Sheng Siong Group (SSG SP) - Maybank Kim Eng 2017-02-27: Look elsewhere for cheaper growth plays

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SHENG SIONG GROUP LTD OV8.SI

Sheng Siong Group (SSG SP) - Look elsewhere for cheaper growth plays

Maintain SELL; cut TP a further 3% to SGD0.85 

• Maintain SELL post-FY16 results. We find it hard to justify 23x P/E for single digit growth, and growth will keep slowing amidst greater traction by online grocers. 
• In our view, Sheng Siong’s operating model is also unsustainable as it depends too much on margin improvement to drive ROE, while asset-use efficiency has deteriorated. With margins close to peaking and store expansion challenges, growth will remain slow unless it is willing to gear up to acquire growth either locally or overseas. But that will certainly change its risk profile. 
• We lower FY17-FY18 EPS estimates 3-4% and our DCF-TP 3% to SGD0.85 (WACC 7.1%, LTG 1%).

1. 4Q/FY16 results review 

Uninspiring end to FY16 for SSSG

• FY16 net profit of SGD62.7m (+10% YoY) was within our expectation, but still uninspiring. Same store sales growth (SSSG) ended the year on a weak note. 4Q16 SSSG was flat at +0.2% YoY, mirroring the full year’s 0.2%. 
• Net profit growth over the last five quarters has slowed drastically from >20% YoY a year ago to single digit growth by 3Q16 and just 5.7% in 4Q16.

Industry beat-rate has eroded

• In the past, Sheng Siong managed to outgrow the rest of the industry by a factor of 1.6x to 1.8x. But its latest full-year results showed that this has fallen to just 1.2x in FY16, partly due to closures of two outlets late last year for renovations, namely Tampines Blk 506 and Loyang Point Blk 258, and also to a sharp slowdown in same store sales growth.

Some bright spots

• However, new store sales growth benefited from the Sep 2016 opening of Yishun Junction 9, rising 8% YoY in 4Q16, taking new store sales growth to 6.2% for the full year. This helped to offset the weak SSSG. 
• Gross margin also improved YoY to 26.3% in 4Q16, another record high, driven by a higher proportion of fresh produce at 42% of total sales in 2016, up from 40% at the end of FY15.

2. Expect growth to slow 

Euromonitor forecasts Singapore supermarket growth to slow drastically in 2016-2021 

• According to Euromonitor, Singapore’s supermarket scene is set to see a sharp slowdown during 2016-2021 to a CAGR of just 1.6% after growing 4.2% in 2011- 2016. The reasons cited include the following: 
  • Online grocery retailers are set to gain traction as tech-savvy consumers in Singapore take to the convenience that Internet retailers offer. In addition, online grocers are set to continue to offer new services and comfortable shopping experiences using data analysis to capture constantly evolving online consumer behaviour.
  • Existing grocery retailers are expected to face competitive challenges; Euromonitor flags the expected entry of global players, such as Amazon and Tesco. Amazon in particular has been reportedly buying refrigerated trucks and warehouses in Singapore as they prepare to launch AmazonFresh online fresh grocery retailing this year. While store-based grocery retailers are likely to still see positive growth, it is likely to be limited. 
  • Convenience stores are also expected to fight back against the encroachment into their territories by store-based grocers that had opened smaller budget outlets in residential areas, such as FairPrice Shops by NTUC.
• 7-11 is responding by increasing the size of their new outlets and by stocking premium products. These include lifestyle products and IT gadgets, 7- Connect lockers (self-collection stations where online shopping parcels can be picked up), ATM machines, seating areas, and a new line of fresh-chilled, ready-to-eat meals delivered to stores daily. 40 flavours will be available in 2017, up from just seven flavours currently. 
• In addition, Singapore’s number 1 online grocery shopping website Redmart was acquired by Lazada in late 2016. RedMart CEO and co-founder Roger Egan was quoted as saying “Through this partnership, we can further scale our logistics and tech platform to extend our product assortment and to offer an even more convenient service for our customers in Singapore. The capital flexibility provided through this deal will go towards innovating to delight our customers”. In our view, we can basically expect a more price-aggressive RedMart in future that will make it easier for consumers to use their services.

