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TheBearProwl: Dairyfarm International is Evolving

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Thebearprowl is a trading and research outfit with focus on Global Equities, FX, Fixed Income and Commodities. We take a view with ideas generated from macroeconomic and fundamental analysis by utilising a comprehensive range of products and solutions across multiple asset classes. We also provide research reports and conduct courses based on the trading strategies we have developed.
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Any content should not be relied upon as advice or construed as providing recommendations of any kind.
Thebearprowl presents Project 2025, a series of investments for the longer term. The term “Project 2025” does not imply that this is a target for year 2025. The term merely attempts to convey the long-term vision of the investment.
The success of every long-term investment is dependent on the existence of both macroeconomic and company centric fundamentals. Such success is typically underpinned by certain initiatives put forth by the company in line with its vision.
This is sixth in the series of our hunt for multi baggers. For the others in our series, please refer to these links:

1) https://www.drwealth.com/genting-is-undervalued-short-term-pain-long-term-gain/
2) https://www.drwealth.com/thebearprowl-why-we-think-temaseks-7-35-offer-for-keppel-is-a-poor-price/
3) https://www.drwealth.com/thebearprowl-perennial-real-estate-holdings-limited-is-undervalued-with-400-upside/
4) https://www.drwealth.com/thai-beverage-public-company-limited-dominant-regional-fb-conglomerate-poised-to-benefit-from-asean-growth/
5) Dairy Farm International Holdings Limited (DFI SP) (SGX: D01)- Evolving into the future

Dairy Farm International Holdings Limited (DFI SP) (SGX: D01)- Evolving into the future

Background

DFI and its associates and joint ventures operated over 10,000 outlets and employed over 230,000 people. It had total annual sales in 2018 exceeding US$21 billion(this number factors 100% share of associates). It is also present in 12 countries and territories in Asia. China, Hong Kong, Singapore, Malaysia, Indonesia account for the majority of its presence.  The Group operates supermarkets, hypermarkets, convenience stores, health and beauty stores, home furnishings stores and restaurants under well-known brands (refer snapshot above). DFI has a 50% interest in Maxim’s, Hong Kong’s leading restaurant chain and 20% interest in Yonghui(601933:CH), a China-based operator of chain supermarkets.

DFI is incorporated in Bermuda and has a standard listing on the London Stock Exchange, with secondary listings in Bermuda and Singapore.

Dairy Farm operates in the following segments: Food, Health and Beauty, Home Furnishings and Restaurants. Food comprises supermarket, hypermarket and convenience store businesses. Health and Beauty comprises the health and beauty businesses. Home Furnishings is the Group’s IKEA businesses. Restaurants is the Group’s catering associate, Maxim’s, a leading Hong Kong restaurant chain.

Brief review of financials

DFI has performed consistently at the Revenue and Gross profit levels over the years, with YoY growth from FY15 to FY18.

However, In FY18, the bottomline took a hit arising from a one time net non-trading charge for the year totaling US$348 million. This included a US$453 million restructuring charge for the Giant Hypermart food business in Southeast Asia partially offset by a net gain of US$121 million principally arising from the reorganisation of Dairy Farm’s interests in the Philippines and Vietnam and the sale of non-core properties. Notably in the Philippines, a gain was recognised on the sale of the Rustan Supercenters, Inc. business in exchange for an investment in Robinsons Retail group.

When we add-back these one-offs in FY18, we note that DFI has actually outperformed FY17. This was driven by higher profits from the convenience stores and Health and Beauty segments. DFI even succeeded in significantly lowering corporate costs. This is the conglomerate benefit where more than one segment outperforms to offset the underperformance of another segment.

DFI has also performed consistently at operating profit levels. Trading ROE has also consistently exceeded 20%, enabled by a D/E ratio of 0.7.


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On a segment basis, all segments with the exception of the Supermarket/hypermarket segment has been able to grow its top-line YoY and also drive higher operating profits. The supermarket/hypermarket segment has faced lower per store revenue and led to multiple store closures and openings in new locations over the years in an attempt to gain market share. Margins were also impacted due to competition and inadequate improvements. Therefore, DFI decided to restructure this segment in FY18 as part of a broader transformation strategy.

