1H16 net profit of RM70.6m (+7.3%) was within our expectation (45% of forecast.) No dividend was declared, as expected. The sustainability of earnings growth still hinges on the price movement of milk powder which has spiked up but we do not expect prices to return to the high level. No changes made to our earnings forecasts. Downgrade to MARKET PERFORM with unchanged TP of RM62.36 as risk-reward ratio has turned less appealing after strong performance in share price and in view of the modest earnings growth.

Result within expectation. 1H16 net profit of RM70.6m (+7.3%) was within our expectation by accounting for 45% of our full-year forecast. Consensus comparison is unavailable as the stock is not widely tracked. No dividend was declared, as expected.

YoY, 1H16 revenue grew 4.5% to RM496.5m which we think might be driven by the healthy consumption growth. 1H16 gross profit climbed 12.4% to RM215.5m, propelled by 3ppt expansion in gross margin due to the favorable raw material prices. Meanwhile, 1H16 PBT growth was milder in comparison (+9.3% to RM96.9m) due to the higher operating expenses (+14.9%) as we believe the Group has reinvested the savings from raw material costs into brand-building initiatives. As a result, 1H16 net profit grew 7.3% to RM70.6m.

QoQ, 2Q16 revenue was flattish (-1.2%) at RM246.7m. Meanwhile, the gross profit margin was little changed at 43.3% as compared to 43.5% recorded in 1Q16 as milk powder prices were relatively stable during the period which resulted in marginal decline in 2Q16 gross profit (-1.6%), in line with the slight drop in revenue. However, 2Q16 PBT managed to jump by 11.6% to RM51.1m driven by lower operating expenses (-7%) which we think was attributable to the difference in marketing expenses and the gain in derivatives contracts. As a result, 2Q16 net profit grew 8.3% to RM36.7m, slightly dragged down by the higher effective tax rates of 28.2% (vs 1Q16: 26.0%).

A swing in supply-demand. Looking forward, we think that the sustainability of earnings growth still hinges on the price movement of milk powder. According to Global Dairy Trade, the Whole Milk Powder price has surged 21.9% to USD2,695/MT from USD2,210/MT in the beginning of the year while Skimmed Milk Powder price has also increased by 7.3% in the same period. We understand that the spike in prices was driven by increased import demand from China and lower milk output in both Australia and New Zealand.

Not expecting the worst. Coincidentally, the spike-up of milk powder prices has occurred during the same period last year (starting August 2015) after Fronterra’s move to reduce the amount of products on offer before normalizing in November 2015. While the movement of the milk powder prices continues to be volatile being one of the major commodities, we are not expecting the prices to return to the high level of USD5,000/MT seen in 2013-2014 until a sustainable trend of overwhelming surge in demand emerges.

Forecast maintained. No changes made to our FY16E-FY17E earnings.

Downgrade to MARKET PERFORM (from OUTPERFORM) with unchanged Target Price of RM62.36. Our TP is retained based on unchanged 23.8x PER FY17E, which is in line with +0.5SD over three-year mean. Share price has performed impressively since the start of the year only to weaken recently probably due to the spike-up in milk powder prices. The risk to reward ratio is turning less appealing with diminishing dividend yield of >4.5% after the strong run-up in share price. Expected earnings growth in 2017 is pedestrian at 6.5% as we do not expect the milk powder prices to sink further from low base and we also do not see other catalyst driving higher profit growth. As such, we are downgrading the stock after a fruitful 24.7% capital gain in share price since our upgrade back in Nov 2015.

Source: Kenanga Research - 24 Aug 2016