Earnings Decline Vs. Positive Indicators

Despite the earnings decline in 1Q17, MIER consumer sentiment showed a slight improvement, and inflation while relatively high, tapered down slightly in April 2017. We take comfort in positive macroeconomic indicators such as GDP and private consumption, along with our belief that the Ringgit will strengthen in 2017. We maintain our NEUTRAL call on the sector, and our top picks are QL Resources for its defensive qualities and Hai-O for growth.

1Q17 Net Profit Down 22% YoY

1Q17 net profit for the sector decreased by 22% YoY, as consumer stocks reeled from weak consumer sentiment and heightened expenses. Among our coverage 6 out of the 10 companies reported below expectation results, while the rest posted in line results.

Consumer Sentiment Up Slightly, Inflation Lower Though Still Elevated

For 1Q17, MIER’s consumer sentiment index improved by 6.8 points QoQ to 76.6, but is still below the 100-point threshold. While inflation has been on an upward trend for 1Q17 (5.1% YoY in March 2017), it has improved to 4.4% YoY in April 2017. Main culprits were higher transport costs, food and non-alcoholic beverages and recreation services/culture.

MIER Retail Trade Dips But RGM Remains More Positive

MIER’s retail trade index fell by 19.8 points to 71.6, the second quarterly dip since 3Q16, while it was above the 100-point level for only 2 quarters. According to Retail Group Malaysia (RGM), 1Q17 recorded another disappointing sales drop of 1.2% YoY (vs 1Q16: -4.4% YoY), but they are maintaining the 3.9% YoY growth forecast for 2017 (vs 1.7% YoY in 2016), as retailers remain optimistic that their businesses will pick up by 2Q17.

GDP and Private Consumption Recorded Stronger Growth

Overall, while both GDP and private consumption recorded strong 1Q17 growth of 5.6% YoY and 6.6% YoY (vs 4Q16: 4.5% YoY and 6.1% YoY respectively), there seems to be a disconnect when compared with 1Q17 earnings, which we discuss later in our report. We still expect consumer sentiment to recover slowly as consumers deal with higher inflation (forecast at 3.5% in 2017 vs.2.1% in 2016).

Maintain Our Neutral Sector Call

The retail sector remains challenged, while the outlook in the F&B segment looks more positive as some raw material prices seem to be tapering down. Illegal cigarettes remain key problems for tobacco players, but 2H17 should show margin expansion at BAT as cost savings may come into play from sourcing cigarettes regionally. We maintain our NEUTRAL sector call; our top picks: QL Resources (QLG MK, RM4.83, BUY) for its defensive nature and Hai-O (HAIO MK, RM3.91, BUY) for earnings growth. Among the brewers, we flag Heineken (HEIM MK, RM18.84, HOLD) and Carlsberg (CAB MK, RM14.80, HOLD) for their solid brand names and dividend yield.

1Q17 Review

1Q17 Net Earnings Decreased by 22% YoY

Headline net profit for the consumer sector decreased by 22% YoY in 1Q17. Net earnings decreased for Aeon, BAT, Heineken, while MSM and Parkson reported net losses which mitigated the gains from the rest of the coverage. This quarter did not see any companies under our coverage with net profit above expectations. Earnings for Hai-O, Nestle, Carlsberg and Heineken were within our expectations, but Aeon, MSM, QL Resources, Parkson, Bonia and BAT reported below our expectations. In the retail segment, Aeon suffered earnings decline of 21% YoY, as consumer sentiment remained relatively weak. Parkson recorded a net loss of RM 33.2m for 3QFY17, bringing total 9MF17 loss to RM 273.8m. Its 3QFY17 revenue posted a slight decline but EBIT losses were recorded across its operations in Malaysia, Vietnam, Myanmar and Indonesia except China which turned around after 3 quarters of losses on cost control efforts. While Bonia’s earnings increased by 8% YoY, stripping out the exceptional items, its core net earnings decreased by 21% YoY. Top line remained weak, but the company’s strategy of reducing discounts and closing down non-performing stores improved margins. On the other hand, Hai-O’s earnings increased by 57% YoY due to growth from its multi-level marketing business. Looking at the F&B segment, Nestle’s earnings grew by 4% YoY as revenue grew by 4% due to growth in both domestic sales and exports. MSM in turn was badly hit, and recorded a net loss of RM34.6m because of a spike in raw sugar price as well as RM weakness. We had downgraded MSM to a SELL from HOLD as we believed that high contracted raw sugar costs will still affect the Group in the next quarter. For QL Resources, 4QFY17 net profit grew by 24% YoY, but stripping out the gain on disposal of property, its core net profit was down 2% YoY (See our initiation). Nonetheless, revenue grew by 6% YoY, mainly due to the palm oil and integrated livestock farming segments. The tobacco segment remained challenging as BAT's net profit declined by 32% YoY because of a large volume contraction of 23% YoY, as volumes are yet to recover from the excise hike-led price increase in November 2015. Of the two brewery stocks, Carlsberg performed better with earnings growth of 7% YoY, compared to Heineken (-4% YoY) due to higher sales in both its Malaysia and Singapore operations versus weaker sales for Heineken. We summarize our recent changes to earnings, ratings, and target prices post the 1Q17 results in Figure 1.

