those margins won't recover and the company's sales will stagnate.

But the market is wrong, and the shares are actually undervalued. While the above factors have put investors off, these elements are temporary. People will forget about the salmonella outbreak at the Wieze factory in Belgium, and investors will get used to the new boss. In the same vein, investors are far too downbeat about the effect higher cocoa prices will have on the business. As a result, the shares are cheap, and value investors can take advantage of this by buying the shares.

The market has misunderstood the impact of higher cocoa prices on the firm's profit margins. The company's cost-plus pricing contracts—Valuabl estimates they price their cocoa powder and butter at about 15% above cost—ensure margins will remain robust. The company's margins do not depend on the price of cocoa, sugar, dairy, transport, or other production costs.

In fact, the firm's contracts with its customers, most of whom are large chocolate bar makers, means their margins will remain steady regardless of inflation. Moreover, as the company gets bigger and better at processing cocoa beans and volumes increase, economies of scale will support margins over time. Over the past 20 years, there has been a +0.5 correlation between sales volumes and operating profit margins.

The cost-plus model and economies of scale will protect and expand margins. As a result, they won't contract to 5% as the market has priced them to. Instead, they'll stay near their current level of 8.3% or even grow slightly over time.

The market has also focused too much on the short-term impact of the salmonella outbreak and the effect higher cocoa prices will have on demand. Bakers and chocolate bar makers will eventually forget about the salmonella outbreak and won't hesitate to buy Callebaut's cocoa powder and butter. The outbreak's impact has already been felt—it's in the past. The ten analysts who cover the stock think the company has recovered from it and forecast a modest 4.4% per year revenue growth over the next three years.

Moreover, higher cocoa prices will support short-term sales growth instead of hurting it. The cost-plus pricing model means revenues will rise somewhat as cocoa prices do. Historically, cocoa prices and revenues have had a +0.2 correlation. At the same time, the volume impact of higher prices remains muted. Volumes fell 1% last year, while the company's long-term volume trend is still solidly positive—a 5% per year growth rate for the past 20 years—and unlikely to reverse.

Furthermore, Statista, a market forecaster, reckons the global chocolate market will continue to grow at 3.5% annually in Swiss francs over the next five years. They expect a steady increase in global chocolate consumption volumes per person and price hikes to drive this. There is long-term structural demand for chocolate products as populations grow and people in poor countries become richer.

Even if higher cocoa prices weigh on volumes, it will be temporary. Agricultural markets are cyclical. Bad cocoa-growing weather across West Africa, particularly in Côte d'Ivoire, the world's largest cocoa producer, caused the rise in cocoa prices over the last 18 months. These poor conditions led to reduced production and a supply deficit.

The International Cocoa Organisation, a global trade group that tracks the market, reported that a significant fall in cocoa supply caused a tight market and higher prices. But this bad weather won't last forever. When it changes, production will boom because of the incentive of high prices.

That, and a hangover from the salmonella outbreak, won't weigh on the revenues like the market expects. Instead, revenues will continue to grow, albeit slowly.

Catalysts

First-quarter earnings release in April: Analysts' consensus is for 4% top-line growth and profit margins to bounce back from their recent fall. This result will show the market is too pessimistic about the firm's prospects.

Bumper cocoa bean harvest: Côte d'Ivoire, the world's largest cocoa producer, has had above-average rainfall over the past six months. That is generally good for cocoa crops but raises concerns about black pod disease. A bumper crop could lead to an oversupplied cocoa market and drag prices down quickly. Investors who believe high prices will hurt the firm will expect lower prices to help and will upgrade the stock.

Industry consolidation: The cocoa and chocolate supply market is bifurcated. A few prominent players are at one end, while the rest are small players. High cocoa bean prices and an undersupplied market will have put many of these small players under stress. This is because they lack the bargaining power to secure the cocoa bean supply or the cash to wear the required increases in working capital. As a result, Barry Callebaut could either swoop in and buy some of these smaller players or steal market share straight from them.

Valuation and sensitivity

Base case: (Assumptions: Growth rate of 2.9%; stable EBIT margin of 8.3%; weighted-average cost of capital of 4.3% in Swiss francs) A Swiss-Belgian cocoa processor and chocolate maker. The firm has a vertically integrated business and attractive cost-plus pricing model. They will continue to grow annual production volumes slowly while the cocoa bean market starts to normalise. However, higher input prices will create more significant working capital requirements over the next few years. That will suck up some free cash flow. But this will eventually return to normal, too. A discounted cash flow model suggests the shares are worth SFr1,900–2,100 each.

Sensitivity: The shares are cheap in 98% of scenarios modelled with Monte Carlo simulation. The simulation assumed the annual growth rate would range from -10 % to 17%, stable margins between 5.1% and 10.5%, and the cost of capital between 3.0% and 5.7%.

Enterprise multiples: Barry Callebaut's enterprise and price multiples are in the middle of the pack. However, the firm deserves to be priced at higher multiples because its business model is structurally less volatile and more capital-light than three-quarters of the peer set.

Risks

Negative perception of sustained high cocoa prices: As the market believes high prices are bad for the stock’s value, sustained high prices could prevent the stock from re-rating. Instead, prices may continue to rise if cocoa bean harvests aren’t as good as expected. That could cause the stock price to continue to drop.

Supply chain shipping disruptions: Global shipping routes, particularly around the Suez Canal and the Red Sea, look more vulnerable than ever. Last month, Yemeni rebels attacked a container ship in the Red Sea operated by Maersk, a Danish shipping giant. Ongoing regional conflict could cut off this critical route and drive up global shipping times and costs. That would hurt the firm’s supply and delivery chains and drive down profitability.

Healthy eating trends: People are getting more interested in eating healthier snacks. As a result, they might buy less chocolate. This trend would hurt sales across the firm’s customer base, lowering sales and profits at Barry Callebaut. To adapt, the firm would need to make new, healthier-seeming chocolate and change how they promote their products.

Worst-case scenario: Should shipping routes continue to seize up while the cocoa market remains tight and consumers reject chocolate for healthier alternatives, the firm’s top and bottom lines would fall. In addition, capital costs would rise as the business becomes systematically riskier. In this worst-case scenario, the shares would fall to SFr862 for a 32% loss. ■