Investment Highlights

• We upgrade our call on Power Root to HOLD from SELL with an unchanged fair value of RM1.21/share, using a PER of 18x FY22F EPS. We make no ESG-related price adjustment for our rating of 3 stars.

• The poor outlook associated with movement restrictions and issues in the Middle East and North Africa (MENA) region has already been priced in, as evidenced by the 41% drop in the share price from the one-year peak of RM2.25/share on 3 September 2020. In spite of this, we believe that weak sales and the lack of positive near-term catalysts would prevent a share price re-rating in the next six months.
   
• Here Are Some Highlights From Our Virtual Meeting With Power Root Recently:

1. Weak margins to continue in the MENA region. With pandemic conditions affecting demand, Nescafe slashing prices to run down its inventory and a 50% sugar tax in Saudi Arabia, Power Root has been forced to sell its products at competitive prices before they expire. As such, the group expects soft profit margins to persist until end-2021E. We believe that the introduction of VAT (value-added tax) in Qatar in 2021E or 2022F would exacerbate the situation in the region.
    
2. Power Root is negotiating directly with potential distributors in non-Gulf Cooperation Council (GCC) countries. Non-GCC countries (Turkey, Iraq) make up c.20% of sales in the MENA region, most of which have been hit by the closure of international borders. Prior to this, the products were distributed via parallel exports in Dubai and other GCC regions. Power Root deems this method as unreliable and is expected to improve its distribution system by 2022F. Until then, we expect weak income contributions from these regions.
    
3. Pandemic lockdowns weigh down Malaysian contributions. With lockdown restrictions still in place, Malaysian sales are expected to remain depressed. Canteen and petrol stations sales in particular have suffered the most. On a positive note, sales in neighbourhood malls and convenience stores are performing better than stand-alone counterparts. Although online contribution has grown significantly over the course of FY21, it is still small. Online sales account for <1% of Malaysian revenue.
    
4. More control over distribution in China. Previously selling straight to third party merchants, Power Root now utilises a subsidiary, which does distribution work via brick-and-mortar flagship stores. Power Root is also utilising e-commerce sellers as well as e-commerce platform grocery stores (similar to Shopee Mart and Lazada Grocery). Although the group is mulling an expansion plan in Japan, the focus remains very much on pre-existing markets such as China.
    
5. Flavouring factory development and production shutdowns. The group’s flavouring factory in Setia Alam, Selangor slated for opening by 4Q2021, is expected to be delayed as a result of MCO and EMCO restrictions. The factory would help reduce reliance on third-party sources for flavouring, thus improving COGS margins. Also, Power Root has halted operations in its Johor factory for one week in July to prevent the spread of Covid-19. However, we doubt that this will have a significant effect on earnings as it is only a week of shutdown. Average utilisation rate in Power Root’s factories is still high at 95% in spite of the 60% workforce restriction.
    
6. Employing alternative marketing methods for new SKU launches, with varying results. While the group’s Ah Huat brand is easier to promote due to its strong brand recognition, newer brands such as Frenche Roast are facing less successful launches due to restrictions prohibiting the use of in-store testing. Thus, Power Root has resorted to more creative methods of getting samples into the household such as attaching free sachets with its Top Baker bread and QL eggs. The group plans to launch three SKUs in 2021E, with two already launched before July. One is an extra Vitamin C-themed drink to capitalise on consumers’ shift towards healthier products.
    
7. Raw material and shipping costs continue to be an issue. Although Power Root has locked in creamer and coffee supplies until 1H2022, rising sugar, aluminium and cardboard costs are expected to erode operating profit margins. The group forecasts a lower gross profit margin of 44% in FY22F in contrast to the usual 47%.

Source: AmInvest Research - 23 Jul 2021