Friday, October 12, 2012

QAF: Man can live by bread alone (CIMB)

Current S$0.76
Man can live by bread alone

 QAF offers a tasty dividend yield of 6.6%, which should be sustained by strong cash flows from its bakery business even though the margin outlook is soft. An improving Australian pork business increases the chances of divestment.

QAF has also recently expanded its bakery footprint to China. While initial contributions will not be material, we like the fact that management is starting to explore growth in the region. Potential divestment of its pork business could add S$280m-320m to the firm’s value if capital is ploughed into expansion of its lucrative bakery franchise.

Consumer staples play with attractive yields
QAF’s recent share price support is probably a consequence of its cash-generating bakery franchise and attractive dividend yield which is drawing yield hunters like bees to honey. While we anticipate margin headwinds and even a slight earnings dip, we continue to expect price support as QAF should be able to maintain the 5 Scts dividend payout seen in 2011, taking capex and cash generation into consideration.

Growth outlook
The Philippines will be the key growth driver in the near term as QAF expands its Gardenia brand outside metro Manila. We think that growth in Malaysia could be crimped by a new rival, Massimo, which is gaining good traction with Chinese consumers. Growth in Singapore should remain stable and should trot in line with historical growth. A longer-term growth driver could come from QAF’s recent venture into Fuqing, China though management is keeping a prudent stance, preferring to understand the market before putting in significant capex.

Potential catalyst?
We think that a potential divestment of its previously-loss-making pork production business could be a price catalyst. According to management, QAF’s Australian pork production business has seen a marked improvement in profitability in 2012 – early fruits of a change in strategy. This enhances potential for divesting the franchise.

1.1 What’s the story, morning glory?
Yield sharks have been on the prowl for most of 2012, in search of defensive stocks with high dividend yields. It is, therefore, not a surprise that QAF has seen very strong price support in recent months as its cash-flow generating bakery franchise across Malaysia, Singapore and the Philippines with high dividend yield (~6.6%) brands it as a defensive, high-yield consumer staple play. Rivalea, QAF’s pork production business in Australia, started to turn around in recent quarters. We previously mentioned that QAF has been looking to divest its pork production business since 2008. A turnaround could enhance the possibility of a divestment. In our view, this could act as a price catalyst as QAF could enhance the firm’s value by S$280m-320m if freed-up capital is ploughed back into its profitable bakery franchise.

In addition to its defensive nature, we think that QAF’s recent venture into China could have helped support the share price. In Jul 2012, together with Lin Kejian (Daniel Halim), son of its major shareholder Andree Halim, QAF set up a joint venture (Gardenia Fujian) to expand its bakery operations in Fujian, China. Entry into a potentially high-growth market like China could have allayed concerns over growth in mature markets like Malaysia and Singapore.

The key investment risk for QAF lies in its ability to sustain its dividend payout. In FY12, emergence of new competition in Malaysia as well as rising wheat and fuel prices should crimp bakery margins and earnings. This should lower operating cash flow generation. In addition, QAF continues to plough capital into expanding and upgrading its bakery lines in Singapore and Malaysia. In the coming years, management also sees growth opportunities in the Philippines which could require additional capex for capacity upgrades and expansion.

In this note, we look at QAF’s historical earnings performance and cash flow generation. We conclude that QAF should be able to dish out healthy scoops of dividends to shareholders. This should provide share price support if risk-off sentiment returns. Its attractive valuations also offer limited downside risks.

2.1 Near-term margin pressures...
Bakery costs should increase in 2H12. Fuel and wheat costs are the largest components of the cost base for bakeries. As a result, Gardenia’s (bakery) operating margin is inversely related to wheat and fuel prices. Bad weather in the US and Russia has led to a 42% spike in wheat prices since Jun 12. Despite weak macro fundamentals, speculation has also helped boost fuel prices.

In addition, Gardenia has been facing stiff competition from Massimo, the new kid on the block. Since its inception in 2011, Massimo, owned by ethnic Malaysian tycoon Robert Kuok, has been very well received by the ethnic Chinese population in Malaysia. From its production facility in Port Klang, Massimo’s fleet of 200 trucks distribute three products (wheatgerm loaves, sandwich loaves, cream rolls) to provision stores and Chinese medicinal stores in Ipoh, Penang, Malacca and Seremban. This puts Massimo in direct competition with Gardenia, which generates around 75% of its sales from provision shops.

