This article first appeared in The Edge Financial Daily on March 25, 2019

Fraser & Neave Holdings Bhd
(March 22, RM34.80)
Maintain hold with a target price (TP) of RM32.50: We highlight the possibility of Fraser & Neave Holdings (F&N) being included in the FBMKLCI. According to FTSE Bursa Malaysia Index series ground rules, a stock component is removed should its market capitalisation ranking of eligible securities drop to about 36th position. As of March 19 market close, Top Glove Corp Bhd’s market capitalisation ranking was 35th. As the next largest market cap outside of the KLCI Index, Westport Holdings Bhd or F&N are in the running to replace Top Glove. However, this will depend on the market capitalisation ranking as of the last trading day in May, which is Friday May 31.

Based on previous KLCI inclusions, there is a highly apparent three-month outperformance to the KLCI’s return of 3.2% (excluding Top Glove, returns were 6.7%). KLCI-linked funds with tracking mandates could be required to replicate the stock’s weight. Stocks with low free-floats such as Nestle (Malaysia) Bhd (15.0%), which well outperformed previously, could be a precursor to F&N, given the latter has a relatively low free float of 24.1% as well.

Fonterra Co-operative Group Ltd, which accounts for the majority of New Zealand’s milk output, has downgraded its forecast for its milk collection due to hot and dry on-farm conditions which have pressured cows’ milk flows. This reflects the challenging weather conditions at some of the world’s largest milk-producing regions, resulting in slowing supply growth against the backdrop of strengthening demand driven by Asia. Current skim milk powder prices at US$2,425 (RM9,846) per tonne are 22% higher than 2018’s average of US$1,994.

Dairy prices account for 45% of F&N’s cost of goods sold (COGS). Fortunately, we understand F&N has hedged its raw material cost until the third and fourth quarters of financial year 2019 (3Q-4QFY19). By our estimates, for every 10% rise in the cost of dairy powder above our assumption, it would cut F&N’s FY20 earnings per share (EPS) by 20% (this assumes no cost pass-through) as F&N’s net margin is relatively thin at about 10%. However, a mitigating factor that we anticipate would be for F&N to raise average selling prices (ASPs) of its dairy sales by 5% to fully pass through a 10% rise in the cost of dairy powder. Based on prevailing milk prices, F&N might have to raise its ASPs by up to 10%. While volume demand for milk is relatively inelastic, it would still likely be affected, given the potentially steep price hike.

Our base expectation is for F&N to either reformulate, repackage smaller units or pass the sugar tax impact on to consumers. The government’s decision to postpone the implementation to July 1 from April 1 would allow F&N more time to reformulate. The sugar tax represents a steep range of 10 sen per 250ml to 60 sen per 1.5l, or a 10% hike to current ASPs, compromising volume demand. However, in the unlikely case that F&N does not pass on the excise tax on its brands of soda drinks to customers, we estimate the tax could reduce F&N’s financial year 2020 forecast (FY20F) net profit by 10-15%.

The government reintroduced sugar import permits, allowing food and beverage manufacturers to source sugar beyond MSM Malaysia Holdings Bhd and Central Sugars Refinery Sdn Bhd. The authorities have indicated a processing time of up to a year for the import permit. Sugar makes up 25% of COGS for F&N. For every 10% cheaper sugar sourced, it would raise F&N’s FY20F earnings per share by 6%. However, based on our channel checks, prices of local sugar and imported sugar are currently at parity. The development is however positive over the longer run, bypassing the restriction to source sugar from the two local suppliers.

Therefore, by factoring in higher skim milk powder prices, we trim our FY20-21 net profit forecasts by 4.7% and 2.2% respectively. — UOB Kay Hian, March 20