High On Caffeine

After a downbeat FY18 on margin erosion from: a) higher raw material prices, b) higher opex, and c) forex loss, Power Root expects to stage a strong recovery in FY19 on lower raw material prices and streamlining of A&P spending. Power Root is seen as a cheaper proxy to the small-cap consumer space, trading at 15x FY19F PE based on consensus FY19 earnings forecast of RM38.6m. The stock offers decent yields given its minimum 50% payout, healthy balance sheet and minimal capex.

WHAT’S NEW

• A leading coffee brand in Malaysia. Power Root, which is established in 1999, is a manufacturer and distributor of beverage products such as instant coffee, instant tea, herbal drinks, energy drinks, etc. Its leading brands include Alicafe, AhHuat, Per’l, etc. Unlike its local competitor, OldTown which derived 25% of earnings from F&B retail outlets, all of Power Root’s sales come from sale of FMCG. For FY18, 49% of its sales were from export markets, mainly in the Middle East region.
• Power Root expects a strong recovery in FY19… Excluding RM6.7m one-off items, FY18 core net profit declined 59.9% yoy to RM16.1m as Power Root was hit with higher raw material prices notably coffee and sugar, higher opex, as well as forex loss of RM5m (FY17: forex gain of RM8m). This is despite a 6.3% yoy growth in its top-line. Moving forward, management has stated that it will focus on improving its margins. Based on consensus estimates, Power Root’s FY19 earnings stood at RM38.6m (+139.5% yoy).
• …on lower raw material prices... Power Root’s COGS comprise of 30% coffee, 30% creamer, 25% sugar and others. It has locked in coffee prices at 14% lower than FY18’s level, to be utilised from 2H18 onwards until end of 2H19. Meanwhile, the recent downtrend in global prices will translate into lower sugar prices for Power Root. Global sugar price is currently at US$11.84/lb, 17% lower from average of US$14.26/lb in FY18. Hence, management expects gross margin to improve from its five-year low of 41% recorded in FY18 vs gross margins of 48-49% for FY15-17.
• …and lower A&P spending. For the past four fiscal years, advertising and promotion (A&P) spending was high, accounting for 21-22% of sales (see RHS chart in Page 2) amid the stiff competition in the instant coffee segment. Given Power Root’s high base of A&P, there could be ample room for it to reduce its A&P spending which could improve margins further.
• A cheaper proxy to the consumer space. The consumer sector has undergone a significant rerating in its valuations since early of the year, with many blue-chip consumer names currently trading +1SD and +2SD above their historical mean valuations. When compared to small mid-cap consumer names such as Kawan Food, Hup Seng Industries, etc. Power Root is cheaper at 15.1x FY19F PE (based on consensus estimates).
• Attractive yields. Power Root has a dividend policy of a minimum 50% payout. We note that historically for FY15-18F, its payouts were considerably higher than the minimum 50% payout (see RHS chart). Below are the yields of Power Root based on various payout scenarios.
• A potential takeover candidate. Last year, OldTown was acquired by Jacobs Douwe Egberts (JDE) for RM1.47b. Based on OldTown’s FY17 net profit of RM60.8m, the pricetag represents a PE of 24x. Its other competitor Super Group, best known for its Super brand instant coffee packs, was also acquired by JDE earlier in Jun 17 for SG$1.45b, which represents a PE of 30x based on its FY15 net profit of SG$47.3m. Based on these acquisitions PE of 24-30x, Power Root could be valued at RM926m-1.16b (based on consensus FY19 net profit of RM38.6m), translating into RM2.80-3.50/share.

ESSENTIALS

• Net cash position with minimal capex. As at end-FY18, Power Root was in a net cash position of RM19.4m, with minimal capex requirement given that its capex is largely on maintenance. Power Root does not manufacture its own coffee powder. It purchases coffee powder and other ingredients from suppliers and mixes them according to its own recipe, hence the low capex requirement.
• Bonus issue with free warrants. In May 18, Power Root proposed a 1-for-5 bonus issue with one free warrant for every existing 5 Power Root shares. The exercise is intended to improve the trading liquidity of the shares and the free warrants provide an opportunity for investors to further increase their equity participation in the company.

EARNINGS REVISION/RISK

• Based on Bloomberg figures, FY19-21 consensus earnings forecasts stand at RM38.6m/RM46.8m/RM51.4m.
• Key risks include higher-than-expected raw material prices, intensifying competition in the FMCG (beverage) segment, and significant strengthening of the ringgit against the US dollar as its export sales are transacted in US dollars.

Source: UOB Kay Hian Research - 22 Jun 2018