We initiate coverage on Hup Seng Industries Berhad (Hup Seng) with a Hold recommendation and a target price of RM1.39/share based on DDM valuation approach. Hup Seng is a food manufacturer, which is involved in the manufacturing and sales of biscuits and confectionary food items. The company exports its products to over 20 countries under the brand names Cap Ping Pong, Kerk and Naturell. The company’s fundamentals are strong and supported by 1) healthy net cash position and 2) stable future earnings.

Hup Seng is a food manufacturer incorporated in 1991 and was listed since 2000. Its main products include cream crackers, biscuits, cookies, 3-in-1 instant beverages as well as other confectionary food items under the brand names Cap Ping Pong, Kerk, Naturell and In-Comix. Hup Seng has a factory in Batu Pahat, Johor, spanning across 7.8 acres of industrial land with a capacity of 39,000 tonnes of food a year. The factory has an utilisation rate of 82%. Hup Seng’s products are sold locally across Malaysia as well as exported to over 20 countries. Currently, the revenue breakdown is 70:30 between local sales and export sales.

Investment Thesis

1. Stable top-line growth;

2. Established household brand name;

3. Healthy balance sheet; and

4. 60% dividend policy.

We believe FY17 will be a challenging year for the company and FY18 will be a year of recovery. Core net profit is expected to decline by 3.0% for FY17 but improve by 2.7% and 2.6% for FY18 and FY19 respectively. This is based on the following assumptions;

• Resilient revenue growth of 1% - 2% between FY17 and FY19,

• Raw material cost to increase by 4% in FY17 but 1% in FY18 and FY19, and

• Resilient net margin of 16% - 18% for FY17 and FY19

1.0 Company Background

1.1 Company’s History

Incorporated in 1991, Hup Seng Industries Berhad (Hup Seng) is a food manufacturer, which listed on the Main Board of Bursa Malaysia in 2000. It has three operating subsidiaries namely, Hup Seng Perusahaan Makanan (M) Sdn. Bhd (HSPM), Hup Seng Hoon Yong Brothers Sdn. Bhd (HSHY) and In-Comix Food Industries Sdn. Bhd (In-Comix), which are engaged in the manufacturing and sale of biscuits and confectionary food items. Hup Seng has one factory located in Batu Pahat, spanning 7.8 acres of industrial land in Johor. The factory was completed in 1981 with a floor space of 47,600 sq ft. To date, it has expanded to 317,995 sq ft to cater for production, storage and office usage. The factory has a food producing capacity of 39,000 tonnes/year and is currently running at an utilisation rate of 82%.

The company name “Hup Seng” translates to “With Teamwork Come Success,” in Chinese. Initially, Hup Seng Co was established in 1958 through the partnership of four brothers who then become the founding Directors. Then in 1974, Hup Seng Co was dissolved and HSPM was founded due to business expansion and increased capital requirements. Three years after (1977), HSHY was incorporated to manage trading. Then in 2005, Hup Seng acquired 100% equity interest in In-Comix. Now, Hup Seng is one of the leading biscuits or crackers manufacturers in Malaysia.

Hup Seng exports to over 20 countries, which are mainly in South East Asia, under the brand names Cap Ping Pong, Kerk and Naturell. Other than that, it has a trading division managing the sales and distribution of cookies, biscuits, crackers and confectionary food items within the Malaysian market. This division has more than 9,000 sales points across Peninsular Malaysia with about 80 sales representatives. Branches are located in Kota Bharu, Kuantan, Ipoh Butterworth, Alor Setar and Klang Valley. Lastly, Hup Seng is also engaged in manufacturing of coffee mix and other beverage mix after acquiring In-Comix in 2005 as part of a complimentary business synergy. The In-Comix’s products are exported to more than 10 countries.

Hup Seng’s net profit grew at a CAGR of 10% between FY12 and FY16. Within the same period, domestic and export sales increased at a CAGR of 2.7% and 5.9% respectively. Factors affected the earnings were i) weakening of Ringgit, which enhanced exports competitiveness, ii) continuous innovation to meet market demand, and iii) competitive pricing strategy as there has been no change in product prices since 2011

1.2 Key Management

Mr. Kuo Choo Song is one of founders of Hup Seng. He has been appointed as the Managing Director of Hup Seng since 2003. He is mainly involved in the planning of the group’s business development programmes and representing Hup Seng at various external functions.

Ms. Kerk Chian Tung has been appointed as the Executive Director of Hup Seng since 2000. She is the niece of Mr. Kuo Choo Song. She had about 10 years of work experience as an auditor, tax consultant, assistant business development manager, finance manager and investment analyst before joining Hup Seng.

Most of Hup Seng’s key management personnel have been with the group since listing and some have even joint since company establishment. They have been directly involved in the company’s day-to-day operations. The balanced mix of expertise in the key management team is evidently important in ensuring the sustainability of Hup Seng’s growth

Shareholding Structure

Mr. Kuo and family own c.51% equity interest in Hup Seng. There are also other substantial shareholders like Citibank NY and Norges Bank, which each hold 3% of company shares.

