Hidden Stock Market Gems: Chr. Hansen
- Chr. Hansen is a global bioscience company that develops natural ingredient solutions for the food, nutritional, pharmaceutical, and agricultural industries.
- The company's patents, as well as the high switching costs, create a wide economic moat.
- The intrinsic value for Chr. Hansen is €48, and at around €45, we find a strong support level for the stock.
After writing about Novo Nordisk (NVO) several times on Seeking Alpha, I am now analyzing three additional great businesses from Denmark that seem to be undercovered at Seeking Alpha although these are great companies with a wide economic moat. Very recently, I published my article about Coloplast (OTCPK:CLPBF) and now I will continue my series "Hidden Stock Market Gems" with an article about Chr. Hansen (OTCPK:CHYHY) - a bioscience company that is developing natural solutions for the food, pharmaceutical, and agricultural industry.
And like many of the companies in this little series, Chr. Hansen seems undercovered but is actually a mid-cap (or even: large-cap) company with a market capitalization of DKK 83 billion (about $12.5 billion).
Chr. Hansen is a global bioscience company that develops natural ingredient solutions for the food, nutritional, pharmaceutical, and agricultural industries. Chr. Hansen develops and produces cultures, enzymes, probiotics, and natural colors for a rich variety of foods, confectionery, beverages, dietary supplements, and even animal feed and plant protection. The company was founded in 1874 and is listed on the Nasdaq OMX Copenhagen since June 2010.
(Source: Chr. Hansen Investor Presentation)
The company is reporting in three different business segments:
- Food Cultures & Enzymes: Chr. Hansen is assisting in optimizing the production processes with microbial and enzymatic solutions that help to produce great-tasting and consistent products (i.e. wine, meats, or dairy products). The company provides the dairy industry with a wide selection of food cultures & enzymes solutions used in meat and fish, in cheese and fresh dairy, and also in fermented beverages. Last year, the segment was responsible for 59% of total revenue.
- Health & Nutrition: Chr. Hansen is a leader in the development and production of probiotics for dietary supplements and infant formula. These probiotics might have beneficial effects on the immune system of infants and adults. Last year, the segment was responsible for 22% of total revenue and concentrates on plant health, animal health, and human health.
- Natural Colors: The company is providing many coloring solutions for different food products. Chr. Hansen helps its customers to match the exact color with the product whether it is beverages, confectionery, dairy, ice cream, or other prepared foods. The company also works together with its customers to develop unique colors. The company is offering every color from red or purple over blue and green or white and brown. Last year, the segment was responsible for 19% of total revenue.
Among the three segments, Food Cultures & Enzymes, as well as Health & Nutrition, are highly profitable (EBITDA margin of 38%), while Natural Colors only has an EBIDTA margin of 14%. Additionally, the Food Cultures & Enzymes segment is generating the highest ROIC of the three segments.
Chr. Hansen is generating revenue all over the world, but the biggest part of revenue is generated in the EMEA region (44% of total revenue last year), followed by North America (27% of total revenue). In the APAC region, Chr. Hansen is generating 17% of total revenue and could report 4% organic growth (after it had 16% organic growth the previous year). Latin America is responsible for 12% of total revenue and could even report 21% organic growth last year.
(Source: Chr. Hansen Investor Presentation)
Wide Economic Moat
Chr. Hansen certainly has a wide economic moat around its business. First of all, Hansen's competitive advantage is based on the company's patents. Right now, the company has more than 2,000 patents granted or pending and the company filed for 26 new patent applications in 2017/18 and for 27 new patent applications in 2016/17. Chr. Hansen is also a research driven company and a new competitor will have to spend a lot of time and money on research and development. Both aspects are certainly not the best competitive advantage a company can have, but they both add to the strong position Chr. Hansen has among its competitors.
Chr. Hansen's wide economic moat mostly stems from the switching costs the company has. First of all, Chr. Hansen is working with its customers and creating individualized solutions, which makes it difficult for the customers to switch to a competitor as the customers not only have to go through the process of finding an individualized solution once again. It is also uncertain if a competitor will be able to offer the same individualized solution as Chr. Hansen.
