Japfa Ltd - CIMB Research 2017-04-13: Victim of cyclicality; multiple near-term headwinds

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JAPFA LTD. UD2.SI

Japfa Ltd - Victim of cyclicality; multiple near-term headwinds

• Japfa had a stellar FY16 that is unlikely to be repeated this year. The problem is weak selling prices in Japfa’s two largest markets (Indo and Vietnam).
• Poultry prices in Indo have weakened considerably in 1Q17 (-11% yoy, -14% qoq on average). The situation is bad and broiler prices are now at loss-making levels.
• In Vietnam, swine prices first started falling in 4Q16 (-c.15%). We were initially expecting a recovery but prices remain depressed. 1Q17 likely sequentially worse.
• We cut FY17-19F EPS estimates by 36-42% on weaker ASPs and lower margins.
• Valuations are now too lofty at 11.7x CY17 P/E (+1 s.d. level) given the multiple headwinds. We downgrade Japfa from Add to Reduce.

What changed? 

• The operating environment has turned against Japfa and the company is facing strong headwinds in two of its biggest markets (Indonesia and Vietnam). 
• As per our latest channel checks, poultry prices in Indonesia have weakened considerably this year (- c.11% yoy in 1Q17, -c.14% qoq). Even as selling prices in 1Q are seasonally weaker (due to the lead up to Lebaran), we understand broiler ASPs are now at loss-making levels. 
• In Vietnam, Japfa is also struggling as swine prices continue to be weak.

Signs of oversupply in Indonesia 

• Concerns regarding an oversupply situation in Indonesia are resurfacing, albeit we are still at a nascent stage. As per our latest channel checks, poultry prices in Indonesia have weakened considerably this year. 
• Day-old-chick (DOC)/broiler prices are down about 11%/11% yoy and 18%/11% qoq. Even as selling prices in 1Q are seasonally weaker (due to the lead up to Lebaran), these are still worrying statistics and we understand broiler ASPs are now below cost of production and at loss-making levels. 
• DOC prices are still at profitable levels but have similarly been on a downward trend.
• Overall, the impact is twofold: 
  1. lower revenue from lower ASPs, and 
  2. depressed margins due to the relatively high fixed cost nature of the breeding and farming business.
• The impact of depressed selling prices on margins is a significant one, especially if prices are below cost of production and dragging down overall profitability. 
• For reference, during the last oversupply imbalance (2H14-1H15), Comfeed’s OP margins were in the 2-5% range. Broiler prices are now at those depressed levels, while the saving grace is that DOC prices are still somewhat holding up. 
• Nonetheless, we think margins will come under pressure and expect margins over the next few quarters to be in the mid-single digit range (4-6%).

Regulatory intervention on the cards 

• According to a Bisnis Indonesia article (dated 31 Mar 2017), the current oversupply situation is estimated to be at c.8%. While this has already had a negative impact on selling prices, the situation is still better than in 2014-15 when the demand-supply mismatch was in excess of 20%.
• In response, it was reported by local media that the Agriculture Ministry has started taking initial measures to reduce supply: 
  1. culling of broiler final stock DOC production by c.8%, 
  2. culling of male layer final stock DOC production by c.20%. 
  This could offer some near-term support to prices but it is worth noting that these initial measures targeted at the final stock level are not long term solutions to the recurring turmoil in the poultry industry. 
• We think there is likely oversupply at the parent stock and grandparent stock level. Hence, we do not rule out the possibility of further government intervention in 2H17 should the oversupply situation persist. 
• While it remains too premature to conclude the severity of the oversupply situation, we take the view that this is a cyclical industry and a downturn is beckoning. 
• 2016 was undoubtedly a good year for the sector but we are now seeing signs of cracks. We think there are near term headwinds for Japfa’s Indonesian market.

High feed margins in FY16 unsustainable; expect some tapering off going forward 

• The group’s mainstay feed business had a strong FY16 showing, buoyed by stellar margins as the group benefited from lower raw material costs.
• Specifically, Japfa had changed its feed mix, using less corn (whose prices were higher following an import ban on corn) and more wheat which was a cheaper alternative. This helped improve feed margins to 13.4% in FY16 vs.
• 10.9% in FY15. However, management is guiding that these are unsustainable levels and we expect feed margins to retreat to FY15’s level.

Swine problems in Vietnam 

• In Vietnam, swine prices continue to be weak due to the tightening of swine imports into China implemented in 4Q16. Recap that this was the weak spot in the group’s 4Q16 results and we think this could continue to strain the group.
• The background is Vietnamese swine producers typically export c.15% of their production to China. When China tightened their imports, this resulted in a domestic oversupply imbalance in Vietnam. Incidentally, management estimates that their swine ASPs also fell by c.15%. We initially expected the situation to quickly pass over but there has been no progress to date. ASPs are still depressed and 1Q17 is expected to be sequentially weaker. Given the longer lead times involved in swine production relative to poultry production, it is also more difficult and takes a longer time for producers to adjust supply in response to a sudden drop in demand.
• Given that the operating environment in Vietnam has not improved, and 1Q17 will include a full quarter of depressed swine selling prices, we see downside risk to 4Q16’s already weak 3% operating margins.

Valuation and Recommendation 

Key changes to earnings estimates 

• While we remain positive on the longer term macro and industry prospects, we note that these current headwinds are especially troubling because Indonesia (67% of FY16 PATMI) and Vietnam (c.21%; Vietnam forms about 70% of animal protein other) are Japfa’s two largest markets.
• We therefore update our model to account for the current depressed selling price environment (poultry in Indonesia and swine in Vietnam). 
• We make the following key changes: 
  1. Lowered Comfeed’s (Indonesia) OP margin assumptions to reflect potential losses in the broiler business 
  2. Lowered Animal protein other’s OP margin assumptions to reflect weakness in Vietnam’s swine prices 
  3. Lowered Dairy’s OP margin assumptions given a still benign raw milk price environment in China.

Downgrade to Reduce on multiple near-term headwinds 

• We downgrade the stock from an Add to a Reduce, with a lower target price of S$0.69. 
• Our lower target price comes as we cut our FY17-19F EPS estimates by 36-42%. Our target price also implies a target multiple of 9.7x/8.3x CY17/18F P/E, which we think is fair given the multiple headwinds the company is facing, although we also note that the stock traded as low as 4x forward P/E during its last downturn. 
• If the selling price environment deteriorates further, we do not rule out the possibility of valuations falling to those trough levels.
• At current valuations of 11.7x CY17F P/E, this also translates to the stock trading near its historical +1 s.d. level of 11.9x and way above its historical mean of 8.7x, which we think is too expensive and unjustified given the multiple near term headwinds. 
• Even as we believe Japfa’s operations on the ground are doing well, the current weak selling price environment means profitability is inevitably going to be weak. 
• Disappointing results will de-rate the stock, in our view. 
• Risks to our call include a recovery in prices, which could be sparked by better than expected demand from Lebaran, or government intervention such as culling.

Jonathan SEOW CIMB Research | http://research.itradecimb.com/ 2017-04-13

CIMB Research SGX Stock Analyst Report REDUCE Downgrade ADD 0.69 Down 1.410