2.0 Industry Analysis - Porter’s 5 Forces

Malaysia is a growing population country, hence the food consumption is expected to continually increase. According to the Department of Statistics Malaysia, the estimated country’s population stood at 31.7mn in 2016 and is expected to grow to 41.5mn by 2040.

Our Porter’s Five Forces analysis reveals that the competition level in the F&B industry is high due to competitive pricing nature in the market and the various options available to buyers. The bargaining power of supplier is considered moderate as there are multiple suppliers of raw materials like palm oil and cocoa (except for sugar and flour) in the market. Threat of substitute is high as biscuits can be replaced with bread or other wholegrain consumables. There is low threat of new entrants as we believe that the F&B industry in Malaysia is highly saturated. (Refer to Appendix A)

Investment Thesis

3.1 Stable Top-line Growth

Hup Seng’s revenue from domestic sales has been increasing at a CAGR of 2.7% between FY11 - FY16. This was generally in line with Malaysia GDP growth. However, for FY08 and FY11, Hup Seng’s revenue grew at faster pace at 14.1% YoY and 9.7% YoY respectively, despite GDP growth moderated to 4.83% in FY08 (from 6.30% in FY07) and 5.29% in FY11 (from 7.42% in FY10). The rise in revenue was attributable to price adjustments in tandem with the rise in raw material costs in FY08. For FY11, revenue increase was due to buoyant demand from domestic and export markets.

Other areas that we believe Hup Seng has the potential to grow is the export sales channel. Currently, Hup Seng’s products are exported to over 20 countries mostly in the South-East Asia region. In FY16, export sales improved by 5.6% YoY to RM85.7mn and accounted for 30.0% of the total revenue. Meanwhile, the export sale margin improved 1.7 percentage points YoY in FY16. We attribute the encouraging sales performance partly to ringgit weakening, which has provided some pricing advantages to the group. Looking at the 5-year CAGR between FY12-FY16, exports grew at a CAGR of 5.7%, supported by growth in regional economies. Note that the emerging and developing Asia GDP grew at an average rate of 6.8% during this period.
 

3.2 Well-Established Brand

Hup Seng has been in the market for almost 60 years. It has a diverse range of product portfolio includes crackers, biscuits, cookies and beverages mix. Hup Seng’s signature household product is the Hup Seng Special Cream Cracker Cap Ping Pong, which has won the Gold and Grand Gold Award from Monde Selection, an internationally renowned award quality since 1994. Other products within the crackers group include Sugar Crackers and Corneo Crackers as well as Wholemeal Crackers and Deluxe Crackers, which are enriched with nutritional values. All these Hup Seng’s biscuit products are sold under the brand names Ping Pong and Kerk (see Figure 7)

Furthermore, Hup Seng launched the Naturell range in 2015, consisting of three types of cookies containing oats. All these products have won the GOLD Quality Award at the 2016 Monde Selection, Belgium. This has again proven that Hup Seng’s product quality is world-class standard.

3.3 Healthy Balance Sheet

Hup Seng’s cash levels continued increasing (FY11-16 CAGR of 7.4%) due to low capex requirement. From FY11 to FY15, the annual capex was limited to only RM2.0mn – RM9.0mn, mostly on plant maintenance. In FY16, a capex of RM19.2mn was needed for the purchase of industrial land, measuring 1.55 acres with buildings erected thereon, for RM17.5mn. The land is adjacent to the group’s current factory, which is ideal for expansion in production capacity in the future. Even though Hup Seng’s current facilities are congested and the current capacity might not be able to meet the increasing demand in 2017 and beyond, management guided that the expansion plan is still under review and the expansion work would only start in the next two to three years. In the meantime, the company would focus on improving operational efficiencies to deal with the current demand. Hup Seng’s free cash flow has been healthy at RM68.4mn in FY16 as compared to RM40.5mn in FY11. Even with the healthy free cash flow, we believe that Hup Seng is undertaking a cautious approach before proceeding to further expansion. We are positive on this as growing with an efficient operating culture would ensure long term earnings sustainability

3.4 Dividend Policy

The group has adopted a dividend policy to distribute at least 60% of the group’s annual net profit as dividend starting from FY09. However, payouts between FY11 and FY16 have been in the range of 75% to more than 100%. For FY11- FY16, dividend payment has been increasing at a CAGR of 9.9%, offering a yield of 4.7% that was comparable with other Fast Moving Consumer Goods (FMCG) companies like Cocoaland Holdings Bhd and Apollo Food Holdings Berhad. Their dividend yields were 4.3% and 5.8% respectively for FY16