DFI has maintained a consistent dividend pay-out in the past few years, paying ~70% of FCF. Barring any operational requirements for a significant cash outlay, we expect the dividends to be maintained. FCF has also been relatively steady. We note that FCF has been about 55-60% of operating cashflow over the years as DFI  has been growth focused. We expect additional capital investments to be incurred in the next 2 years as part of DFI’s transformation strategy and expect FCF/share to be a tad lower. Accordingly, we expect operating cashflow to improve from the capital spend.

Why are we investing?

(i) Economic growth of China and rest of Asia

In 2018, Asia was the fastest growing economic region with South East Asia’s economy expanding 5.1% on average while China’s economy expanded 6.6%. This pace of growth is expected to continue, underpinned by favourable demographics and large-scale capital investments. Foreign direct investment into Asia from the rest of world and rapid productivity growth is also expected to provide further uplift. A consequence of China’s Belt and Road Initiative is that substantial trade and investments also occurring among the various trading partners within Asia.

The population of middle-class in Asia is now about 1.5b, demanding higher standards of living in all aspects of the life, including essentials like Food and other daily necessities. In comparison, there were only 0.5b middle-class people in Asia ten years ago. The upper middle-class population is also expected to double in the next few years from 150m currently. The expectation of this growth is for increased consumer spend on essentials and also certain non-discretionary spend.

While the current economic outlook is susceptible to macro pressures relating to the heightened trade tensions between the US and China. We think that the larger impact will be on capital expenditure and investments and expect essential consumer spend to be stable or even grow.

(ii) Segment Growth – organic and acquisition

DFI has a track record of carrying out acquisitions and also organic growth by opening new stores. DFI has set out concrete plans and targets in relation for new stores across all segments. As DFI’s borrowings is not overly unwieldy, We also expect additional acquisitions in countries with high GDP growth and a growing middle income population.
Previous acquisitions include Yonghui Superstores (China), Giant Supermarkets (Singapore & Malaysia), San Miu Supermarkets (Macau), PT Hero Supermarkets(Indonesia) Robinson Retail Group and Rose Pharmacy (both in Philippines). Maxim’s itself has taken on several franchises in the region, including Starbucks, Shake Shack and Genki Sushi.
These acquisitions are typically funded by debt which tends to be EPS accretive and also enables DFI to build economies of scale in these locations.

(iii) Operational transformation – Rationalisation of operations and adoption of technology

Following the completion of a detailed strategic review in FY2018, it was concluded that Southeast Asia Food was not viable in its current form, impairments were made against the goodwill and assets associated with the Giant business and the leases of the underperforming stores have been provided for as part of the business restructuring charge. Net cash costs related to the restructuring charge was expected to be less than US$50 million.

In addition, DFI has come up with some strategic priorities and improvement programmes which is expected to lead to immediate benefits to the bottom-line. The priorities and improvement programmes will drive revenue growth and also cost efficiencies. The strategic priorities focuses on growing the topline of the business while the improvement programme aims to drive higher same-store revenue and also lower operating costs via logistical efficiencies and labour productivity.

Major risk factors to our call

(i) Macroeconomic headwinds impacting discretionary consumer spending

Risks of recession, cost inflation, currency fluctuations, increases in financing costs, oil prices, the cost of raw materials or finished products might lead to increased operating costs, reduce revenues, or result in some of DFI’s businesses being unable to meet their strategic objectives. DFI has businesses that are deemed as discretionary consumer spend. In addition, consumers can also switch to lower margin goods.

(ii) Impact of political headwinds and evolving government policies

The ongoing social unrest in Hong Kong has impacted and will continue to impact DFI. It was noted that in Guardian Hong Kong, while there was increased spend on certain ‘protest essentials’ like masks and umbrellas, spend on higher profit items like beauty products significantly declined. As such, we have already seen that while Southeast Asia Health and Beauty sales improved, overall Health and Beauty revenue weakened as performance was impacted by difficult market conditions in Hong Kong. Maxim’s performance has also been affected by the ongoing social unrest.