Massimo still has a long way to go before it can reach Gardenia’s production scale, product suite and distribution capabilities. Gardenia has five plants and 12 production lines in central Kuala Lumpur compared to Massimo’s sole line in Port Klang. Gardenia has a 1,000-strong truck fleet; Massimo has 200. Gardenia has over 20,000 distribution points, the largest network in Malaysia. Consequently, operating leverage has made Gardenia the price leader in Malaysia’s branded bread market. However, with backing from FFM, Robert Kuok’s flour mill, Massimo has been able to wage a price war against Gardenia despite its lack of scale and reach. For example, Massimo’s wheatgerm loaf, which, at RM2.50 is 22% cheaper than Gardenia’s equivalent wholemeal loaf costing RM3.20, has been taking market share from Gardenia’s wholemeal loaf.

In response, Gardenia has come up with a similarly priced wheatgerm loaf. In addition, management has been flooding the market with its products, limiting shelf space for Massimo. This will inevitably increase bread returns (typically 15-20% of unsold bread is returned to Gardenia) and, thus, reduce margins. Price competition between Massimo and Gardenia will also limit the latter’s ability to pass through cost increases to customers.

2.2 … but margins could be supported as pork production in Australia starts to break even
Management continues to see a recovery in its Australian pork production business, reflecting traction gained from the change in its corporate strategy. Rivalea is now avoiding head-on competition with cheap frozen pork imports from the US/Canada/Europe by introducing higher-margin branded pork products, minimising sale of fresh pork to product manufacturers (sausages, ham etc) and increasing supply to supermarkets (Woolworths, Cosco) and butcheries. Additional services include manufacturing hams and sausages for supermarkets and tray-packaging for both supermarkets and butcheries. Such additional products and services helped lift ASPs and sales volumes, thereby raising margins and consequently, profitability. While QAF does not release segmental quarterly performance, management indicated that Rivalea was EBITDA-positive in 1H12 compared to losses in 1H11. Assuming Rivalea is able to maintain its earnings momentum in 2H12, we could see some margin support from its pork production business.

2.3 Potential divestment of Rivalea?
In our first Not-Rated report on 29 Mar 2012 (So good, you can even buy it on its own), we mentioned that management has been looking to divest its pork production business since 2008. Rivalea’s improving profitability increases the chances of divestment. We estimated that QAF will be able to free up around S$148m-170m based on a 20-30% haircut for Rivalea’s net asset of S$211m (based on 2011 annual report disclosure). Assuming QAF is able to plough freed-up capital back into its lucrative bakery operations, we estimate that it can raise the firm’s economic value by S$280m-320m in the longer term.

2.4 Will China venture change growth profile significantly?
In Jul 2012, QAF announced that it has set up a joint venture with its major shareholder, Daniel Halim, to set up a bakery (Gardenia Fujian) in Fujian, China. QAF will hold a 55% interest in the JV. The total investment cost to set up the manufacturing facility and initial working capital for Gardenia Fujian is estimated at S$16m (~Rmb80m). QAF will provide S$4.4m capital and S$4.4m in shareholder’s loan. Mr Halim will provide S$3.6m in upfront capital and S$3.6m in shareholder’s loan.
Prima facie, QAF will be ploughing around S$8.8m into Gardenia Fujian in capital and shareholder’s loan. In actual fact, QAF’s investment in Gardenia Fujian will be rather minimal. QAF is in the midst of upgrading its plant in Singapore and will be transferring spare parts from its Singapore plant to Fuzhou county in Fujian. In addition, the new manufacturing facility will operate on a ready-built site in Fuqing, Yuan Hong Investment Zone. A bonus for this venture is that Gardenia Fujian will be operating on a rent-free lease for 20 years up till 2032, granted by Fujian Dongjia Feeds, a company controlled by Mr Halim.

We think that Gardenia Fujian will not materially change QAF’s near-term growth trajectory. We sense that management could be taking a measured approach to its Chinese investment and developments in Fujian could be at snail’s pace. Gardenia Fujian can be considered as a testing ground for Gardenia’s renewed Sino ambitions. As China does not have a culture of consuming loaf bread, Gardenia’s bestselling product, management will have to take time to understand the market and fine-tune operating and distribution models, recipes and product offerings. As such, initial production will be on a small scale, at around 2,000 loaves per hour (top-of-the-line production line can produce around 10,000 loaves per hour). Gardenia Fujian will first test the market with hot dog rolls and hamburger buns.

This is not QAF’s maiden venture into China. It set up shop in Tianjin close to a decade ago but the venture did not succeed as the factory was located too far from its distribution points, it resulted in high distribution costs. We think that chances of success should be higher this time round, given the low upfront capital. In addition, consumer spending has been on the rise in Fuzhou, with total sales of consumer goods hitting Rmb194.8bn in 2011 vs. Rmb55.3bn in 2002. As such, Fuzhou can be considered a blue ocean in the branded bread segment as it does not have a major branded bread producer in the market. Having said that, we prefer to observe QAF for a few more quarters before coming to a verdict on whether Gardenia Fujian will be a major growth profile changer.