7-Eleven could also enter the site-bidding race 

• The bidding for sites has already become intense due to the aggressive entry of smaller regional supermarket operators, such as Yes, U-Star and Angmo since 3Q16, as we flagged last year. If 7-Eleven, which is owned by Dairy Farm and has 430 outlets in Singapore currently, goes ahead with its expansion plan, this could lead to greater competition even for smaller HDB sites.

3. Operating model not sustainable 

ROE improvement not driven by asset-use efficiency 

• We did an ROE decomposition to see what has been driving Sheng Siong’s ROE growth in the past few years and we did not like what we found. From the charts, it’s clear that ROE improvement has been driven only by margin improvement, while financial leverage and asset-use efficiency have not been factors.
• The biggest problem we have with this is the fall in asset turnover since 2013, as it implies an inability to improve asset-use efficiency. This is a more sustainable driver of ROE than margins, which can be due to trends that can either stall or go into reverse (as we will explain later). The reason behind the fall in asset turnover becomes clearer when we use fixed assets turnover to illustrate it. Since 2014, Sheng Siong has purchased three properties which currently house three outlets - 506 Tampines Central for SGD65m, 209 New Upper Changi Road for SGD53m, and 18,500 sf of retail space in Yishun Junction 9 for SGD55m – and they have directly contributed to lower asset turnover.
• Another reason for the struggle to improve asset turnover is deteriorating inventory turnover. Sheng Siong is maintaining more stock than ever now that it has expanded its store network to 42 outlets. On the negative side, the distribution centre has not helped to reduce inventory turnover, while on the bright side, cash collection has not suffered. The higher inventory could have been exacerbated by slower sales growth, as comparable store sales have fallen due to greater competition and belt-tightening that has affected even Sheng Siong.
• So essentially, Sheng Siong has seen slower turnover of its assets as comparable store sales have fallen, and this has been compounded by the need to acquire expensive fixed assets (instead of an asset-light renting approach) to maintain its store presence in busy areas, such as bus interchanges and town centrals. At the same time, it has not been able to leverage on operating efficiency or asset-use efficiency to reduce capital needs. And now even new store sales growth could be affected by increasing competition from smaller regional supermarket chains or perhaps even 7-Eleven. This is not a sustainable operating model for a lowcost, high turnover business, such as Sheng Siong’s, in our view.

Potential for further margin improvement could be limited 

• One part of supermarket margins that is not well-discussed is the rebates they get from suppliers for whom they sell their products. There are generally three types of rebates.
  • One, service rebates, which suppliers pay in exchange for centralised delivery to Sheng Siong’s warehouse so that they do not have to deliver to each separate outlet.
  • Two, promotional rebates, which supermarkets get when they boost sales of their products by running promotions on them and hit volume targets. For example, Coca Cola could offer a percentage discount on 1-litre bottles if enough of them are sold within a given period.
  • Three, “play-one-against-another” rebates where Sheng Siong gets different suppliers to compete against one other to offer the best price. Products where there are many brands that are similar (e.g. instant coffee, cigarettes, beer) lend themselves best to this tactic.
• Sheng Siong’s margin and ROE trends do not appear to be correlated to greater operating efficiencies, but we note that there appears to be a closer correlation to the number of stores than either asset turnover, inventory or comparable store sales growth. If the improvement had been driven more by greater supplier rebates, it would make sense. The more stores it has, the greater sales volume it would be able to achieve, thus raising the volume-related rebates from suppliers. It could also charge higher listing fees. According to management, these rebates accounted for 3 percentage points of its gross margin in 2016, compared to just 1% in 2011.
• The issue is now slowing turnover and the rising competition for sites. As a result, Sheng Siong’s ability to grow volumes enough to justify more rebates could become increasingly hampered. Hence, the potential for margins and ROE to improve further would appear to be limited.
• Interestingly, Sheng Siong’s management admitted that online grocers can become a credible threat once they scale to a high enough volume, as suppliers become enticed to work with them to promote their products. They will also be eligible for supplier rebates that Sheng Siong counts on for more than 12% of its gross profit (3ppt of its FY16 gross margin of 25.7%).