Aside from the individualization, the switching costs are so powerful as Chr. Hansen is producing a product that is very important for the end result, but makes up only a small fraction of the overall costs. The products of Chr. Hansen, for example, determine the color of food products, as well as beverages and the color, is extremely important as it plays an important role in the perception of the quality and has a huge influence how the end customer sees the product. Changing the color could be devastating for any product. Chr. Hansen's products also determine taste and texture and changing these is similar dangerous as changing the color. A change in color, flavor, or texture might lead to fewer customers and every producer will be hesitant to change these aspects. And while the ingredients of Chr. Hansen have a huge influence on the end product, they make up only a very small fraction of the overall costs. When considering the costs for cheese production for example, the cultures and enzymes are responsible for only 1-2% of the total costs and the savings by switching to a competitor would be very little. Hansen's products have a high benefit/cost ratio and this makes switching costs usually very high and creates a powerful moat around a business.
I don't know much about the process of making dairy products, cheese, confectionery, or ice cream, but I assume we are looking at rather complex processes and the products of Chr. Hansen (the enzymes, natural colors or cultures) are, therefore, embedded in a big, complex structure. This makes the switching even more difficult and the moat of Chr. Hansen even wider. Back in 2015, Chr. Hansen described the moat pretty well in one of its earnings presentations.
(Source: Chr. Hansen Q3 2014/2015 Earnings presentation)
Growing Market and Megatrends
And a wide economic moat around the business is important as there are several (mega)trends that could be beneficial for Chr. Hansen over the next few years (or even decades). And high growth potential usually attracts new competitors to an industry, which could lead to even lower market shares for individual companies in the end.
First of all, the growing world population, the rapid urbanization as well as the expected resource scarcity will increase the need for innovation to improve productivity and reduce food waste. Cultures as well as enzymes that might enable a producer to make a few percent more cheese from every measure of milk and, therefore, will help to increase productivity and to feed the world might get more and more important.
Second, the growing middle-class is a driver for higher consumption of dairy products. For yoghurt consumption as well as cheese consumption, we can show a correlation between consumption on the one side and GDP/capita on the other side: The higher the GDP per capita is in a country, the higher the consumption of yoghurt and cheese will be, and we can, therefore, expect that the countries with a growing middle class and a growing GDP per capita will be drivers of growth for Chr. Hansen.
(Source: Q3 Roadshow Presentation)
The global growth of dairy products is especially visible in Asia, Latin America, and Eastern Europe. The sector has tremendous growth potential as dairy is increasingly considered a healthy choice of food. Chinese customers are also very open to yoghurts as well as fermented milk products, and China has a rapidly growing middle class.
Chr. Hansen might also profit from the trend towards sustainability and plant-based proteins. We might see an increasing pressure from customers to curb chemicals usage in crop production over the next few years. Additionally, companies might switch more and more to natural colors for food and beverages. All these trends might be positive for the business of Chr. Hansen. In this regard, it might also be worth mentioning that Chr. Hansen is called the most sustainable company in the world by Corporate Knights.
It doesn't matter how great a business model is, almost every company is facing risks and uncertainties that investors have to keep in mind and that have to be reflected in the intrinsic value calculation. But, in the case of Chr. Hansen, I don't see any major risks aside from the typical risks every company is facing in a similar way - like global uncertainties, trade wars, an economic downturn, or failing to be innovative as a company - and the risks bioscience companies are facing - like being very dependent on research and development. This certainly doesn't mean that Chr. Hansen is facing no risks or that investors should be careless. When looking at the very high valuation multiples investors are assigning the company, investors, obviously, don't see any major risks either - despite the global recession and pandemic (but both affect the business only marginal).
With a D/E ratio of 0.96 and about 2.5 times annual operating income necessary to repay the outstanding debt, we should keep an eye on the company's debt levels but they are certainly not posing a major threat or are a reason to be concerned. Over the past decade, Chr. Hansen always had a D/E ratio between 0.6 and 1.0 and performed quite well.
Chr. Hansen is also dependent on its patents. Right now, the company has more than 2,000 patents granted or pending and the need to protect intellectual property is increasing. If one or several of these patents are challenged, it could pose a threat to the business of Chr. Hansen.