Margin Compression for 6 Out of 10 Companies

While four companies under our coverage experienced margin expansion mostly due to the companies’ efforts in cost rationalisation and increasing efficiency, the other six under our coverage experienced margin compression this quarter as seen in the table below as they were hit by higher raw material costs and expenses. For example, MSM has seen revenue growth since 4Q15 but margins have been hit at the net profit level due to the sharp increase in raw sugar prices and Ringgit weakness. Retailers like Aeon and Parkson also saw core net margin contraction for most quarters as the department store format continues to experience declining spending while costs balloon.

KLCSU Index Up 8.5% Ytd Despite Earnings Weakness

Although earnings declined, the Bursa Malaysia Consumer Product Index (KLCSU Index), a capitalization-weighted index of all consumer stocks in the EMAS index, recovered by 8.5% ytd to 626 (vs: a decrease of 2.1% to 577 in 2016). This may be partly due to the Ringgit strengthening from RM4.48/US$ in January 2017 to RM4.26/US$ levels currently which will be a boon for companies with high percentage of expense in foreign currency.

On the Consumer Side…

MIER Consumer Sentiment Index Still Shows Weak Reading

Based on the MIER Consumer Sentiment Index, consumers remain subdued, with the MIER’s latest 1Q17 reading up by 6.8 pts QoQ to 76.6 but still below the 100-point confidence threshold. We believe it remains a challenging year with factors such as higher inflation, but consumer sentiment may recover slowly as several macroeconomic indicators, such as a higher-than-expected GDP growth and resilient private consumption, point towards a better 2H17.

Headline Inflation Improved to 4.4% YoY in Apr 2017

While Malaysia’s headline inflation has been on an upward trend in 1Q17, it improved to 4.4% YoY in April 2017, from 5.1% YoY in March 2017. The largest increase in the CPI index would be the transportation price index, which saw double digit YoY increases since February 2017 to April 2017(+16.7% YoY). This is followed by food and non-alcoholic beverages (+4.1% YoY) and recreation services and culture (+3.0% YoY). Nonetheless, clothing and footwear as well as communication experienced a decrease in price at 0.1% YoY and 0.3% YoY, respectively. Our economist had previously revised the full-year inflation rate in 2017 to 3.5% YoY in March 2017 (higher than earlier 2017 forecast of 2.7% YoY and 2.1% YoY in 2016), which is at the mid-point of the official forecast of 3.0-4.0%. Based on this, we believe inflation will likely moderate in the months ahead, though it is highly dependent on the direction of the global oil price.

On the Retailer Side…

MIER Retail Trade Index Below the 100-pt Threshold

The 1Q17 MIER Retail Trade Index reading has dipped by 19.8 pts to 71.6, the 2nd quarterly dip since 3Q16, while it was above the 100-point threshold for only two quarters, delaying hopes of a longer term strengthening of sales and business conditions.

Producer Price Index Reached a High in Feb 2017 Before Trending Down

Looking at Malaysia’s producer price index (PPI), which measures inflation at the producer/manufacturer level that can be used as a rough gauge of future consumer prices, growth was previously in the negative territory for 23 straight months from October 2014 to August 2016, before rising significantly from September 2016. In February 2017, PPI spiked to 10.8% YoY, highest since 2011, attributed partly to the weaker Ringgit against US$ and higher global commodity and energy prices, but it has tapered down to 7.5% YoY in April 2017. Nevertheless, this is still a considerable increase, which suggests producers may still pass on costs to consumers, which in turn might dampen spending. Nonetheless, some companies have already raised prices in 1Q17.

RGM Maintains Sales Growth of 3.9% YoY for 2017E

According to Retail Group Malaysia (RGM), the retail sales growth rate was on a downward trend from 8.4% YoY in 2010 to 1.4% YoY in 2015 before growing slightly by 1.7% YoY in 2016 (below previous estimate of 3% YoY). Following this, RGM had, in March 2017, revised down their target for 2017 from 5% YoY to 3.9% YoY, and they are still maintaining this target. While 1Q17 recorded another disappointing growth rate of -1.2% YoY (vs 1Q16: - 4.4% YoY), Malaysian retailers are optimistic that their businesses will pick up by 2Q17, projecting a growth rate of 4.8% YoY.

Malaysia Tourist Arrivals Up by 4% YoY in 2016 (vs -6% YoY in 2015)

Tourist arrivals to Malaysia increased by 4.0% YoY to 26.7m in 2016, a

Recovery From 2015 When the Visitors Decreased by 6% YoY to 25.7m.

Arrivals are expected to continue to recover, with the government targeting 31.8m in 2017 and 36.0m by 2020. While 1Q17 recorded a relatively flat total number of 6.63m (vs 1Q16:6.67m), we believe that the government is committed to attracting tourists with the extension of visa exemptions for a year to tourists from China until 31 December 2017. Also, the introduction of e-Visas in March 2016 to target tourists from China and India should facilitate tourist arrivals. Moreover, tourists may find Malaysia more attractive due to the Ringgit weakness.

