We came back from a management meeting with DLADY feeling slightly more comforted on its near-term outlook. During the meeting, Finance & Accounting director Mr. Ivo Ogink briefed us on the recently released 2Q14 results, the movement of raw material prices as well as the price increase over the range of DLADY products in June. Maintain UNDERPERFORM with a revised Target Price of RM44.22 (from RM42.32).

Shedding lights on 2Q14 results. On its 2Q14 results, management stressed that the operating cost was lifted by the high raw material prices, which was amplified by the stronger USD against MYR. As a result, gross margin saw a decline of 4ppt to 33.1% from 37.1% in 2Q13, which dragged gross profit down by 4.3% YoY to RM88.8m (from RM92.7m) despite a top line growth of 7.4%. As a reference, skimmed milk powder (SMP) and whole milk powder (WMP) surged 28.4% and 26.1%, respectively, (refer overleaf) in the Jan-Mac 2014 period as compared to the same period in 2013 (raw material prices generally lag 3-6 months to be reflected in the operating costs). On the top line growth, management indicated that the growth was driven by both sales volume and the increase in selling price in Jan 2014.

Milks get dearer. The Group has increased its selling price over the range of its products in June 2014; the second round of price hike in 2014 since January. We reckon that the price increase is necessary to factor in the higher raw material prices, but the quantum of the price increase was undisclosed. Meanwhile, the Group has also downsized its ready-to-drink (RTD) UHT milk to 200ml/pack from 250ml/pack previously in a strategy to mitigate the impact of the price increase on the consumer.

Muted impact envisaged. DLADY expects minimal impact from the price increase to the child nutrition segment, particularly the premium brands and early life stage range of products (0-12months) due to the low price elasticity as compared to other products. For the beverages segment, the Group expects demand to be sustained by the rising health awareness as the average consumption of Malaysian is low at 2 servings/week vs 2 servings/day recommended by World Health Organization (WHO), which suggest room for improvement.

Milk powder prices taking breather. As for the raw material prices, WMP price has retreated from the year-high of USD5000/mt in 1Q14 to below USD3000/mt level in September 2014 while the SMP price has also followed suit (refer overleaf). Management attributed the decline in milk powder price to the high stock level in China, one of the biggest consumers in the world; and the impaired business link to Russia on the back of economic sanctions. Thus, we expect the earnings margin to recover on the back of lower raw material prices. We are forecasting gross margin of 32.9% in FY14 vs 32.5% achieved in 1H14.

Impact from price increase. We revisit our earnings model and impute the latest round of price increase into our earnings forecast. As a result, the net profits for FY14E and FY15E were nudged higher by 2.9% and 4.4%, respectively. Post earnings revisions, FY14E EPS still represents a negative growth of 18.7% while FY15 EPS is forecasted to grow 13.9%.

Maintain UNDERPERFORM with higher Target Price of RM44.22 (from RM42.32). Pursuant to the earnings upgrade, the TP is adjusted higher, but we are ascribing the same valuation of 22.1x PER, which is slightly above +1SD over a 5-year mean. While, the price increase is positive to the earnings growth, we do not think that the growth can be healthily supported by volume growth in view of the weak consumer spending, although dairy products are less discretionary in nature. Valuation appears to be on the high side with last closing price trading at PER of 23.1x, which is close to +1SD of 5-year mean. Meanwhile, dividend yield is below 5% level which we think is not enough to compensate for the risk of the volatile movement of raw material prices and weakening consumer sentiment with the imminent implementation of GST in April 2015.

Source: Kenanga