While the main focus of the trade tensions is between China & USA, there are also trade tensions between other countries and economic blocs. Tariffs have caused many companies to incur costs in revamping their logistics and supply route and this is a risk for DFI as well.

Government policies regarding human capital and infrastructure planning are of significant importance to DFI. Labour costs account for more than 10% of revenue and 35% of operating expenses. Similarly, rental expense accounts for about 8% of revenue and 30% of operating expenses. Especially in Singapore and Hong Kong, labour and rental costs has pressured DFI’s bottom line in recent years and will likely continue to do so.

(iii) Delays in implementation / underperformance of planned operational efficiencies  

Following the completion of a detailed strategic review in FY2018, it was concluded that Southeast Asia Food was not viable in its current form, impairments were made against the goodwill and assets associated with the Giant business and the leases of the underperforming stores have been provided for as part of the business restructuring charge. Net cash costs related to the restructuring charge was expected to be less than US$50 million.  DFI is now in the early stages of a transformation and is also continuing its growth and expansion strategy, delays and inability to deliver the expected returns could arise as a result of the other risk factors mentioned in this article.

(iv) Competition

DFI operates in areas that are highly competitive, and failure to compete effectively, whether in terms of price, product specification, technology, property site or levels of service or to adapt to changing consumer behaviours, including new shopping channels and formats, can have an adverse effect on earnings. Significant pressure from such competition may also lead to reduced margins.

Before the advent of the internet, DFI pretty much operated in an oligopoly, however it has now changed with various online shopping sites that enables convenience, possibly at cheaper prices as well. In addition, as some research have shown that a customer prefers to shop in a physical space, some online shopping sites now even have a physical presence which exacerbates the competitiveness of the industry.

DFI is required to consistently evolve just to keep up, and to their credit, they have constantly been forward looking, by building capabilities and innovate, both digitally and offline. DFI is also rolling out

(vi) Conglomerate risk – segmental and geographical underperformance

This is a summary point pulling together the risk factors mentioned above, with this many segments and products, there is a risk that DFI may not be able to deliver a respectable performance on all its segments. DFI averages 30% in gross margins and 4% net profit and any underperformance will have a large impact on the net profit.

This risk has already eventuated as we have seen the supermarket segment drag down the performance of the entire group in FY18. While it seems like the supermarket segment is beginning to turnaround, as evidenced by the stable 1H19 results, the health and beauty segment and also Maxim’s has begun to underperform as a consequence of the social unrest in Hong Kong. A Group-wide underperformance may have significant flow on effect on its operating cashflow, balance sheet and ability to maintain dividends.

5. Valuation and Conclusion

DFI is currently trading at US$5.78, which translates into a market cap of US$8b. This represents a P/E of 19. The 52-week trading range is US$5.65 to US$9.94. The 5-year trading low and high is also similar to the 52-week low and high.
DFI has traded at a PE ratio range of 16-34. (excluding the 2018 non-trading expenses).

The main reason for the initial increase in share price was due to its inclusion into the Straits times index, however the restructuring of the supermarket segment and the subsequent social unrest in Hong Kong caused the share price to plunge more than 40% from the highs.

DFI currently faces macro and competitive challenges in every market that it operates and while it is trying to address the underperformance, drive synergies and also scale up in each market, it is still in the early stages of its recovery plan.

We derive our target by applying a P/E model assuming PE ratio of ~25, a 20% ROE and retained earnings of about 25% is reinvested. We landed on similar valuations by applying the same growth rate to the EBITDA, and cross checking our target against a 13 times EV/EBITDA multiple (The current EV/EBITDA valuation is about 12.8 times).

Entry price: US$5.50
Project 2025’s intrinsic value: S$11.00 providing 100% returns (excluding dividends).

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