Positivity in Macroeconomic Indicators

Real GDP Growth Surprised at 5.6% YoY in 1Q17

Malaysia recorded 1Q17 GDP growth of 5.6% YoY in 1Q17 (vs 4Q16: 4.5% YoY and FY16: 4.2% YoY), attributed to total investment growth of 10% YoY, which was mainly driven by private investment that rose sharply to 12.9% YoY in 1Q17, significantly higher than 4.9% YoY in 4Q16.

Private Consumption Rose Further to 6.6% YoY in 1Q17

Growth in private consumption rose further by 6.6% YoY in 1Q17, higher than 6.1% YoY in the previous quarter, supported by healthy employment and wage growth and selected Government measures such as BRIM. Despite the unemployment rate remaining at around the 3.4-3.5% level, employment growth in 1Q17 was actually the strongest in these two years at 1.8% YoY, compared to the growth of 0.9% YoY in 4Q16

Higher 2017E GDP Growth of 4.8% YoY, From 4.2% YoY in 2016

Our economist has revised forecasts for 2017 GDP to 4.8% YoY (previous forecast of 4.4% YoY) from 4.2% YoY in 2016, with the belief that economic growth momentum will continue on the back of strong export performance and sustained domestic demand. Moreover, based on our economist’s assumption that the Ringgit will strengthen to RM4.10/US$ by end-2017 with an average at RM 4.20-4.30/US$ for 2017 (ytd average at RM 4.40/US$, 2016 average of RM4.14/US$), we expect it to have a positive effect on consumer sentiment.

Labour Market Conditions Remain Stable

Labour market conditions remained stable, with i) a growing population of 31.7m in 2016, with 70% below the age of 40, ii) a healthy labour market with a healthy unemployment rate of 3.4% as of March 2017, iii) a steady labour force participation rate of 67.7% as of March 2017 although estimated wage growth of 1.3% YoY in 1Q17 has slowed from last year’s average of 3.8%.

Update on FMCG

Cost of Raw Materials: Some Tapering Down

We had previously argued that the cost of raw materials would continue to be a significant factor for companies. Nonetheless, while we note that average prices for some raw materials have increased for 1Q17 as compared to 2016, some appears to have tapered down in 2Q17, the most notable being raw sugar.

Valuation and Recommendation

Why the Discrepancy Between 1Q17 Earnings and GDP Growth?

1Q17 saw earnings disappoints from six out of the ten companies under our coverage, while performance were in line for the rest. Nonetheless, GDP surprised on the upside with a 5.6% YoY growth and private consumption remained resilient, climbing higher to 6.6% YoY. Perhaps one might wonder why the 1Q17 earnings did not reflect this positive news. Below we highlight some of the reasons: a) Firstly, we need to understand the components of GDP and private consumption to know where the growth came from. GDP growth does not only come from private consumption, but also from the investment side which rose strongly by 12.9% YoY in 1Q17, significantly higher than 4.9% YoY in 4Q16. Nevertheless, looking at the components of private consumption, food and beverage accounted for the largest portion at 21%, followed by utilities (16%) and transport (14%). Therefore, within the consumer space, we would assume the food and beverage sector should have benefited more. b) Nonetheless, beneficiaries of higher private consumption may not necessarily be listed companies on the stock exchange. For example, higher consumption is mainly driven by higher F&B spending, but the outlets that benefit from this may be smaller shops that are not listed. Looking at our F&B stocks, Nestle’s top and bottom line grew and was in line with our and consensus expectations as their products are mainly in the consumer staple space. MSM and QL showed top line growth, but MSM disappointed on the bottom line due to high cost of sales, whereas QL’s net profit was slightly below expectations after discounting the gain on disposal of investment property. Another example would be the retail segment where listed stocks are not showing the benefits partly due to e-commerce platforms such as Lazada, FashionValet and Zalora. c) The consumer sector is highly fragmented and each segment has their own specific drivers, also some may be company specific. For example, despite the recovery in overall retail sales, retail stocks under our coverage such as Aeon and Parkson did not do well. This is due to an industry wide trend, where in department stores are not doing well, and statistics show the shift from hypermarkets to smaller format stores. The illegal market is a specific problem faced by the tobacco and brewery industry. Consumer staples should have been doing well in this weak sentiment, but stocks in the consumer discretionary space such as Bonia are still challenged at the top line possibly due to less spending and partly due to many alternatives/competitors in this space.

Maintain Our Neutral Sector Call

We maintain our sector NEUTRAL call as we expect 2017 to be a challenging year for the stocks under our coverage. For top line growth, sentiment will still take time to recover, while the bottom line will be constrained by increasing cost of sales and operating costs. The KLCSU Index currently trades at a 2017E PER of 31.7x (less than 1SD above its historical 5-year mean PER of 20.7x).

Source: Affin Hwang Research - 16 Jun 2017