We came away from F&N’s 1H19 results’ briefing feeling optimistic of its near-term prospects. Malaysian operations could still remain challenging amidst competitive beverage space, but could be cushioned by strong traction in F&B Thailand’s dairy products range. Ahead of the sugar tax in July 2019, the group will reformulate up to 70% of its affected products. Maintain MP but with a higher TP of RM36.60 (from RM33.85) on a rolled-over FY20E valuation.

Weaker domestic offset by better foreign operations. In the recent 1H19, the group’s reported sales growth of 4% as a slight dip (-1%) in F&B Malaysia revenue was supported by a 10% increase from F&B Thailand. F&B Malaysia was weaker due to heavy price competition in spite of a 3% growth in sales volumes, which was also led by more exports. F&B Thailand, on the other hand, enjoyed better demand for its dairy products (i.e. creamers, squeeze tubes) from both local and export markets.

Input costs in a mix. Earnings also came in better for F&B Thailand (operating margins at 21.5%, +5.3ppt) thanks to better cost and marketing management, while F&B Malaysia’s profitability remained stagnant (operating margins at 7.4%). With regards to input costs, there could be cost pressures from strains in global supply. This could mainly arise from dairy commodities (as of 16th April 2019, skim milk powder was traded at USD2,462/mt, +12% CYTD and anhydrous milk fats at USD6,126/mt, +19% CYTD. Source: Global Dairy Trade). While higher milk prices will leave an impact on F&B Thailand’s profitability, management opines that input costs are still at manageable levels in FY19 thanks to its hedging practices.

Finding a knack in healthier offerings. The deferment of the implementation of sugar taxes to July 2019 has allowed the group more time to adjust its product portfolios accordingly. To recap, the tax entails an excise duty of 40.0 sen/litre to be charged on: (i) sweetened drinks with more than 5g of sugar/100ml, (ii) milk-based drinks with more than 7g of sugar/100ml, and (iii) fruit/vegetable juices with more than 12g of sugar/100ml. With up to 90% of its Malaysian product offerings being affected by the tax, the group looks to shake up the formulation of up to 70% of its product ranges. While doing so, management commented that R&D costs would be incurred to bring these new products to the market. We believe that although these new products’ prices could potentially rise to levels close to the original products with the additional sugar tax, it could also potentially open up new market opportunities in the health cautious consumer market. Previously, the group had announced a RM30.0m capex to expand production lines to facilitate the entry of these new products.

Post-briefing, we raise our FY19E/FY20E earnings by 5.0%/4.3%, mainly from higher sales estimates from Thailand being mitigated by thinner margins in FY20.

Maintain MARKET PERFORM with a higher TP of RM36.60 (from RM33.85, previously). We derive our TP on an unchanged 30.0x PER (+1.0SD on its 3-year average Fwd. PER) on a rolled-over FY20E EPS of 122.0 sen. In the FMCG space, F&N is slightly discounted from DLADY (which we ascribed a 31.0x Fwd. PER) owing to its less attractive yields and lower ROE. Still, assuming better economies of scale kicking in, this could potentially mitigate some production cost pressures in the near future.

Risks to our call include: (i) higher/lower-than-expected sales, (ii) higher/lower-than-expected operating costs, and (iii) more/less favourable currency exchange exposure to the group.

Source: Kenanga Research - 2 May 2019