INVESTMENT HIGHLIGHTS

• Rising commodity prices to pressure profit margin

• Focusing to improve operational efficiency

• Potential revenue accretion expected from route-to-market approach revamp

• Reduction in expenses expected by decentralizing manufacturing operation

• More emphasis on growing own brand exports

• Maintain NEUTRAL with a revised TP of RM20.69 per share

Rising commodity prices will impact on margin. Sugar and skim milk powder, two of the largest raw material for F&N has risen by +32% and +46% respectively since the beginning of FY16. Coupled with the weakening Ringgit, this will further increase raw material costs which will apply downward pressure on the company’s gross profit margin (GPM). Going forward, we expect the GPM to narrow by the higher cost of sales.

Focusing to improve operational efficiency. As future revenue growth and profit margins are expected to remain suppressed, F&N has embarked on several initiatives to improve operational efficiency such as: (i) introducing new route-to-market approach and; (ii) decentralising its manufacturing operation. Two projects have already been completed under these initiatives. In FY16, operating profit rose by +72%yoy which was partly contributed by the realised manufacturing efficiencies of F&B Thailand.

Potential revenue accretion expected from route-to-market approach revamp. F&N has combined both its soft drinks and dairies business operations in Malaysia which previously had separate distribution networks. By so doing, it can leverage on a combined route-to-market approach and thus, ensuring all outlets served within its network have accessed to a full range of its product portfolio. With this end-to-end one-stop selling model, lower marketing expenses can be achieved by enabling effective cross selling. The expected revenue accretion is up to RM300m in the coming years.

Cutting expenses by decentralising manufacturing operations. For the past two years, inventory turnover has been exhibiting a downward trend with 4QFY16 being the lowest quarter with 72 inventory days recorded, while distribution expenses rose by +9.3%yoy in FY16. By decentralising manufacturing operations, F&N will enhance production and warehousing capacity in the different regions, thus, enable it to optimise inventory for each product category by adopting a just-in-time production system. This is expected to reduce distribution cost as well as eliminate unnecessary inventory, warehousing and logistics costs which are estimated to be about RM1m daily per warehouse.

Focusing on growing own brand exports. F&N has two types of exports: (i) Export of its own brand and; (ii) Export of original equipment manufacturer (OEM) products. Going forward, the company will focus more on growing the former. Currently, the export segment commands approximately 10% of F&N’s revenue which is commendable but this is expected to grow given that export from F&B Malaysia segment showed a promising sign by growing a significant +31%yoy in FY16. The geographical distribution of the business segment customers is depicted in Chart 2. Revenue contribution from outside Malaysia is approximately 47% in FY16 with double digit growth recorded in the last five years (between 11-35%yoy) in contrast to the contribution from Malaysia which is on a downward trend with FY16 recorded a decline of -6.0%yoy. Due to this, we expect that export revenue will continue to grow more than the domestic market. However, it will take three to four years before it contributes a significant amount to the overall revenue.

Earnings revision. We are revising our FY17 and FY18 earnings by -18.3% and -12.4% respectively. The downward revisions are mainly due to the increase in the raw material prices such as sugar and skimmed milk powder which will significantly impact earnings in FY17. However, over the longer term, the increase in raw material prices will be mitigated by the; (i) improvement in operating efficiency and; (ii) a new focus on finding new markets through export.

Reaffirm NEUTRAL stance with a revised TP of RM20.69. We remain NEUTRAL and revised our target price to RM20.69 (previously RM25.33 per share). Our target price is based on PER17 and EPS17 of 21.0x and 98.5sen respectively. Our target PER is premised on the average PER of the company for the past two years.

Source: MIDF Research - 25 Jan 2017