Key takeaways from our recent meeting with management are:
i. Favourable commodity price trends;
ii. Expanding capacity and enhancing efficiency; and
iii. Diverting to Below-The-Line marketing strategy.

We adjust our FY17 - FY19 earnings projections higher by 5.0% - 7.2% respectively. Upgrade to Buy (from hold) with higher target price of RM1.50/share.

Favourable Commodity Price Trends

We estimate that 30% of Hup Seng’s total costs of production come from refined palm oil, thus the group’s profitability is highly dependent on the movement in CPO price. In the past, Hup Seng’s profit growth has been inversely correlated with the CPO price movement (see Figure 1). In our sensitivity analysis, we find that for every 1 percent decline in refined palm oil price, our projected earnings for Hup Seng will increase by 0.5% vice-versa.

Considering our in-house average CPO price forecast of RM2,700/tonne for 2017, which is 1.9% YoY higher than 2016’s average of RM2,650/tonne, the cost of CPO is expected to drag Hup Seng’s FY17 results performance. In terms of quarterly results performance, FY17 earnings are expected to be back-end loaded as CPO price is expected to weaken to RM2,460/tonne in 2H17 versus RM2,940/tonne in 1H17. Note that Hup Seng’s 1Q17 earnings contracted by 15.7% YoY to RM11.7mn and one of the culprits was high refined palm oil price. As far as sugar is concerned, we understand from management that the sugar price has been on a downtrend. The group is currently paying RM2,600/tonne for its sugar consumptions. This is much lower than our assumption of RM2,780/tonne for FY17-FY19. As such, we tweak our sugar price assumption to RM2,600/tonne for FY17-FY19.

Expanding Capacity and Enhancing Efficiency

Hup Seng has 6 ovens with a production capacity of 39,000 tonnes/annum. It is looking to add another oven to expand the capacity to 45,500 tonnes/annum (+17%) to ease the production congestion issue faced by the company. Currently, management is in discussions with suppliers on the final specifications and we project the new oven to be commissioned by 2H18. Estimated costs for the new oven is approximately RM2.0mn. In the production process, each oven will require six workers to stack the biscuits, crackers and cookies. According to management, the group is exploring the idea of auto stacking system, which would cost approximately RM1.0mn per line, to improve productivity and increase efficiency. For a starter, Hup Seng will implement the auto stacking system onto 1 of the ovens. Currently, the system is undergoing a trial run. When completed, profit margins are expected to expand slightly due to reductions in labour costs and wastage. Given the net cash position of RM105.7mn as at FY16 and expected RM55.8mn and RM56.1mn cash flow from operation for FY17 and FY18 respectively, the estimated capex of RM3.0-4.0mn for each FY17 and FY18 can be financed via working capital. Importantly, it would not affect the group’s ability to pay dividend of 6.0sen/share for FY17 – FY19.

Divert from Above-The-Line to Below-The-Line Marketing Strategy

In the past, the company had been adopting the Above-The-Line (ATL) marketing strategy to reach out to its target customers. This include mass media advertising. Moving forward, Hup Seng would like to divert to Below-The-Line (BTL) strategy, i.e.: buying shelf space at supermarkets/hypermarkets with better visibility and ii) working closely with supermarkets/hypermarkets for sampling activities, which are more targeted to the intended recipients. We are positive on the adoption of BTL on the cost perspective as BTL method generally costs lesser than the ATL method. We tweak our sales and marketing (A&P) expenses lower by 1.8%-pts for FY17 and FY18.

Outlook

All in, we are positive on Hup Seng’s earnings prospects on the back of i) efforts to meet growing demands, ii) initiative to improve efficiency through automated operations, iii) favorable commodity price trends and iii) opting for a more effective marketing strategy. Despite Hup Seng adopting a competitive strategy and has not increased product prices since 2011, we believe future topline growth would be driven by improving consumer sentiment and growing export sales.

Forecast

Given the expected reduction i) sugar costs and ii) sales and marketing expenses, we increase our earnings forecasts for FY17 – FY19 by 5.0% - 7.2%.

Valuation

We upgrade our call from hold to Buy with an increased target price to RM1.50/share (previously RM1.39/share) based on DDM valuation. Downside risks to our call are i) wild swing in commodity prices, and ii) weakening of ringgit against major currencies.

Source: TA Research - 13 Jul 2017