We met with the management of F&N and left with the following takeaways: i) margin pressure not abating; ii) minimal impact of Price Control and Anti-Profiteering Act (PCAP); and iii) steady growth in dairy unit. Earnings are adjusted slightly lower by 1.1% for FY17 and slightly higher by 1.5% for FY18. The target price is downgraded to RM21.63/share based on unchanged 21x CY17 EPS. Maintain Sell.

Margin pressure not abating

F&N is expected to face added pressures from increasing sugar prices coupled with the possibility of sugar ‘sin tax’ implementation this year. Note that sugar price has resumed its uptrend since Dec-16 and is currently trading at around US?20.6/lb. It is 13.2% higher than the average sugar price of US?18.2/lb in 2016. Looking forward, we expect the global soft commodity price, including sugar, to escalate due to unfavourable weather causing output falling behind demand according to sugar market experts. However, F&N is expected to increase soft drink prices to pass on the cost pressure to consumers. As such, we do not expect a sharp contraction in soft drink’s profit margin in 2017

As far as sugar “sin tax” is concerned, management believes that the sin tax will be implemented eventually in Malaysia and the company is cautious on the earnings impact. Referring to a news press, Vietnam and the Philippines had introduced a 10% tax on sweetened drinks in 2014 and 2015 respectively. Meanwhile, neighbouring countries like Indonesia and Singapore are debating over the ‘sin tax’ imposition. Other than that, an experiment has been conducted in Mexico by the Mexican National Institute of Public Health, whereby imposition of 10% sugar tax has reduced sweetened beverages sales across the country by 6% over the course of two years since 2014.

To mitigate the impact, management has always been working on reducing the sugar index level of its beverages. F&N sugar index level has been decreasing at average rate of 2.6% YoY in the last 10 years. This could lessen the negative impact arising from the “sin tax”. In our view, we expect F&B companies to increase product prices more than the sin tax cost to buffer the drop-in sale volume in order to keep margin constant.

Price Control and Anti-Profiteering Act Impact

Ministry of Domestic Trade announced that the Price Control and AntiProfiteering Act Regulations 2016 (PCAP) takes effect January 2017 with new ironed out guidelines coming February 2017. Management guided that F&N is already in compliant with PCAP where there will be no mark-up in margins of products sold for FY17. However, considering the rise in sugar price and the consequent increase in production costs, prices of selected F&N products have been adjusted higher for FY17 to protect its profit margins. We believe this could affect near-term demand amid weak consumer confidence (see figure 3) in 2017.

Steady Growth for Dairies

Over the years, F&N’s dairies business have been growing steadily at average yearly growth of 6% since 2012. We project FY17 revenue to produce similar trend. Typically, in Malaysia, we expect revenue growth to be driven by i) favourable global milk-based commodity prices and ii) improvement in operational efficiencies. In Thailand, revenue growth will be anchored by effective branding and consumer trade programme. On top of that, there will be first full-year contributions from the RM70mn new UHT lines in Sarawak plant as well as new evaporated milk processing and packaging line in Rojana. Margin wise, we expect dairy margin to improve underpinned by 1) higher dollar sales from Thailand unit; 2) higher operating efficiencies. This is more than offset the pressure from Ringgit weakening

Forecast

We tweak our earnings slightly lower by 1.1% for FY17 but higher by 1.5% for FY18 after factoring in FY16 audited profit into our forecast.

Valuation

Target price is revised lower to RM21.63/share (from RM21.71/share previously) based on unchanged 21x CY17 EPS. Maintain Sell on the company as valuation is running ahead of company’s fundamentals

Source: TA Research - 31 Jan 2017