We reiterate our NEUTRAL rating on the consumer sector. We foresee 2017 to be a more challenging year for consumer sectors as the cost advantage from the soft commodity market is diminishing, further aggravated by the weak local currency. Meanwhile, consumer sentiment is likely to stay subdued in 2017 in view of the continuing concern on the state of economy, job market as well as rising cost of living. On the flipside, we have not turned bearish on the sector as we believe the sector is resilient and defensive enough, supported by the healthy private consumption, further evidenced by the recovery in sentiment from the low in end-2015. In a nutshell, we think that the investment strategy for the sector 2017 should be focused on identifying companies with: (i) solid fundamental and proven track record, (ii) generous dividend pay-out backed by sturdy balance sheet and healthy cash flow, and (iii) reasonable valuation rather than seeking for companies with strong earnings growth in view of the more challenging operating environment moving forward. Our Top Pick for the sector is HEIM (OP; RM18.48) as we believe its market leading position and commitment in the brand-building initiative will continue to propel growth in the longer run. We also like PWROOT (Trading BUY; FV: RM2.56) for its steady growth with proven track record, sturdy balance sheet and generous dividend payout. Lastly, we highlight OLDTOWN (OP; RM2.11) as we see opportunity in the share price weakness following the recent sell-down arising from the group’s exit from being a Shariahcompliant stock, despite the group’s strong fundamentals still remaining intact.

More disappointments. 5 out of 11 companies under our coverage reported disappointing 3Q16 results, including all 3 retail-based companies (AEON, PADINI and PARKSON), BAT and CARLSBG. Meanwhile, F&B companies all reported results within our expectation to showcased the resilient nature despite soft sentiment and challenging operating environment. As expected, 3Q16 results reflected the effects of minimum wages, which have inflated the operating costs. Meanwhile, feedback from companies revealed that the overall consumer sentiment is still subdued.

Consumer Index in the red. The KL Consumer Index (KLCSU) fell into negative territory with YTD decline of 1.05%, in line with the lacklustre performance of the benchmark KLCI (-1.82%). We believe the uninspiring performance can be attributed to the cautious sector outlook following the persistent subdued consumer sentiment and costs pressure arising from the normalization in commodities trend and rising operating costs. Similar to the past few quarters, automotive players, including UMW and TCHONG continued to be the main drag of the index while BAT was also one of the biggest laggards as a result of the declining legal market volume.

Subdued sentiment to persist. After two consecutive quarters of rebound in 1Q16 and 2Q16, the recovery momentum has been halted in 3Q16 with a decline in reading of consumer sentiment index compiled by Malaysian Institute of Economic Research (MIER) while Nielsen Global Survey of Consumer Confidence and Spending Intentions indicated that the sentiment has remained pessimistic. The usual suspects, including the state of economy, job security and rising food prices continued to be the main concerns of consumers. Looking forward, we foresee the subdued sentiment to persist in 2017 barring any strong stimulating catalyst while the political risk arising from the GE14 might turn out to be the additional concern capping the sentiment.

From friend to foe. Food manufacturers have been enjoying favourable raw material prices on the back of the soft commodity market over the year, leading to lower operating costs and profit margins expansions. However, in view of the normalization or recovery in prices of few key commodities, including milk powder, sugar and coffee beans, the tide might turn against the food manufacturers. Profit margins are likely to be under pressure following the uptick in input costs, further accentuated by the low base as comparison. Hence, we believe food manufacturers will intensify the initiatives in improving the production efficiency as the other alternative in mitigating the costs spike by raising price may not be the better one in view of the weak sentiment and competitive landscape.

Lapse of anti-profiteering mechanism. We believe that the lapsing of The Price Control Anti-Profiteering Act 2011 (PCAP) in January 2017 might be an interesting event to watch out for. To recap, the act was introduced in conjunction with the GST implementation (on January 2015 for an initial period of 18 months) in order to deter traders from indiscriminately raising prices of goods or services by profiteering from GST. Theoretically, companies offering products with sticky or inelastic demand, including the brewers (HEIM and CARLSBG) and premium coffee chain operator (BJFOOD with Starbucks) should be able to benefit from the expiry of the act should any strategic price increase is implemented.

All in, we reiterate our NEUTRAL rating on the consumer sector. We foresee 2017 to be a more challenging year for consumer sector as the cost advantage from the soft commodity market is diminishing, further aggravated by the weak local currency. Meanwhile, consumer sentiment is likely to stay subdued in 2017 in view of the continuing concerns on the state of economy, job market as well as rising cost of living. On the flipside, we have not turned bearish on the sector as we believe the sector is resilient and defensive enough, supported by the healthy private consumption, further evidenced by the recovery in sentiment from the low in end-2015. In a nutshell, we think that the investment strategy for the sector 2017 should be focused on identifying companies with: (i) solid fundamental and proven track record, (ii) generous dividend pay-out backed by sturdy balance sheet and healthy cash flow, and (iii) reasonable valuation rather than optimistically seeking for companies with strong earnings growth in view of the more challenging operating environment moving forward.

Our Top Pick for the sector is HEIM (OP; RM18.48). We believe its market leading position and commitment in the brand-building initiative will continue to propel its growth in the longer run. 6Q16 earnings should improve on the back of year-end holidays and the event of Oktoberfest. While the Group has not indicated its pricing strategy with the expiry of anti-profiteering mechanism come 31 Dec 2016, we believe HEIM is in good position judging on its market-leading position and sticky demand of its products. As such, we are maintaining our positive stance on the company. We like to highlight PWROOT (Trading BUY; FV: RM2.56). We like the stock for its steady growth with proven track record, sturdy balance sheet and generous dividend pay-out. The stock offers upside of 21% with compelling valuation at 13.3x PER FY17E as compared to other mid cap F&B counters and its dividend yield is attractive at 5.7%. The resilient nature of FMCG products and robust export sales will be able to drive top line growth while margins are expected to be stable. In addition, we see opportunity in OLDTOWN (OP; RM2.11) as we believe the share price weakness following the recent sell-down arising from the exit of the group’s Shariah-compliant status was overplayed. Also consider that the group’s strong fundamentals are still intact in the Manufacturing of Beverages business with visible earnings growth prospects. Valuation for the stock is undemanding (15.1x PER FY18E) as it commands a steady balance sheet and strong cash flow, which will allow the company to continue to reward shareholders with dividends.

Meanwhile for the sin sector, we maintain our NEUTRAL rating. Outlook of the tobacco industry is bearish considering the high illicit trade market share (at c.50%) and we do not anticipate quick recovery in legal industry volume in view of the dented affordability as a result of high selling prices. However, we are more positive on the brewers as we expect the effective cost management, brand building exercise and more favourable product mix to sustain healthy growth, while the lapse of anti-profiteering mechanism might provide the brewers the opportunity to raise prices for better profitability.

Source: Kenanga Research - 6 Jan 2017