Dairy Farm - CIMB Research 2016-05-18: Margins still finding a bottom

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DAIRY FARM INT'L HOLDINGS LTD D01.SI 

Dairy Farm (DFI) - Margins still finding a bottom

• Our key grouse about Dairy Farm (DFI) is its declining margins.
• FY15 EBIT margins were at a 10-year low of 3.9%, mostly due to challenges in its East and South Asian markets.
• Cost pressures continue to squeeze margins in 1Q16; forex made things worse.
• Company initiatives to drive gross margins will support a longer term recovery.
• We update our model and cut our FY16-18F EPS. Downgrade to Hold, with a lower TP of US$6.75. Change of covering analyst with this note.

FY15 margins at a 10-year low

• Dairy Farm (DFI) has always been very successful in growing its topline. Historically, sales growth typically outstrips store growth as existing stores register positive same store sales growth. However, this was not always matched with earnings growth. 
• In its bid to chase higher market share, the group was sacrificing margins in certain segments. An environment of cost pressures from rental and labour did not help either. 
• 2015 felt the brunt of margin compressions, with FY15 EBIT margins at a 10-year low of 3.9% (vs. margins of c.6% in good years). The group still sees ongoing margin challenges and weak sales leading to negative operating leverage. DFI has yet to reach a turning point where margins have bottomed out.

Margins could deteriorate further from FY15’s level

• While our recent meeting with management left us feeling positive about the group’s long-term prospects, we think FY16 is still likely to be a year of transition given the higher labour costs and rents, and store closures.
• There is constant cost pressure from labour and rents. This is not new but 2015 saw a whole host of new problems that continue to squeeze margins. 
  • Malaysia: GST implementation, political uncertainty and currency weakness; 
  • Singapore: SG50 promotional activities and alcohol selling restrictions; 
  • Indonesia: higher labour costs following an increase in minimum wages; 
  • Hong Kong and Macau: declining mainland tourist arrivals. Broad food price deflation and unfavourable forex make things worse.
• Part of today’s woes is also the result of the group previously expanding too quickly in East and South Asia, particularly in Indonesia and Singapore. Demand failed to keep up and there was also intense competition. All these factors meant profitability was severely hampered. While the store closures are a long-term positive, there will be short-term pain. We expect the group to continue to rationalise non-performing stores in Indonesia and Singapore. DFI has already announced that it will be exiting the convenience store business in Indonesia. We could also see store closures in Malaysia on the back of weak sales. Store rationalisation costs, labour and rent will pressure near-term margins, in our view.

We expect a longer term margin recovery to come at the gross level

• From a margin recovery angle, the group has already set in place a number of initiatives aimed at improving margins. Management indicated caution in regards to chasing sales growth, and shared that DFI’s near-term emphasis will be on cost optimisation. We like this strategy but believe the group will not likely see the benefits in FY16.
• Major cost items for DFI include: 
  1. COS (72% of total FY15 expenses), 
  2. labour (10%), and 
  3. rent (8%). 
  COS forms the bulk of costs and is also an expense the group has the most control over, whereas labour and rent are largely tied to local employment conditions and the economy. Therefore, COS, in our view, is where DFI will be able to extract the most cost benefits.
• We believe the improvement in margins will be driven by the following initiatives:
  • Fresh vs. dry sales mix: DFI is actively trying to introduce a greater range of fresh products. We understand that its current sales mix is still largely dry groceries (c.60-70% dry). Fresh produce enjoy higher gross margins, up to twice that of dry groceries. Similarly, the group is also introducing a greater range of ready-to-eat products in its convenience store segment; management sees significant growth opportunity in this product category.
  • Private labels: Introducing a higher proportion of private label products (i.e. DFI’s own branded products) is another key emphasis for the group. The benefits are not only higher margins, but also greater bargaining power when negotiating with traditional FMCG suppliers.
  • Direct sourcing: This is an area where DFI is relatively lagging behind some of its peers. Direct sourcing not only lowers costs by reducing the middleman’s role, but also improves freshness by shortening the supply chain. Furthermore, this is an area associate company Yonghui is particularly strong at and the group intends to leverage on its fresh direct sourcing capabilities for its other markets.
  • Distribution centres (DCs): DFI already has DCs across a number of its markets. However, it is looking to strengthen its fresh storage capabilities. It opened a new DC in Singapore in 1Q16, and is looking to build a new DC in Malaysia over the next 18 months. Our channel checks indicate that supplier rebates from centralising procurement and delivery at DCs can be significant.

How soon before we can expect to see margins recover?

• We think any recovery in margins will only start to play out in FY17. The overall trading environment in 1Q16 remains weak and little changed from 2015. Management also confirmed in an interim statement that the group is still facing margin pressure from increasing costs, food price deflation and competition.
• However, our margin improvement hypothesis is premised on: 
  1. management executing its cost optimisation initiatives, 
  2. North Asia maintaining its margins, and 
  3. a small margin improvement in East Asia and South Asia following closure of underperforming stores.

Valuation and recommendation

Key changes to earnings estimates

• Following a change of analyst coverage, we updated our model and made the following key changes:
  • Reduced store growth assumptions to reflect the group’s store rationalisation programme.
  • Reduced sales/store assumptions to reflect a tough operating environment.
  • Reduced margin assumptions for the food business in FY16 but a pick-up over FY17-18.
  • Increased margin assumptions for the home furnishings business as Indonesia achieves greater operating leverage.

Current valuations reflect a dim outlook; Downgrade to Hold due to lack of near-term catalysts

• We downgrade the stock from an Add to a Hold, with a lower target price of US$6.75. Our lower target price comes as we cut our EPS estimates and change our valuation methodology (previously residual income model) following a change of covering analyst. Our new target price is based on 20.0x CY17F P/E, pegged to ASEAN peer average.
• The stock is currently trading at 20.2x/19.4x CY16/17F P/E. These are near trough P/E levels and the last time DFI traded at such levels was during the 2008/09 global financial crisis. This is also below the stock’s historical -1 s.d. level of 21.4x. However, we think the focus will be on earnings and whether margins show signs of a recovery. 
• While current valuations may appear attractive relative to its historical trading band, they aptly imply a dim outlook. Its share price first took a beating in mid-2015 after a poor set of 1H15 results and has not recovered since. Management’s 1Q16 statement hints that the worst may not be over; 2H16 may be a better time to relook at the stock.
• Relative to ASEAN peers’ 23.3x/20.5x CY16/17F P/E, DFI trades at a 13% discount to the sector, but it also has a lower 2-year EPS CAGR of 3.2% that lags behind peers’ 11.6%.

PEER COMPARISON

Jonathan SEOW CIMB Securities | http://research.itradecimb.com/ 2016-05-18

CIMB Securities SGX Stock Analyst Report HOLD Downgrade ADD 6.75 Down 10.00