Kenanga Research & Investment

Consumer - Navigating the Commodity Maze

Publish date: Tue, 07 Nov 2023, 09:42 AM

We maintain our NEUTRAL view for the consumer sector. In light of a detailed correlation study, we find that commodity prices significantly impact the gross profit (GP) margins of key F&B companies such as DLADY, NESTLE, F&N and PWROOT, with varying time lags. Given mixed commodity price trends, we anticipate fluctuating GP margins for DLADY and NESTLE, leading us to lower our GP margin assumptions by 0.5% each, which in turn lower their earnings estimates. Valuation-wise, we maintain a 22x historical forward PER for consumer staples and keeping our discounted 12x PER assumption for departmental store and apparel players. Post review, DLADY’s target price is adjusted to RM26.60 with an unchanged OUTPERFORM rating, while NESTLE retain its UNDERPERFORM call with a DCF-derived target price of RM115.00. Our sector top picks remain DLADY (OP; TP: RM26.60), F&N (OP; TP: RM28.45), and MR DIY (OP; TP: RM1.67).

The interplay of commodity prices. In the investment landscape, deciphering the interplay between commodity prices and the margins of consumer staple equities is pivotal. While rising input costs typically indicate challenges for margins, the intricate dynamics at play often present a more complex picture. Through this correlation study, we seek to interpret the relationships among commodities and their correlations with consumer staple firms. Our goal is to offer investors a comprehensive analytical tool for informed portfolio decisions within the sector.

Key observations from the commodities prices’ correlation study. Post examining the correlation among commodities over the past 5 and 10-year, our observations are as follow:- (i) over the past decade, a strong correlation has been observed among the prices of staple grains like wheat, corn, and soybean, which has intensified in the last five years, (ii) A similar strengthening relationship has emerged between cotton, aluminium, and crude palm oil (CPO), likely influenced by shared global economic factors such as regional trade and industrial growth in emerging markets, and (iii) WTI crude oil has shown a positive and increasingly strong correlation with a range of commodities, including soybean, cotton, corn, coffee, and aluminium, suggesting that global economic dynamics and inflationary pressures are driving these relationships. (please refer to exhibit 1 - 3 for details)

GP margin study: After an extensive examination of the correlations among various commodities, we took it upon ourselves to delve deeper into the impact on the GP margins of certain F&B companies over 5 and 10-year timeframes. Intriguingly, we observed that specific commodity price fluctuations could provide clues to certain F&B companies’ forward GP margins direction with a 3 to 9-month lag, which suggested the importance of forward-planning for these businesses. To illustrate these findings, we have highlighted the three most significant negative correlations between various commodity/raw material prices and companies' GP margins across different time horizons.

Key findings from the GP margin study. Our correlation study highlights distinct patterns in GP margin sensitivities across DLADY, NESTLE, F&N, and PWROOT. DLADY and NESTLE's GP margins are most influenced by sugar, corn, crude oil, coffee, and soybean prices, with a 9-month lag effect. F&N's GP margin, conversely, shows a 3-month lag correlation with sugar, aluminium, the Baltic dry index, and CPO. PWROOT's GP margin is immediately impacted by fluctuations in sugar, coffee, aluminium, and the Baltic dry index. In summary, the prevailing commodity price environment corroborates our GP margin projections, with DLADY and NESTLE likely to oscillate within a narrow range due to mixed commodities price trends. F&N, on the other hand, could see a short-term margin uplift in 3QCY23, although this could be neutralized by subsequent commodity price hikes. As for PWROOT, despite immediate cost pressure, the company's robust brand and pricing leverage should help it weather these challenges. (Please refer to exhibit 4 to 17 for details)

Change in forecast numbers. Following the correlation study and the latest trends in commodity prices, we have revisited our initial GP margin assumptions for DLADY, NESTLE, F&N, and PWROOT. We find that our earlier GP margin projections for DLADY and NESTLE were likely optimistic. As a result, we are adopting a more conservative stance, reducing our GP margin forecasts for both companies by 0.5%. This leads to updated GP margin projections of 28.8% and 29.0% for DLADY's FY23-24F numbers, and 31.2% and 31% for NESTLE's FY23-24F numbers. These adjustments result in lowered net profit forecasts for DLADY and NESTLE by up to 1.7% and 1.5%, respectively.

Valuation update: We maintain our valuation basis for consumer staples players at 22x, in line with the segment’s average historical forward PER. For departmental store and apparel players, we maintain a 12x valuation, at a 20% discount to the sector's 15x average, reflecting the diminished purchasing power of their core M40 customer base. Post-review, DLADY retains its OUTPERFORM rating with a slightly reduced target price of RM26.60 (from RM27.00 previously), while NESTLE's UNDERPERFORM rating remains, with a DCF-derived target price of RM115 held steady. Forecasts and ratings for F&N, PWROOT, AEON, MRDIY, PADINI, and QL remain unchanged.

Commodities Prices’ Correlation Study

Finding 1: Wheat, corn, and soybean. Over the past decade, data reveals a compelling correlation among wheat, corn, and soybean prices, with coefficients nearing or even surpassing 0.84. When focusing on the recent 5-year span, this relationship becomes even more pronounced, with correlation values exceeding 0.90. Such consistency underscores the persistent interdependence of staple grain prices which suggested that these prices are driven by common supply and demand factors including weather patterns, global yield figures, trade dynamics, currency fluctuations, energy costs, and etc.

Finding 2: Cotton, aluminium, and CPO. In examining the past decade's data, we are surprised to observe that the correlations between cotton, aluminium, and crude palm oil (CPO) have become more pronounced, particularly in the last five years. We believe, this upward trend, moving from figures of 0.83 and 0.81 to 0.90 and 0.91 respectively, highlights a strengthening relationship due to shared global economic influences. Key factors include regional trade dynamics, industrial growth in emerging markets, and shared production challenges. In addition, the economic ascent of emerging markets could also further amplify these commodities' price momentum.

Finding 3: WTI crude oil relation with commodities. WTI crude oil showcases a positive correlation with most of the commodities. This is not a surprise as increase in oil prices can be a sign of rising global demand or inflationary pressures, thus driving up the prices of other commodities. In the 10-year data, WTI crude oil showed a moderate-to-strong correlation with commodities like soybean (0.76), cotton (0.69), corn (0.65), coffee (0.55), and aluminium (0.51). These relationships grew stronger with values of 0.79, 0.85, 0.83, 0.81 and 0.81, respectively, in the last 5-year. We believe these increasing correlations could be attributed to global economic dynamics that jointly influence the prices of oil and these commodities.

Source: Kenanga Research - 7 Nov 2023

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