4.0 Risks 4.1 Exposed to Raw Material Price Fluctuation

In general, raw material costs accounted for 60.0% of group’s total revenue. Of this, 80% of the costs are direct input cost from the purchase of palm oil, wheat flour, sugar, milk-based products, chocolate chips. The other 20% cover mainly packaging, labour as well as utilities and maintenance costs. In our sensitivity analysis, we find that for every 1% increase in the cost of raw materials, Hup Seng’s net profit would reduce by 2.2%. Wheat flour and sugar are price-controlled items in Malaysia. In Nov-2016, sugar price for food manufacturing companies increased by 11.2% to RM2,780/tonne (from RM2,500/tonne) while the price of wheat flour remained stable in

between RM40-55/25kg bag since June-14. This has resulted in profit contraction in 1Q17 (see 5.1). In the case of refined palm oil, Hup Seng, like other food manufacturers, gets the supplies from local producers paying the market price. In 2016, the average price of CPO increased by 22.3% YoY to RM2,652/tonne from RM2,168/tonne the year before. Consequently, Hup Seng’s gross profit margin contracted by 2.1%pts YoY in FY16 to 40.5%. Looking back to 2011 when CPO price increased by 19.1% YoY from RM2,748/tonne to RM3,274/tonne, Hup Seng’s gross profit margin reduced by 2.1%pts from 34.6% to 32.5% YoY for FY11. We project CPO price to average at RM2,700/tonne for 2017, an increase of 1.8% from 2016. Coupled with the recent hike in sugar price, Hup Seng’s gross profit margin is expected to be below 40% level, hence, dampening earnings for FY17. Hup Seng attained a gross profit margin of 42.6% and 40.5% for FY15 and FY16 respectively.

4.2 Stiff Competition

Despite the decline in administrative expenses (FY11-16 CAGR of -5.2%), selling and marketing expenses have been increasing at a CAGR of 4.2% within the same period. We attribute this to stiff competition domestically as well as abroad. Locally, we have done a price comparison between Hup Seng and its rival’s products and realise that there are over 35 brands of biscuits and cream crackers on Tesco online shopping website that priced as competitive as Hup Seng’s products

5.0 Financial Highlights

5.1 High Costs Dampening Margins

Hup Seng recorded lower adjusted earnings of RM11.7mn (-24.9% QoQ, -14.7% YoY) for 1QFY17 mainly due to overall rise in raw material prices i.e. sugar and CPO. Revenue improved slightly by 2.0% YoY to RM73.9mn due to stronger export sales from higher Asian region demand. However, this was limited by a decline in domestic sales. While QoQ, revenue declined by 10.8% on the back of slower demand from overseas and domestic markets. Overall this has reduced net margin to 21.0% (-3.0%-pts QoQ, -3.1%-pts YoY). For FY16, Hup Seng registered a lower profit after four consecutive years of earnings growth. FY16 adjusted net profit declined by 9.4% to RM50.0mn due to increase in raw material cost (i.e.: CPO) and operating expenses. Revenue declined slightly by 0.4% to RM285.6mn due to lower domestic sales. Hup Seng has free cash flow of RM68.4mn (equivalent to 8.5 sen/share). The average cash conversion cycle is 15 days, which is relatively fast as compared to other F&B companies. All these factors have supported the group’s generous dividend policy. Moving forward, management believes that the weak consumer sentiment and uncertainties in the economy will remain as challenges for FY17. Consumers are expected to remain cautious in their spending and competition is expected to remain intense. To withstand the pressure, Hup Seng is expected to expand the export markets especially in China, and improve operational efficiency.

Net margin contracted Fast cash flow Expanding the export markets

5.2 Forecasts

In our forecasts, we estimate a 5-year revenue CAGR of 1.5% for FY16 to FY21. This is supported by continuous demand from the domestic and overseas market. In terms of sales breakdown for FY17, we project the export sales to maintain its contribution of 30% and domestic sales make up the balance 70%. Furthermore, we also project FY16-21 profit before tax margin to be in the range of 22% to 24% underpinned by stable CPO price (average RM2,700/tonne). With that, Hup Seng’s FY16-21 earnings is expected grow at 5-years CAGR of 1.8%. As far as dividend is concerned, we project 6.0 sen to 6.5 sen dividend for FY17- 21 with a payout ratio of 97.3% on average. Our dividend assumptions have taken into account the net cash position of the company and positive future FCFE.

6.0 Valuation

Using a dividend discount valuation approach, we value Hup Seng at RM1.39/share based on 7.6% discount rate. At RM1.39, the implied forward PE works out to 22.3x based on CY18 EPS. We believe this is reasonable after benchmarking to peer’s performance in terms of i) balance sheet strength, ii) future earnings growth, and iii) prospective future dividend yield. Our target price suggests that the upside to the current trading price is only 11.4%. As such, we initiate coverage on Hup Seng with a HOLD recommendation.

Source: TA Research - 25 May 2017