Consumer companies should do well in 2H18 on the back of a rosy consumption outlook, lower raw material prices yoy and a stronger ringgit yoy. However, the sector has outperformed the FBMKLCI by 39% ytd, which has led to limited sector upside. Nevertheless, the lofty valuations will be supported during this period of risk aversion. For exposure to the sector, buy decent yielding stocks, eg brewery stocks. Maintain MARKET WEIGHT.

WHAT’S NEW

Rosy consumption outlook in 2H18, driven by a three-month tax break from zero-rated GST. Since the implementation of the zero-rated GST on 1 June, positive momentum has been seen in sales of food and beverage (F&B) items, as well as cigarettes. However, we note that in the longer term, the sustainability of the positive outlook will depend on the implementation of various policies (eg increase in minimum wage, introduction of sales and services tax (SST) and its quantum, etc.) by the new government to increase the purchasing power of consumers.

ACTION

Maintain MARKET WEIGHT on the sector as lofty valuations will be supported during period of risk aversion. Notwithstanding the rosy consumption outlook in 2H18, we see limited upside for the sector. This is due to the significant run-up in share prices ytd, whereby all consumer companies under our coverage are trading well above their historical mean valuations with uncompelling yields.

SELL Nestle and QL. Although we expect Nestle to chart double-digit 11.1% yoy earnings growth for 2018 driven by: a) a 5.3% yoy growth in top-line, and b) improvement in margins from lower raw material prices, we note that its valuations are stretched at 45.8x 2019F PE, way above its five-year historical mean PE of 30x. We also take the opportunity to downgrade QL Resources (QL) to SELL (from HOLD). Despite a prospective strong recovery of +25% in its FY19 PBT after a lacklustre 3-year PBT growth CAGR of 1.3% in FY15-18, the recent run-up in share price does not justify its lofty valuation at 38.8x FY19F PE, which is way above its five-year historical mean PE of 26x.

For exposure to the sector, buy decent-yielding stocks. The brewery segment still offers decent yields of c.4% despite the ytd run-up in share price. Given the effective price hikes of 3-5% by the brewers for Malaysia in Apr 18, we prefer Heineken as almost all its sales are derived from Malaysia (vs Carlsberg which derives one-third of sales from its Singapore operation). We also like Power Root, a small-cap beverage manufacturer of instant coffee brands such as Alicafe, Ah Huat, etc. Power Root expects to stage a strong recovery in FY19 on lower raw material prices and streamlining of A&P spending. Based on consensus FY19 earnings forecast of RM38.6m, Power Root is trading at 14.9x FY19F PE and offers decent yields given its minimum 50% payout, healthy balance sheet and minimal capex.

ESSENTIALS

Rising skimmed milk and cocoa prices since early-18… We expect 2H18 gross margins of F&B companies to rise yoy on lower prices of raw materials which were hedged during the downtrend in raw material prices in 2H17 – skimmed milk, cocoa and CPO. However, we expect gross margins for 2019 to be impacted by the uptrend in skimmed milk and cocoa prices (see RHS chart).

…and higher packaging costs may hit gross margins for 2019. The recent surge in oil prices will lift prices of resin, a key raw material of plastic packaging, while aluminium price increase of 8% ytd from 2017’s average of US$1,968/tonne will raise can packaging costs.

However, low sugar prices in 2H18 will benefit F&B players with sizeable COGS exposure to sugar. Sugar prices declined 25% to US$11.8ct/lb currently from 2017’s average of US$15.8ct/lb. All large F&B players buy sugar from MSM Malaysia (MSM) based on a pricing formula, which depends on MSM’s locked-in prices for raw sugar and the US$/RM rate. Given the estimated 6-12 months’ hedging done by MSM and the yoy strengthening of the US$/RM to RM4.05 currently, we expect lower sugar prices from 2Q18 onwards to benefit F&B players such as F&N and Power Root.

Potential excise duty hike for tobacco, highly unlikely for brewery. An excise duty hike for tobacco products is likely, given that the last hike (at +43%) was back in Nov 15. However, we believe that the brewery segment will be spared from hikes in excise duty for beer given that the existing excise duty is already the third highest in the world, after Norway and Singapore.

Source: UOB Kay Hian Research - 6 Jul 2018