Other ROE-moving levers also limited 

• Management could also try other levers to drive ROE higher. 
• In our view, the following are possible: 
  • Raise margins further by more bulk handling & direct sourcing – but the scope to achieve this is increasingly limited. 
    • Sheng Siong could further raise the proportion of sales from higher-margin fresh produce from 42%, which is up from 32% of sales when it first listed in 2011. However, the pace of improvement is likely to slow as Sheng Siong is already sourcing 65-70% of its fresh produce directly. 
    • Also, its warehouse is almost fully utilised, hence further upside to centralised bulk-handling rebates from suppliers is also limited. The extension will take 18 months to complete. 
    • Direct sourcing has its own unique challenges. For example, chicken from Thailand is not well accepted in Singapore as Thai farmers use seafood-based feed, which results in the chicken meat smelling fishy. According to management, they do not see much upside left for vegetables, fish, and meats, which are already sourced directly. Only frozen meat and seafood have scope for extension, but we believe demand is minor for frozen foods in Singapore. We have already factored in 300 basis points improvement in gross margin pa for FY17-19E, in line with management guidance. 
  • Raise financial leverage (assets/equity) – but what to buy? 
    • Sheng Siong could gear up its currently net-cash balance sheet. However, then the question becomes, what is desirable to buy? It could become a multi-format retailer, such as Dairy Farm, which is in supermarkets & hypermarkets, convenience stores, health & beauty stores, restaurants (and even home furnishing stores). But the same pressures that are affecting supermarkets would also apply, namely a limited domestic market that is already highly competitive in all these areas. 
    • Acquisitions of supermarkets in other countries, such as China are also possibilities, but that would change the risk profile of Sheng Siong – not something that investors, who buy it for the stable earnings and dividends, and low risk operations, would want to see.

4. Forecasts & assumptions 

• We are forecasting flattish net profit in FY17 (up just 1% YoY) before a soft recovery in FY18 of 5%. We had previously forecasted 5.5% growth in FY17, and our latest forecast represents a 4% downgrade.
• Our FY17 forecast factors in the following: 
  • Closure of The Verge and Woodlands 6A outlets. By end-May 2017, Sheng Siong’s 45,000 sf store at The Verge will be vacated as the lease has ended without the possibility of renewal following the new owner’s plan to redevelop the whole building. By end-Aug 2017, another store with 41,000 sf of selling space at Blk 6A Woodlands Centre Road will be closed following the HDB’s plan to redevelop the whole estate. These two stores contributed 8.5% of FY16 revenue and accounted for 19% of total selling space. The good thing is that these two stores have underperformed and generated only SGD783 in revenue PSF pa in FY16 vs the group average of SGD1,826. Essentially, Sheng Siong only needs to add 33,000 sf of space in FY17E to plug the hole.
  • Re-opening of Loyang Point and Tampines 506 stores, plus one more. It will get this 33,000 sf once the Loyang (7,200 sf) and Tampines (25,000 sf) stores are re-opened. Loyang Point was opened in Feb, while Tampines will be opened in May. Along with another 10,000 sf of new selling space (which could come from a closed bid that it is currently pursuing with HDB), Sheng Siong should be able to almost fully plug the hole left by the two closures.
  • In addition, we have factored in some revenue contributions from China from FY17, using the assumptions shown in the tables below. However, we have also modelled in higher operating expenses, such as labour.
• Further out, we have lowered our FY18E and FY19E Singapore sales growth forecasts to track Euromonitor’s forecasts. Even assuming Sheng Siong is still able to grow faster than the market average by the lower-end of its historical industry beat-rate of 1.5-1.8x, we now only project growth of 2-2.5% pa vs expectations of 4-5% previously. 
• Our latest FY18 forecast of 4.9% growth represents a 3% downgrade from our previous forecast. 
• Our FY19 forecast of just 3.3% growth is newly introduced.

Swing Factors

Upside

• Higher-than-expected revenue growth on the back of food inflation and more new stores than expected.
• Better-than-expected food cost savings or lower labour costs following greater automation.
• Winning of more-than-expected number of tenders for public housing sites for new supermarkets.

Downside

• Inability to win bids for HDB supermarket sites due to entry of aggressive competitors could lead to delays in new store expansion.
• China supermarket venture does not take off as successfully as expected.
• Inability to pass on higher food costs due to increased competition.

Gregory Yap Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-02-27

Maybank Kim Eng SGX Stock Analyst Report SELL Maintain SELL 0.85 Down 0.880