2.5 Growth in existing markets
Management continues to see strong growth potential in existing markets. According to management, production capacity in Malaysia and Singapore is nearing full utilisation and there is still scope for further expansion. QAF has budgeted around S$20m for upgrades in Singapore and S$20m for a new production line in Malaysia, both of which are expected to be completed in 2013.

The Philippines will be a key growth driver. Gardenia Philippines has 70% share of the metro Manila branded bread segment and is now serving Mindanao through its newly set-up production facility in Cebu. Management is also attempting to raise margins by reducing its reliance on the flour cartels in the Philippines and turning to cheaper flour supply from Indonesian flour mills. However, initial flour supply volumes from Indonesia make up only 10% of Gardenia Philippine’s flour requirements and should not have much impact on near-term margins.

Historically, the 5-year revenue CAGR was around 0.8% for Singapore, 12% for Malaysia and 13.3% for the Philippines. Singapore, as a mature market, should remain around 1% growth. In the near term, we expect competition from Massimo in Malaysia to impede growth potential, leading to high-single-digit topline growth. Lastly, we think that the Philippines to sustain double-digit annual growth as Gardenia Philippines extends its reach throughout the archipelago.

3.1 Can QAF sustain dividend payout?
In 2011, QAF gave out S$26m in dividends or 5 Scts/share. QAF has already dished out a 1 Sct/share dividend in 1H12. Assuming it is able to maintain its dividend payout, the prospective end-CY12 dividend yield at current prices will be around 4.2%. Near-term cost pressures and competition in Malaysia could reduce profitability and operating cash flow generation. QAF is expected to invest around S$40m in plant upgrades and new production lines in Singapore and Malaysia in 2013. In view of margin headwinds and competitive pressure in Malaysia, we think that operating cash flows could fall from the typical S$90m-100m range to S$80m-90m for FY12. There is a risk that management might decide to cut its FY12 dividend payout.

However, we believe that management should be able to sustain its dividend payout. First of all, QAF has never reduced its dividend payout since 1999. Secondly, despite facing cash outflows during its dark days in 2007 and 2008, QAF continued to dish out healthy scoops of dividends to investors. Earnings volatility also did not have any impact on its dividend payout decision. Lastly, with 2Q12 net gearing of 0.11x, QAF still has sufficient debt headroom to fund its capex requirements in 2013. Even if it were to fund its capex requirements fully by debt, net gearing would merely increase to 0.2x, still at comfortable levels. This should allay concerns that management may reduce FY12 dividend payout to conserve cash for capex in 2013.

4.1 Inability to divest Rivalea
It could take some time before QAF is able to divest its pork production business to a willing buyer at a decent price. Profitability for Rivalea depends largely on weather conditions, which has a big influence on feed costs. In recent years, severe weather conditions like floods and droughts have led to poor grain harvests, thereby decimating margins for Rivalea’s pork production business. Coupled with a tough pricing environment (supermarket chains like Woolworths have been suppressing prices for all its merchandise, including fresh products), the profit outlook for the meat production business in Australia seems to be very volatile. In addition, pork consumption is not big in Australia as consumers still prefer red meats like beef and lamb. While Rivalea was able to support sales volume by exporting its pork produce in the middle of the decade, recent strength of the Australian dollar has also eroded export competitiveness for Rivalea’s pork products.
Management has yet to raise the white flag. Efforts to raise pork consumption are underway, via cooking classes, demonstrations at supermarkets and promotion of lean cuts as a healthier alternative to lamb. In our view, more can still be done to raise Rivalea’s profitability though new measures will probably have to be creative. For example, Rivalea can explore tying up with restaurants and celebrity chefs to promote innovative pork dishes. Rivalea could also consider introducing snacks like pork jerkies (bak kwa) or the famous pork cutlet buns from Macau. While QAF might incur some near-term increase in opex or capex, we see this as a small investment to free up its locked-up capital in Australia, which could be more efficiently deployed to fund its bakery expansion.

5.1 Attractive valuations
QAF currently trades at 4.8-5x c.CY12 EV/EBITDA, below regional peers’ average of 12.0x. It also offers a very attractive CY13 dividend yield of 6.6%, above regional peers’ 3.4% average (CY13). It is even higher than REITs’ 6% yield. Lastly, we think that a potential divestment of its pork production business could be a major price catalyst.

Source/Extract/Excerpts/来源/转贴/摘录: CIMB-Research,
Publish date: 10/10/12

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