Worst is over for Fraser & Neave’s beverage division

This article first appeared in The Edge Financial Daily, on January 8, 2018.
Worst is over for Fraser & Neave’s beverage division
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Fraser & Neave Holdings Bhd
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The worst is over for Fraser & Neave Holdings Bhd’s (F&N) beverage division as it reaps cost savings from the merger between the dairy and soft drink divisions, and lower sugar prices this year. Its dairy divisions in Malaysia and Thailand should benefit from falling milk prices since the second half of 2017 (2H17).

Given the recent valuation rerating at Nestle (M) Bhd and the big discount gap, F&N is a laggard play.

Excluding restructuring costs, we estimate that F&N’s beverage division charted a 60% year-on-year (y-o-y) decline in earnings before interest and tax (Ebit) to RM28 million in the financial year ended Sept 30, 2017 (FY17), on the back of higher sugar prices (sugar accounts for 30% of cost of goods sold [COGS]) and aggressive discounting amid intense competition.

We believe the worst should be over for the beverage division as there is ample room for cost savings following the completion of the merger between Dairies Malaysia and Soft Drinks Malaysia, resulting in a leaner structure, as well margin improvement on lower sugar prices (down 5% to 10%) this year.

A potential hike in beverage prices will improve margins further, although we note that there is no such plan at this juncture.

Skimmed milk accounts for 45% of F&N’s COGS and global prices of skimmed milk powder are currently hovering at US$1,700/tonne from 2H17’s high of US$2,000/tonne in July 2017. Although F&N’s dairy division in both Malaysia and Thailand saw margin compression in the fourth quarter of financial year 2017 (4QFY17) due to higher locked-in milk prices, we expect margins to recover from 2HFY18 on lower locked-in milk prices.

We see F&N as a laggard play versus its bigger peer Nestle, which is trading at 35 times 2018 price-earnings (PE), representing a big discount gap of 35%. Based on the five-year 12-month forward PE, the average discount of F&N versus Nestle was 20%.

In addition, we note that its smaller peer Dutch Lady Milk Industries Bhd with less than half of F&N’s earnings base is trading at 26 times 2018 PE, according to consensus estimates.

Soft Drinks Malaysia had a lacklustre FY17 with a 15% y-o-y decline in top line and an estimated 60% y-o-y drop in Ebit (excluding restructuring costs).

Despite an estimated 10% y-o-y drop in sales volume for FY18, we expect earnings to recover on cost savings from the recent restructuring as well as lower sugar prices this year. Our sensitivity analysis suggests that for every 10% change in sugar prices from our base assumption, our FY18 to FY20 net profit forecasts for F&N will be impacted by 6%.

We are still hopeful of a recovery in sales volume on market share gain as we gather that major competitors in the soft drink industry recently ended their steep price discounting campaign after raising average selling prices by more than 20%.

Given that Dairies Malaysia is operating at full utilisation, it plans to expand capacity at its Pulau Indah plant for de-bottlenecking. In Thailand, it has completed installing an evaporation line in Rojana and bought gable top filing machines in Pak Chong.

The plan to install a sweetened condensed milk pouch and tube filling line in Rojana are under way. Not least, the dairy division will also benefit from the recent downtrend in milk prices. For every 10% change in skimmed milk powder prices from our base assumption, our FY18 to FY20 net profit forecasts for F&N will be impacted by 8% to 9%.

The bulk of the restructuring costs of RM48.4 million for FY17 were due to the reduction in staff count from the merger of Dairies Malaysia and Soft Drinks Malaysia. The merger will see simplified processes and a leaner structure that minimises duplications and increases efficiencies.

The group targets sustainable operating expenditure (opex) savings of more than RM40 million per annum on the back of a lower staff count, automation and savings from its new warehouse, which is in the midst of completion.

We raise our FY18 to FY20 net profit forecasts by 9.6%, 5.7% and 5.5% respectively after updating our key assumptions.

A key risk includes the introduction of sugar tax.

Our TP is based on 26 times 2019 PE (from 21 times), or a 25% discount to Nestle’s 12-month forward PE of 35 times.

F&N is trading at a discount of 35% to Nestle following the recent valuation rerating at Nestle on the back of Nestle’s inclusion into the FBM KLCI in December 2017.

If F&N earnings outperform on the back of contributions from its upcoming capacities and margin improvement from sustained strategic cost savings post-merger, it will see simplified processes and a leaner structure that minimises duplications and increases efficiencies.

The group targets sustainable opex savings of more than RM40 million per annum on the back of a lower staff count, automation and savings from its new warehouse, which is in the midst of completion.

We raise our FY18 to FY20 net profit forecasts by 9.6%, 5.7% and 5.5% respectively after updating our key assumptions.

A key risk includes the introduction of sugar tax.

Our TP is based on 26 times 2019 PE (from 21 times), or a 25% discount to Nestle’s 12-month forward PE of 35 times.

F&N is trading at a discount of 35% to Nestle following the recent valuation rerating at Nestle on the back of Nestle’s inclusion into the FBM KLCI in December 2017.

If F&N’s earnings outperform on the back of contribution from its upcoming capacities and margin improvement from sustained strategic cost savings post-merger between Dairies Malaysia and Soft Drinks Malaysia, its valuation gap with Nestle could narrow from current levels. F&N has a dividend policy of a minimum 50% payout. In FY13 to FY15, the group paid out more than 70% of its earnings. However, we note that FY16 to FY17 headline payouts fell to 55% and 65% respectively (with absolute dividend per share [DPS] maintained at 57.5 sen) mainly to fund capital expenditure for new projects. Hence, our conservative payout assumption of 55% for FY18 to FY20 represents yields of 2.5% to 2.8%. — UOB Kay Hian, Jan 5