A final risk might be the changing consumer preferences and regional tastes the company has to respond to. Chr. Hansen has to understand its customers including the regional taste preferences and identify shifts in consumer preferences ahead of time. This is certainly not a serious risk and many other companies are also facing the challenge to understand the customers. But in contrast to many other companies, the sectors in which Chr. Hansen operates (especially food and beverages) might see changes in consumer trends over time (although food and beverage tastes are more stable than fashion trends for example).
Since its IPO in 2010, Chr. Hansen is also paying a dividend, and while the company paid a dividend every year, the amount fluctuated as Chr. Hansen also paid an extraordinary dividend in many years. In 2019, the total dividend was DKK 13.31 (a combination of an annual dividend of DKK 7.07 and an extraordinary dividend of DKK 6.24). Similar to Coloplast - the company covered a few days ago - Chr. Hansen is paying out a huge part of its earnings. Currently, the payout ratio is 94% and results in a current dividend yield slightly above 2.0%.
(Source: Chr. Hansen Investor Relations)
Intrinsic Value Calculation
In order to determine if the stock is a good investment at this point, we have to calculate an intrinsic value - and as always, we are using a discount cash flow analysis. For that calculation, we need to estimate the free cash flow of Chr. Hansen in the years to come. And the company's performance in the past might give us some hints. Since 2005 - the oldest data I could find - revenue increased 8.23% on average every single year. Free cash flow, however, increased 15.42% annually in the same timeframe. For the next few years, Chr. Hansen is expecting revenue growth between 8% and 10% annually and management is also expecting free cash flow to grow 10% every single year.
It is also important to look at the performance of a company during a recession or economic downturn. During the Financial Crisis of 2008, Chr. Hansen performed admirably. Not only did revenue increase every single year, but Chr. Hansen could also increase its gross profit every single year. But when looking at net profit and free cash flow, the picture gets a bit mixed. In 2005 and 2009, Chr. Hansen had to report a loss and the numbers fluctuated during that time. But free cash flow was always positive and during the recession, free cash flow declined only in the year 2009/10.
(Source: Chr. Hansen Investor Presentation)
For 2020, Chr. Hansen is assuming free cash flow to be €190 million and management is also holding on to its guidance and sees no major supply interruptions from the global pandemic. As mentioned above, management is assuming revenue to increase in the mid-to-high single digits in the following years and I would also assume about 8% annual revenue increase to be realistic - which is also in line with the long-term average growth rates of Chr. Hansen. And management is also assuming that margins might improve over time (which might contribute about 1-2% additional growth). 10% annual growth for EPS and free cash flow seems realistic over the next decade. For perpetuity, we assume 6% growth, which will lead to an intrinsic value of €48.20 (assuming a 10% discount rate). Similar to past articles, I would also assume 20% as margin of safety to correct for mistakes or false assumptions leading to an entry point of €38.56.
Finally, we can look at the chart of Chr. Hansen in order to find support levels, that might offer a good entry point. Although Chr. Hansen is a Danish company trading in Copenhagen, I took the chart in Euro as the company is reporting mostly in Euro and I also assume the trading volume in Euro is much higher.
One support level would be around €68, where we find the 61% Fibonacci retracement, but as the stock already declined lower in the last few months, this is no longer a support level we have to pay attention to. Following that, the next support level would be in the area between €57.50 and €61. Here we find the 50% Fibonacci retracement at €57.38 as well as the highs of 2015 and 2016 and the low of 2018 at around €61. In March 2020, the stock also dropped below that level, but the monthly close was about the support level and therefore we can see that support level as still valid.
(Source: Author's own work created with Traderfox)
However, the only support level which is interesting for us is around €46 as it is the only support level close to our calculated intrinsic value. Here we find the 38% Fibonacci retracement at €45.79, the 200-months simple moving average at €46.50 as well as the low of 2016.
In my opinion, it is also possible that Chr. Hansen hit its low in March 2020, but we have to see what the next months will bring. And due to the IPO in 2010, we don't have any data how the stock is behaving during recessions and bear markets and we have no past data that could give us hints about the performance over the next few quarters.
Similar to Coloplast - another Danish company we covered recently - Chr. Hansen is also trading at very high multiples and it remains debatable if the stock will drop steep enough to trade at price levels where I would consider Chr. Hansen to be fairly valued. Nevertheless, Chr. Hansen is a great business with a wide economic moat around its business and growth potential in the years to come.
This article was written by
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